DOCUMENT OF THE EUROPEAN BANK FOR RECONSTRUCTION AND DEVELOPMENT

Evaluation Department Country Strategy Evaluation for Azerbaijan

1 AUGUST 2005

Country Strategy Evaluation for Azerbaijan Preface This draft report is partly based on a mission to Azerbaijan in October 2004, during which Evaluation Department (EvD) staff discussed country strategy issues with the resident office staff, EBRD project beneficiaries, central and local governments, an NGO in the environment sector and members of the international community located in Baku. In addition, all past country strategies were reviewed, including related Board meetings and workshops. This report was carried out by Nicolas Mathieu, Senior Economist of EvD. Marit Varmo, Evaluation Manager, actively collaborated with this Country Strategy Evaluation (CSE) exercise in providing productive background papers. EvD prepared this report in close collaboration with the resident office in Baku and the Office of the Chief Economist (OCE) at headquarters and would like to express its appreciation for their contributions to this evaluation. According to the Approach Paper which was approved by the Executive Committee (ExCom) in September 2003, the preparation of a CSE mainly consists of reviewing a series of strategies over an extended period for a selected country, including: (a) analysing changes in the business environment and the transition challenges that the strategies were facing; (b) assessing the relevance of the strategies in their response to perceived challenges; (c) reviewing the implementation of the strategies; and (d) assessing their impact on transition towards a market economy. The first three steps above, (a) to (c), are part of what is called the top down approach, which starts with the stated country’s economic and sector objectives for each strategy and analyses how they were translated into a portfolio of projects. On the other hand, the bottom up approach, essentially step four or (d) above, consists of assessing the extent to which the projects selected through the strategies generated transition impact, at sector and national levels.1 The latter involves further review of the projects, technical cooperation programmes and policy dialogue that were implemented under the strategies. Both approaches are complementary in assessing the strategy and identifying the lessons learned. Since the EBRD shares transition and development objectives with other members of the international community, the CSE also looks into the contribution of these members - including international finance institutions (IFIs), donors and NGOs toward the fulfilment of the shared objectives. The evaluation focuses on the quality of coordination of EBRD with its development and transition partners and the comparative advantage among IFIs.

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It does this, essentially, by following the methodology of the Transition Impact Retrospective Report for the sector assessments and then assembling the sector results to make an overall assessment at national level. See Transition Impact Retrospective – How the EBRD has advanced transition, European Bank, April 2001, chapter 4 and the Companion Paper, section 4, transition impact summary, pages 97-109.

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COUNTRY STRATEGY EVALUATION FOR AZERBAIJAN TABLE OF CONTENTS ii iii iv v

PREFACE TABLE OF CONTENTS ABBREVIATIONS EXECUTIVE SUMMARY

1. 2.

INTRODUCTION

1

RELEVANCE OF PAST STRATEGIES

1 1 2 2 5

2.1 2.2 2.3 2.4 3.

STRATEGY IMPLEMENTATION

3.1 3.2 3.3 3.4 3.5 4.

The Bank’s investment portfolio Rating implementation of investment priorities Technical cooperation Policy dialogue Rating overall implementation

TRANSITION IMPACT

4.1 4.2 4.3 5.

Background Reforms toward the market economy Transition challenges The strategic response of the Bank

Transition at sector level Transition impact at national level Technical cooperation

COORDINATION WITH IFIS AND DONORS

5.1 5.2

The State Programme for Poverty Reduction and Economic Development framework for IFI coordination Assessing coordination

6 6 7 8 8 10 10 11 13 13 14 15 15

6.

COMPLIANCE WITH ENVIRONMENTAL REQUIREMENTS

16

7.

OVERALL ASSESSMENT AND RATING

17

8.

RECOMMENDATIONS FOR FUTURE STRATEGIES

18 18 20

8.1 8.2

Remaining challenges Recommendations

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COUNTRY STRATEGY EVALUATION FOR AZERBAIJAN ABBREVIATIONS ACG ADB BEEPS CSE BD BTC ED EFSAL EIB ETC EU EvD ExCom FDI GDP IBA IBRD IDP IFC IFI IMF NGOs OCE OGC OL OPER OT PCR PMM PRSC PRSP PSA SMEs SOCAR SOEs SPPRED TA TC TIMS TOR TRACECA UNDP

Azeri-Chirag-Deepwater Gunashli oilfield Asian Development Bank Bank Business Environment and Enterprise Performance Survey Country Strategy Evaluation Banking Department Baku-Tbilisi-Ceyhan pipeline project Environmental Department Enterprise and Financial Sector Adjustment Loan European Investment Bank Early Transition Countries European Union Evaluation Department Executive Committee Foreign Direct Investment Gross Domestic Product International Bank of Azerbaijan International Bank for Reconstruction and Development (also known as the World Bank) Internally Displaced Person International Finance Corporation International Finance Institution International Monetary Fund Non-Governmental Organisations Office of the Chief Economist (EBRD) Office of the General Counsel (EBRD) Operation Leader Operation Performance Evaluation Review Operation Team Project Completion Report Project Monitoring Module Poverty Reduction Support Credit Poverty Reduction Strategy Paper Production Sharing Agreement Small and Medium-Sized Enterprises State Oil Company of the Azerbaijan Republic State Owned Enterprises State Programme for Poverty Reduction and Economic Development Technical Assistance Technical Cooperation Transition Impact Monitoring System Terms of Reference Transport Corridor Europe Caucasus Asia United Nations Development Programme iv

USAID USD WB XMR XMRA

US Agency for International Development United States Dollar World Bank Expanded Monitoring Report Expanded Monitoring Report Assessment

DEFINED TERMS

the Bank

the European Bank for Reconstruction and Development

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COUNTRY STRATEGY EVALUATION FOR AZERBAIJAN EXECUTIVE SUMMARY The country strategies for Azerbaijan have continuously identified three major transition challenges for this country: (a) to create an investment climate that attracts foreign investors; (b) to transform the financial sector in order to fully support industrial development; and (c) to build an efficient infrastructure and utilities network that serves household and industrial clients well. To address these challenges the Bank has tried to diversify its portfolio towards private sector non-sovereign operations in the corporate and the banking sectors. Turning to implementation, the strategic objectives in the natural resource sector were implemented in a timely manner, but targets appear to be under implemented in the corporate and banking sectors. Regarding policy dialogue, the Bank was successful during the 1990s in helping to establish the Production Sharing Agreement (PSA) contractual framework which attracted foreign investors and in increasing national and international awareness of the level of corruption in business practices towards the end of the 1990s. The dialogue became more effective in 2002, when the Bank was able to more effectively promote the private sector development agenda through its participation in the State Programme for Poverty Reduction and Economic Development (SPPRED). The mixed findings on transition impact, which ranged from marginal to satisfactory in the non-oil sectors, are essentially the result of two factors. First, the reform environment has been poor and corrupt practices have been rampant in all sectors. Second, in spite of this adverse environment, the Bank could have been more proactive in identifying business opportunities with local and foreign investors that could generate positive demonstration effects. During the 1990s, coordination with IFIs and donors was adequate at project level. This was not enough, however, to influence the required changes in the pace of structural reforms. The policy dialogue became more complex and effective in 2002 when a consultation network was established through the SPPRED with the active participation of Azeri counterparts in both the public and private sectors. Recommendations: (a) the Bank could be more involved in supporting regional objectives within the country by clustering investment programmes at the regional level; (b) future strategies should continuously focus on the few sectors that are well positioned in the economy and that can fulfil multiple goals, for example agribusiness and rural infrastructure; (c) in order to achieve higher levels of employment and income generation across sectors, the Bank should continue promoting appropriate financial instruments and relying more on microfinance programmes; and (d) in the future, a technical cooperation (TC) grant aimed at supporting the institution building of a large company could precede the lending phase in order to pave the way for reforms associated with future operations.

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COUNTRY STRATEGY EVALUATION FOR AZERBAIJAN 1.

INTRODUCTION

This report reviews five country strategies for Azerbaijan for the period 1993-2004. The period chosen is long enough to evaluate the extent to which the strategies realised their long term objectives of support for progress towards a market economy in a context of commitment to democracy, as defined in Article 1 of the Agreement establishing the Bank. The first strategy was issued in 1993, the second in 1996, with an update in 1997, the third in 1998, the fourth in 2001 and the fifth in 2003. This report is presented along the lines of the Approach Paper for Country Strategy Evaluation. 2.

RELEVANCE OF PAST STRATEGIES

2.1

BACKGROUND

The relevance of the strategies is assessed against: (1) the political context; (2) the macroeconomic performance of the country; (3) the quality of governance in the public and private sectors; and (4) the nature and speed of structural reforms in the country. All four factors determine the level of business opportunities - or business environment - and the related challenges.2 The relevance of each strategy is qualitatively measured by the adequacy of the strategic response to the business environment and related challenges. The political, governance and macroeconomic contexts have been marked by a conflict and then post conflict country. The turbulent internal political period between the declaration of independence in 1991 and the presidential elections in 1993 were associated with an escalation of the conflict with Armenia over Nagorno Karabakh. Although there was a ceasefire in 1994, this did not lead to a peace agreement, leaving the region occupied by Armenia with about 800,000 refugees and internally displaced persons (IDPs) to be resettled in Azerbaijan. The re-election of President Heydar Aliyev in 1998 ensured continuing internal political stability, a return to a controlled macro economy and a steady but slow pace of economic reform. The progress in welfare of the Azerbaijan nation has been hampered however by governance, corruption and human right issues, which have been highlighted by both national and international NGOs. President Aliyev died in the autumn of 2003. His son Ilham Aliyev was elected President soon after. In most respects, there has been a slower pace of reform than expected during the past twelve months. However, political stability and macro stabilisation policies have been maintained. 2

Due to the level of reforms and transition already achieved in different sectors, for each business opportunity there are a number of challenges to be met in order to achieve the next level of transition. Each challenge requires specific strategic interventions from the Bank through investment programmes, technical assistance and policy dialogue. One major finding of the Transition Impact Retrospective report is that the higher the level of the business environment, the greater the transition impact. The role of each strategy is to maximise the transition impact within sectors and across sectors for a given level of business environment.

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2.2

REFORMS TOWARD THE MARKET ECONOMY

Except for the oil sector, the reforms have been very slow. Over the past decade, progress in structural reforms in order to achieve transition towards a market economy in Azerbaijan has been recorded in the EBRD transition indicators country tables issued in the annual Transition Reports. Data for all sectors start with a very low level of reforms during the 1992-93 war, and show a low performance in the second half of the 1990s. During this period, while no peace agreement was foreseen, the government remained conservative with respect to economic reforms. During the past three years, the pace of reforms accelerated somewhat, following a wider opening to the international community and renewed prospects for a peace agreement. In recent years, however, the reforms did not reach a level that would trigger enough confidence on the part of foreign direct investors to intervene on a large scale basis in areas other than the oil sector. Sectoral details indicate the sequence in which reforms were accomplished in Azerbaijan, with external trade, foreign exchange and small scale privatisation coming first and staying at high levels, and competition policies lagging seriously behind.3 Large scale privatisation and banking sector reforms did not progress much during the entire decade of the 1990s.4 There was some acceleration in the performance of the banking sector in the early 2000s. Progress in the successful privatisation of large enterprises has been negligible. Corporate governance and the restructuring performance of large enterprises have been less than satisfactory during the entire period of evaluation. In addition, reforms in the transport, power, and water supply sectors were slow during the mid 1990s and the early 2000s and attempts to privatise telecommunication companies during that period did not lead to agreements that would satisfy both the government and foreign sponsors. 2.3

TRANSITION CHALLENGES

The strategies have continuously identified three major transition challenges for Azerbaijan: (a) creating an investment climate that attracts foreign investors in the non-oil sectors; (b) transforming the financial sector in order to fully support industrial development; and (c) building an efficient infrastructure and utilities network that serves household and industrial clients well. In addition, the strategies identified challenges more specific to the low income, early transition and post conflict characteristics of the country. Finally, other transition challenges were related to the geographical position of Azerbaijan. The country is

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Price liberalisation was implemented as early as 1992. The exchange rate was unified in 1995. While a law on unfair competition was adopted in 1995 and a law on natural monopolies in 1996, the government did not focus on the preparation of a new more widely encompassing and effective competition law until 2004. Small scale privatisation started in 1996 and progressed rapidly during the following year. Privatisation of large scale industry started two years later with the voucher system and then a new privatisation law in 2000, but implementation in this area has been very slow. 4 A Central Bank law was adopted in 1992, but proved to be unsatisfactory. A new banking law was adopted in 2004. However, the presidential decree that enacted the law affected the independence of the central bank. A new Central Bank law that is likely to address this issue is currently under discussion.

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located on the trade route linking east central and western regions south of Russia, referred as the new Silk Route. Improving the investment climate With the introduction of production sharing agreements in the mid 1990s, a reliable, internationally recognised investment framework was established for the development of the oil and gas sector. The business climate for investors in other sectors, however, remained very challenging. The lack of transparency in the privatisation process created an economic environment in which fraud and corruption were frequent. During the early 2000s Azerbaijan introduced notable reforms to its legal system, however, the country continued to face considerable difficulties in implementing legal rules. There was corruption within law enforcement agencies and the judiciary. The challenges facing Azerbaijan were to upgrade its commercial laws, implement regulations for standards that are generally acceptable internationally and to make those laws and regulations fully effective, particularly through the court system reform, the tackling of corruption and other measures to strengthen the rule of law. Strengthening the financial sector The financial sector has been a significant bottleneck to private sector development. The withdrawal of the main foreign owned bank in July 2002 was a major setback to the development of and competition in the banking sector. The banking sector is still very fragmented. Most of Azerbaijan’s banks remain under capitalised and illiquid and, therefore, lack the confidence of the population. Due to the absence of a level playing field, the state owned International Bank of Azerbaijan (IBA) and United Universal Bank continue to dominate the banking sector. At of the end of 2001 the state owned banks controlled 65 per cent of total banking assets. The planned privatisation of the IBA has been repeatedly delayed, mainly due to vested interests opposed to privatisation. The restructuring of the other state owned bank, the United Universal Bank, has yet to start. Non-banking financial institutions remained at a very early stage of development. The insurance sector was undercapitalised and poorly regulated. The pension system was to be reformed, but there are still no active private pension funds in Azerbaijan. Rehabilitating infrastructure A substantial degradation of Azerbaijan’s infrastructure constituted another major obstacle to private sector development and, in particular, to companies operating in rural areas. Companies faced frequent power outages, gas shortages, unreliable water supplies, poor transport infrastructure and inadequate telecommunications services. Utilities suffered financial difficulties. Poor payment discipline from customers and low tariff levels led to an accumulation of debts and utilities were unable to undertake necessary investments for the maintenance and modernisation of their facilities. Against this background the effective implementation of the programme for the commercialisation of energy and water utilities has been a major challenge during the 1990s and the early 2000s. 3

Transport experience slow progress on privatisation. Although reforms gained momentum with the creation of the Ministry of Transport, many transition challenges remain to be addressed. The commercialisation of state owned enterprises in the transport sector should be advanced and competition should be enhanced through the further opening of the sector to private sector investments by granting necessary licences and permits as well as through the implementation of the planned privatisation of state owned transport enterprises. Stalled restructuring in the telecommunications sector. The restructuring of the telecommunications sector has been stalled for many years. The Ministry for Telecommunications continued to combine commercial, regulatory and policy functions. As a result, the telecommunications sector continues to lack transparency and the quality of the regulatory framework remains poor. Foreign investors continued to hold back major investments in that sector, as groundbreaking reforms were not implemented. In 2004, however, significant changes were made to the telecommunications legislation in order to support new momentum in the privatisation of this sector. Challenges specific to early transition countries. One common characteristic of early transition countries (ETCs) resides in their low income per capita. On a GDP per capita basis Azerbaijan remains one of the poorest countries in Europe, despite encouraging economic growth figures during the past years.5 Private sector development and more efficient markets, which are Bank objectives, are part of the solution for poverty alleviation that other IFIs and the international donor community set as a high priority in their assistance policy to Azerbaijan. The above mentioned transition challenges reflect the private sector development issues identified in Azerbaijan’s SPPRED in 2002.6 Regional Integration Azerbaijan’s geographic location has always given it a key strategic position in the development of the southern Caucasus, as well as the integration of Central Asia with Turkey and Europe. The EU has supported the strengthening of this historical trading route under the Transport Corridor Europe Caucasus Asia (TRACECA) initiative. The participation of Azerbaijan and its neighbouring countries in this initiative is an important element of a common strategy towards closer regional integration. A major impetus for regional integration came from the construction of additional pipelines to ship Azerbaijan’s and other Caspian states’ oil and gas reserves to the markets of the Mediterranean and Turkey.

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The results of a household budget survey conducted by the state statistics committee indicate that 49 per cent of the population were living in poverty in 2001. In order to reduce the level of poverty, the government prepared a comprehensive State Programme for Poverty Reduction and Economic Growth in cooperation with international institutions, including the active participation of the EBRD, bilateral institutions, NGOs and the wider civil society. This programme was officially launched by President Aliyev on 25 October 2002. 6 The comprehensive SPPRED was prepared with the support of EBRD and other members of the international donor community in 2002 and it was launched on 25 October 2002. It covers policy reforms and the financing of projects in public and private areas including financial sector development, investment policy, private sector development, the energy sector, rural development, environment, judicial reforms, tourism and culture.

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Working towards a regional agreement that benefits Azerbaijan as well as its neighbours and potential transit countries has been major challenge for foreign policy, but also one where IFI financing may play a role. In particular, a peaceful settlement of the conflict with Armenia should be an important element of a pact for regional stability. Resettlement of IDPs and refugees A lasting regional peace settlement is of significance beyond issues related to Azerbaijan’s strategic location. Providing new economic opportunities for IDPs and refugees were key to containing social tensions arising from the present unequal distribution of Azerbaijan’s oil wealth.7 The government has embarked on a resettlement programme, the success of which relies on regional stability. Job creation through small and medium-sized enterprises (SME) and microfinance programmes should facilitate resettlement and the transition to a market economy. 2.4

THE STRATEGIC RESPONSE OF THE BANK

The response was adequate in the natural resources sector, but less so in other sectors where constraints from the business environment tended to be underestimated. Sector transition In the early years of Bank intervention, the Bank was fully aware of the very low level of reforms in the industry and banking sector and the poor macro economic performance of the war torn economy. The challenges were properly identified at that time. The Bank, however, did not propose much more than exploratory technical cooperation at sector level. This response was in conformity to the low quality of the business environment at that time and was rated as good. Later in the mid 1990s, it became clear that the government was willing to open a key sector, oil, to foreign investors. The Bank then reacted promptly giving a high priority to this sector in its strategies. The relevance of the Bank’s reaction was rated as good. At the same time the Bank, guided by its mandate to develop the private sector, had hoped to assist industry restructuring and privatisation, in spite of very little reform progress in this area. The timeliness of the strategic response was less relevant in that case and was rated as satisfactory. Toward the end of the 1990s the Bank became more committed to private sector development in Azerbaijan beyond oil sector operations. Given the absence of substantive structural reforms in the key sectors of industry, finance and infrastructure, however, the Bank did maintain its strategy in the infrastructure sector, trying to bring about sectoral reforms in terms of regulation and tariffs, while the policy environment was not receptive. The relevance of the strategy was only satisfactory in this case. The Bank further refined its strategy in the banking and SME sectors. In coordination 7

The number of IDPs and refugees from the conflict over Nagorno Karabach represents 10 per cent of the population.

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with international community efforts to help alleviate poverty in a post conflict situation, the Bank focused its strategies on SME and microfinance development. In this way the Bank contributed to positive restructuring and job creation in Azerbaijan. The same positive restructuring approach was applied to the banking sector where the Bank decided to diversify its support from large banks to smaller ones and facilitate their merger. This strategic response in the SME and financial sector was rated as good; the strategies refined in this way became more relevant to challenges specific to early transition countries. This new strategic approach has been subsequently endorsed by the Bank’s ETC initiative.8 Regional integration In the 1998 strategy one of the Bank’s objectives was to support the rehabilitation and expansion of east west communications in Azerbaijan under the EU TRACECA initiative. This strategy shares a cross country development objective which has links with domestic transition impact to a market economy in Azerbaijan, but goes further in that it creates a strong positive externality for a group of countries. The EvD team considers this strategic support to regional development highly relevant to the development requirements of Azerbaijan as well as further consolidation of inter country relations in a delicate post conflict situation. Overall rating for relevance With the previous evaluations of the components of the Bank response at sector level leading to good results and the above statements on regional integration also making room for a good rating, the overall assessment for the relevance of the strategies, which rely upon these two components, was considered to be good. 3.

STRATEGY IMPLEMENTATION

The assessment of the implementation of the strategies is telling with respect to whether the challenges were met on the ground. Implementation refers to the use of three basic instruments: (a) investment and lending projects; (b) technical assistance; and (c) policy dialogue. Each one is reviewed independently. The strategic objectives in the natural resource sector were implemented in a timely manner, but targets appear to be under implemented in the corporate and banking sectors partly due to the disadvantageous business climate. 3.1

THE BANK’S INVESTMENT PORTFOLIO

The growth and composition of the Bank’s investment portfolio for Azerbaijan reveals the outcome of the final decisions on how the Bank assisted the country on its path of transition to a full market economy. In principle, these decisions should adhere to the country strategies covering the same period. Portfolio growth and financial structure 8

There is a distinctive strategy for early transition countries which builds on and supplements EBRD’s current core practice. The strategy includes a focus on smaller scale investments, enhanced SME and microfinance development and targeting institutional reforms.

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The portfolio of Bank investments grew slowly during the entire period under review in terms of number of projects. In terms of cumulated amounts, the portfolio increased faster in the second half of the 1990s, mainly due to the contribution of oil projects. The size of the Bank’s annual new commitments fluctuated considerably due to irregular, large sized oil and gas sector and infrastructure projects. In 2002 the level of new commitments was moderate in terms of investment volume, as they were mainly directed at the financial sector and the promotion of SMEs. In 2003, however, the portfolio increased substantially as a result of major oil and gas as well as infrastructure investments. The disbursement performance was quite good in the oil sector due in large part to the successful implementation of the Production Sharing Agreements (PSAs).9 Disbursements in the other sectors did not perform as well. The implementation of a number of public infrastructure projects has been slower than expected due to delays caused by longer than expected procurement processes and the lack of covenant compliance with respect to the commercialisation of state-owned enterprises. Changes in sector composition Renewed priority was given to the oil sector in the strategies when the government began to open the sector to foreign direct investors. However, the pace of structural reforms in the industry and banking sectors turned out to be much slower than expected. Turning now to the investment priority aspect of strategy implementation, changes of portfolio composition over time are analysed for evidence of response to new priority signals from the 1993, 1996, 1998, 2001 and 2003 strategies. The changes toward a higher share of the natural resource sector during the mid 1990s fully reflects the renewed priority given to the oil sector in the strategies when the government began to open the sector to foreign direct investors. It was expected, however, from the subsequent strategy statements that this share would gradually decrease and leave room for a higher proportion of operations in the non-oil sector. This has not been the case. The pace of structural reforms in the industry and banking sectors was much slower than expected. The Bank then reacted accordingly by focusing its strategic priorities in recent years on the SME and microfinance sectors, the only ones in the non-oil group that were operating according to private sector rules, ownership or competition. A low but significant share of activities classified as SME business is now part of the Azerbaijan portfolio. 3.2

RATING IMPLEMENTATION OF INVESTMENT PRIORITIES

The changes in the shares of the portfolio for the 1993-2003 period indicate differences in the pace and intensity of strategy implementation across sectors. While they did follow the strategic objectives in the natural resource sector in a timely manner, the shifts were lagging in the corporate and banking sectors where the targets appear to have been under implemented. Implementation has been especially disappointing with respect to the restructuring and privatisation of large public enterprises, in that there are no such projects in the Bank’s portfolio. This is in 9

Penalties were included in the PSA contracts in case of delays in implementation.

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contrast to the Bank’s stated objectives with respect to the restructuring and privatisation of large public enterprises, which were at the forefront of strategies in the mid 1990s.10 In addition, the reconstruction and cross border objectives regarding transport projects were not implemented to the extent expected, again due to the lack of structural reforms in these areas.11 Overall, the implementation of investment priorities was satisfactory 3.3

TECHNICAL COOPERATION

TC did not always follow stated strategic objectives for TC. From 1993 to mid 2004, the Bank had arranged and managed 82 technical assistance operations with cumulative financing commitments of €16.1 million in Azerbaijan. The sectors which benefited the most from these funds were financial institutions for SME and micro enterprise lending (44 per cent), the transport sector (29 per cent), the power sector (10 per cent) and the banking sector (9 per cent). The Project Completion Report (PCR) ratings indicate 86 per cent of partly to highly successful technical cooperation. EvD ratings tend to confirm the ratings of the PCR, with the caveat that the sample of evaluated TCs is much smaller. More generally the quality of TC operations was rated as good. As noted earlier, the quantity of technical assistance compared with the number of projects it supports is very substantial. However, the distribution of the TC across sectors does not always reflect the priorities of TC objectives in the strategies. The TC support for Banking SME and transport operations was clearly stated in the strategies. The TC was also concentrated in the power, agribusiness and municipal infrastructure sectors, even though TC objectives in those areas were not as clearly stated in the strategies as separate items. In addition, there were no TCs related to supporting the auditing of major state owned commercial banks as stated in the strategies. Likewise, there were no TC operations reviewing programmes to restructure and support privatisation of state-owned enterprises (SOEs) or focusing on private sector development in infrastructure. 3.4

POLICY DIALOGUE

The Bank was successful during the 1990s in helping to establish the PSA contractual framework which attracted foreign investors in the oil sector. However, the policy dialogue was less successful in other sectors. It became more effective after 2001 through: (a) the Bank’s participation in the State Programme for Poverty Reduction and Economic Development; and (b) a more intensive Bank stand alone dialogue at high levels of decision making. 10

This is primarily due to the failure of the 1995 law on large scale privatisation which was implemented through a voucher system that led to speculation instead of attracting strategic investors. The revised law of 2000 was more favourable to strategic investment but the attached processes lacked transparency. 11 While the strategy documents obviously reflect what the Bank believes to be the key priorities for transition progress, their implementation was to a great extent dependent on the business environment and policy direction. In that sense the overall rating of implementation should take into account the degree of adversity of the business environment which, to a large extent, is an external factor and weight (discount) the components of the overall rating accordingly. On the other hand, it is expected that the Bank, in close coordination with other members of the international community, will proactively seek an improvement in the business environment through policy dialogue and will refine its strategy in order to break the ground with projects and technical assistance carrying high demonstration effects. There should not be room for discounts in the implementation ratings where strategic priorities are set in poor or slowly improving business environments.

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Macro and sector levels In the area of macro policy dialogue, the Bank made a forceful attempt to increase the awareness of the extent of corruption in business practices in Azerbaijan through the 1999 BEEPs survey, by disclosing and discussing the results with the authorities. The Bank did not, however, receive the support of the authorities. Like other IFIs, the Bank found a government concentrating on oil development issues on one side and conflict resolution over Nagorno Karabakh on the other. At sector level, the Bank was successful in the 1990s in helping to establish the PSA contractual framework which attracted foreign investors. During this time period, the Bank was less successful in promoting reforms in the financial, industrial and infrastructure sectors. •

The senior management of the Bank proactively discussed with the authorities a reform programme for the banking sector that was centred on the privatisation of the main Azeri bank, the IBA, and the strengthening of the other banks in order to increase competition. The privatisation of IBA did not materialise since there were strong local interests opposed to the privatisation. The strengthening of the potentially competing banks, however, received the support of the authorities.

•

In the industrial sector, senior management also carried out an ongoing policy dialogue to help restructure and privatise large public enterprises. However, the lack of transparency in the privatisation process was the major obstacle to a successful outcome.12

•

In the power and utility sectors, the dialogue on institutional reforms to increase the independence of public sector enterprises achieved some results. On the other hand, the dialogue on tariffs, recovery of receivables and financial autonomy has been very slow.13

Later on, starting in 2002, the Bank was able to more effectively promote the private sector development agenda when it chose to help prepare and support the recommendations of the SPPRED, which included: (a) government commitments to the transparent management and sensible utilisation of revenues generated by the oil and gas sector; and (b) improvement of the investment climate. Senior management also became more proactive in its dialogue on private sector reforms with high level authorities in 2003 and 2004. Legal transition While Azerbaijan’s commercial laws have gradually improved during the past three years, they still fall short of internationally accepted standards. Azerbaijan’s 12

The situation has substantially changed since the 1990s. In December 2004, the government of Azerbaijan held an investors conference in London at EBRD headquarters that was successful and well attended and the recently established Azerbaijan Investment Promotion Foundation appears to be quite entrepreneurial. 13 The policy dialogue regarding infrastructure and utilities improved in 2004, as key government counterparts indicated a renewed interest in actively pursuing tariff and institutional reforms that will further increase the commercialisation of public entities.

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commercial legal rules that affect commercial transactions, such as debt restructuring and joint stock companies, fare poorly compared with those of more developed countries. These legal rules are not sufficiently clear and accessible and they are not as adequately implemented administratively and judicially as they would be in more developed countries. The gap between the quality of the laws on the books and their implementation was attributable to weaknesses in the legal system, in particular difficulties in ensuring adequate respect for the rule of law in court decisions. The international donor community is aware of this issue and keeps providing support toward building more independent and effective judiciary institutions. The Bank’s focus has been on private sector transactions. The Bank provided substantial assistance on secured lending procedures, as well as foreign investment protection and bankruptcy procedures. The impact of the law on mortgages of 1998 was undermined when the new civil code took over some key features of that law and put them into the code in an uncoordinated and contradictory manner. 3.5

RATING ON OVERALL IMPLEMENTATION

The main component of the ratings is investment priorities since this is what the Board strategic documents focus upon. It should, therefore, have a heavier weight in the overall rating. Policy dialogue and legal transition must still carry a significant weight in the evaluation since they are the necessary complements to achieving transition impact at sector level. Overall, the support for legal transition was substantial, focusing on the key financial sector issues identified in the strategies. Interventions in macro and sector policy dialogue remained limited outside of the oil sector, especially in industry, power and utilities, leading to an overall policy rating of satisfactory to good. As noted earlier, the main component, investment, does not appear to have followed the diversification priorities identified in the Board documents to the extent that was advocated and its implementation record was only satisfactory. Therefore, the bottom line of the implementation component in the strategy evaluation was rated as satisfactory. 4.

TRANSITION IMPACT

The transition impact of the strategies for Azerbaijan is essentially the result of two factors: (a) the ability of the Bank to effectively encourage transition progress over years according to its mandate; and (b) its capacity to coordinate with other IFIs and donors who share the same transition goals, in order to further enhance the transition impact. Since the transition impact of a project keeps evolving during its implementation and beyond, the timing of the rating is particularly crucial in the assessment. The rating for Azerbaijan appears quite robust, as different methods at different times appear to

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converge to the same assessment.14 The rating of transition impact (TI) of Bank operations at sector level was first assessed in the framework of the Transition Impact Retrospective in 2001 as satisfactory. The ratings from EvD reports and expanded monitoring report assessments (XMRAs) confirmed this rating. The overall outcome from the EvD strategy assessment exercise in 2004 using the TIR methodology with updated project data further confirms the initial rating of satisfactory.15 The results mainly reflect the difficulties of Bank interventions in achieving transition impact in non-oil sectors which are well recorded in the EvD’s operation performance evaluation reviews (OPERs) and XMRAs. 4.1

TRANSITION AT SECTOR LEVEL

The transition impact performance of EBRD projects for the period 1994-2003 in the different areas highlighted by the country strategies is summarised below. •

Banking sector - small banks are being strengthened but large bank still lack transparency. The Bank has been tackling two transition challenges in the banking sector, - institutional strengthening and privatisation. It has fairly good presence in the sector. The Bank has been working with key players in the sector. Clients include larger Azeri banks such as IBA, the Bank of Baku, Azerdemiryolbank, Azerigazbank and Unibank. The latter was the first private financial merger in Azerbaijan. The Bank, however, has not been able to help privatise IBA, the dominant bank in Azerbaijan, mostly because the final capital ownership structure remained unclear and left room for strong vested interests that were opposed to privatisation. In retrospect, the de facto abandonment of direct support for the privatisation of IBA protected the Bank from entering into a transaction that would not have been transparent enough in the eyes of the international business community. The Bank then turned to a strategy of strengthening the other banks. Since these banks are considerably smaller then IBA, this new approach will not bring a real competitive structure to the sector in the immediate future. In the meantime, the problem of a dominant publicly owned Bank remains intact.

•

The SME sector needs more policy dialogue and microfinance must develop beyond Baku. The Bank has tackled one transition challenge, increased access to local commercial finance, and has fairly good presence in the banking sector. The Bank is working with several key players in the sector, including the Bank of Baku, Azerdemiryolbank, IBA and Unibank. It has also been involved in the

14

EvD’s ratings are evaluations of the TI of projects after final disbursements (i.e. realised TI). The Chief Economist Office ratings determined through the Transition Impact Monitoring System (TIMS) are estimates of the TI potential. The TIMS tracks projects through their life cycleand usually applies to projects of recent years. For the projects that are still ongoing and that have a TIMS rating, both the TI potential rating and the risk to TI are presented. 15 The sample of projects covers all the 35 active and completed projects in Azerbaijan as of June 2004 for a total amount of €352 million. Each project has been classified according to the transition challenges it was addressing and the Bank’s response to these challenges, according to the event line approach used in the TIR report. The contribution of the project to the transition of a sector is based on its TI rating within the sector, as well as on the number of challenges that have been addressed, the number of operations, the involvement of key players and the associated technical cooperation and Bank policy dialogue within the sector, in accordance with TIR benchmarks. EvD evaluation covers 17 of the 35 projects, in OPERs and XMRAs.

11

establishment of a greenfield financial institution, the Azerbaijan Microfinance Bank, in order to provide financial services to SMEs in Azerbaijan. The business is developing relatively fast, but is still limited to the Baku area. •

General industry sector experienced lack of real commitment to privatisation. The Bank was tackling one transition challenge, increased access to external finance, but has little presence in the general industry sector with only one regional project. The Client is sponsored by a direct investment arm of a major US based insurance and financial group. Industrial operations from this group in Azerbaijan have been minimal. The number of solvent large scale private companies operating outside the oil and gas sector continues to be small. These companies generally use old accounting standards and questionable governance practices. As a result the Bank has yet to finance such companies.

•

Agribusiness sector saw missed opportunities. The Bank was tackling one transition challenge, low productivity in agroprocessing enterprises, but so far has little presence in the agribusiness sector with only two projects.16

•

Natural resources sector experienced good to excellent transition impact. The Bank has tackled three transition challenges in the natural resources sector: (a) private sector participation; (b) legislation to offer security to foreign investors; and (c) removal of transport bottlenecks. The Bank has substantial presence in this sector. It is working with highly visible international players under PSAs with the State Oil Company of Azerbaijan. In the mid 1990s the Bank was instrumental in the establishment of PSAs that created the proper contractual framework to attract foreign investors. Presently, the Bank is supporting the restructuring of the State Oil Company, SOCAR, through a TC operation with other IFIs. The Bank is also supporting institutional changes toward more transparent and effective use of oil revenues.

•

Property and tourism experienced cases of both good and bad transition impact. The Bank has tackled one transition challenge in the property and tourism sector, skills transfer, and has some presence in the sector with three projects. New managerial and accounting skills developed through the Landmark project had some demonstration effects in the sector. The Bank is currently supporting the preparation of a new register for mortgages.

•

Transport saw slow reforms and slow transition accomplishments. The Bank was tackling two transition challenges in the transport sector, public enterprise restructuring and systems upgrade, and has some presence in the sector with three projects. The clients were visible key players in the sector and include the state railway of Azerbaijan, the State Concern for Civil Aviation and Baku Port, one of the largest ports in the country. However, the loan for the latter project was cancelled as requested by the borrower and exhibited no significant transition impact.17

•

The municipal and environmental infrastructure sectors experienced project conditionalities that take time to be fulfilled. The Bank has been tackling one

16

One of which was recently approved in the dairy sector. This cancellation was due to continuing conflicting views on the opportunity of such a project among public sector authorities and vested interests.

17

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transition challenge in the municipal and environmental infrastructure sectors, corporatisation of municipal utilities, and has little presence in the sector with only one project. The Bank has been working with the Aspheron Regional Water Company (ARWC), which is responsible for the production and distribution of water in the Baku metropolitan area. Progress on tariff reforms and cost recovery has been slow. •

4.2

Power and energy - little transition impact beyond the company. The Bank was tackling one transition challenge in the power and energy sector, efficiency gains and company management strengthening of power plants, and had some presence in the sector with two projects. The Bank has been working with Azerenerji, the state owned company responsible for power generation, transmission and distribution. Progress toward the use of commercial practice in power companies beyond companies in which the Bank invested has been slow. TRANSITION IMPACT AT THE NATIONAL LEVEL

While the oil sector which was rated good and excellent represents a large part of the portfolio, the overall rating was still satisfactory, because a key element of the strategy for Azerbaijan was to diversify away from oil and facilitate transition in nonoil sectors. In these areas the evaluation has been predominantly satisfactory. The mixed findings on transition impact could be related to previous findings on the relevance and implementation of strategies. First, the priorities selected from one strategy to the next in the non-oil sector did not always match opportunities from the business environment. Second, while significant policy dialogue occurred in the oil sector with the establishment of the PSAs and later the oil fund, the dialogue on structural reforms was almost non-existent up to the second half of the 1990s in the areas of privatisation of large industries and utilities. It became significant only in recent years within the framework of the preparation and implementation of the SPPRED. The slow pace of reforms outside the oil sector in the 1990s and early 2000s appears to be neither due to the Bank’s attitude during that period, nor to its partners from the international community. It is mainly the outcome of the political orientation of the government, which was unwilling to undertake radical measures to increase foreign direct investment outside of oil at that time, and the caution of the international business community, due to its awareness of the adversity of the business environment. Now that the principle of reforms in both public and private sectors have been accepted by the government and investment opportunities for the private sector are growing fast, the prospect of realising higher transition impact through the involvement of international sponsors appears to be more promising. 4.3

TECHNICAL COOPERATION

Since most technical assistance is closely associated with projects, it is not possible to assess its direct effect on sector transition as separate from projects. However, the distribution of technical assistance across sectors should contribute indirectly to maximising transition impact in each sector. In the implementation section, the findings were that, in general, the quality of the technical assistance was good, but the sectoral distribution did not always match the stated priorities in the strategies 13

regarding TC. 18, 19 When the transition impact dimension is added to these findings it is notable that, for SME and transport, both of which were stated as priorities in the strategies and received technical assistance, there was a better transition impact than what was observed in other non-oil sector categories. This could be an indication of the positive impact of technical assistance. 5.

COORDINATION WITH IFIs AND DONORS

During the 1990s, coordination with IFIs and donors was adequate at project level. This was not enough, however, to change the pace of structural reforms. The IFIs and donor partners of EBRD in Azerbaijan selected post conflict reconstruction, poverty alleviation, cross border links and public sector reforms as the main strategic objectives for their assistance programmes. They were aware of the importance of private sector development, however, and intervened accordingly. The public sector reforms aimed at channelling oil resources to appropriate public uses in a transparent manner should create a better environment for the development of the private sector. The partner IFIs used both adjustment policy loans and project loans. Most of the project loans were in the social and infrastructure sectors. Some of the IFIs, for example the International Finance Corporation (IFC), directly intervened in the private sector, for instance in food processing and SMEs. EBRD’s main counterparts were the International Monetary Fund (IMF), the European Union (EU), the World Bank Group, the United Nations Development Programme (UNDP) and bilateral donors. In terms of resource transfer, the EBRD and the EU come next to the World Bank group, with similar amounts (see the chart below). Total Lending/Assistance to Azerbaijan by IFIs and the EU 1992 - 2003 (m EUR) 600 500

EUR m

400 300 200 100 0 WB (IDA)

IFC

EBRD

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EU

There are notable exceptions where some key TCs were evaluated as unsatisfactory. While the TC operations are tied to investment projects and the EvD evaluation team mentioned that investment projects did not entirely match priorities, the TC can be also be assessed independently regarding priorities especially those set for TCs in strategies. The early strategies for Azerbaijan rightly put emphasis on SMEs and offshore oil field development, as the first priority, and banking, telecommunications, transport and agribusiness as the second priority, in order to pave the way for investments in these areas.

19

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Source: World Bank group, EU websites, EBRD investment database

5.1

THE STATE PROGRAMME FOR POVERTY REDUCTION AND ECONOMIC DEVELOPMENT FRAMEWORK FOR IFI COORDINATION

The policy dialogue became more dense and effective in 2002 when the State Programme for Poverty Reduction and Economic Development consultation network was established. Against the background of the high poverty level and early transition in Azerbaijan, it was crucial for IFIs to ensure the continuing support of the population in moving toward a market economy as a way to increase national welfare with more efficient allocations of national resources. To further move its strategic goals within the broader context of international support for Azerbaijan, EBRD staff participated in the IFIs’ mission to launch the preparation of the SPPRED in 2002 and contributed with other IFIs to the private sector development analysis and recommendations. The SPPRED addressed the interrelated issues of the use of oil resources, industry diversification, private sector development and poverty alleviation. The SPPRED acknowledged that the current business environment was a significant obstacle to broad based growth which relied more upon a market economy.20 5.2

ASSESSING COORDINATION

During the evaluation a judgment has to be made as to what extent IFIs and donors were instrumental in completing and amplifying the Bank’s efforts to achieve transition impact at sector and national levels. The assessment consists of evaluating the Bank’s ability to: (a) perceive and hold its relative advantage within the context of the many interventions by the international community on behalf of Azerbaijan; and (b) seek complementary actions from others through coordination in order to enhance the impact of its own initiatives, an approach which was recently endorsed by the ETC review.21 Overall coordination was rated as good. The SPPRED exercise in 2002 created a close collaboration among IFIs, donors, government, private entrepreneurs and NGOs that did not exist before. (In the above sentence, please specify what Ibis stands for.) The nomination of new government ministers favourable to the SPPRED further strengthened the consultation process. The SPPRED generated a genuine division of labour among IFIs, with UNDP supporting the management of the State Programme, IFC investing in leasing companies, the U.S. Agency for International Development (USAID) providing technical assistance to the public and private sectors and the 20

The Azerbaijan economy has been highly dependent on oil and gas related activity, with extraction and processing contributing more than 30 per cent of GDP in 2001. The government’s medium term expenditure framework, which was established in 2002, provided a new financial basis for the implementation of the investment components of the SPPRED. These investments have been financed by domestic sources consisting of the state budget and the State Oil Fund as well as by external sources provided by multilateral and bilateral institutions. The programme also stresses the urgent need to achieve balanced economic growth and, therefore, aims at fostering private companies in the so called non-oil sectors. In order to achieve this goal the government is facing the challenges of improving the investment climate, attracting foreign investment, accelerating the privatisation of medium sized and large enterprises, strengthening the financial sector and improving infrastructure. 21 The relative advantage of the Bank is understood here as the past and future ability to identify transition challenges toward market economy at project, sector and national levels and to respond to these challenges.

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World Bank and the Asian Development Bank (ADB) intervening in the social and infrastructure sectors and supporting structural adjustment. EBRD focused on SME and microfinance development which, in addition to transition, had social and welfare dimensions that are relevant to objectives of the Bank’s ETC initiative.22 At sector level, the Bank cooperated closely with the IFC on the financing of the Baku-Tbilisi-Ceyhan (BTC) oil export pipeline and the Azeri-Chirag-Gunashli (ACG) Phase I oil upstream projects. In association with the financing of these large scale projects, the Bank worked together with the IFC on the arrangement of major commercial bank syndicates, the promotion of backward linkages, environmental risk mitigation, the provision of financing and technical assistance to the local supply industry and the improvement of the investment climate facing these local companies. In the future, however, the oil and gas industry in Azerbaijan is likely to find more private sector funding without further participation of IFIs. This could then accelerate the shift of emphasis in Bank investments from oil to non-oil operations. 6.

COMPLIANCE WITH ENVIRONMENTAL REQUIREMENTS

The Challenges. Environmental pollution continued to impose high economic and social costs on Azerbaijan. The government approved a National Environmental Action Plan (NEAP) in January 1998. The main environmental problems identified in the NEAP and requiring urgent responses were pollution resulting from oil exploration and production, poor water quality, the lack of pollution abatement equipment and the industrial use of low quality raw materials.23 The Bank’s response. One of EBRD’s environmental initiatives has been the development of the Azerbaijan National Oil Spill Contingency Plan, which was proposed in view of increasing petroleum development and shipping activities. This contingency plan contains provisions for regulating oil spills and waste discharges in the Caspian Sea, identifying available oil spill combat resources, appropriating response strategies and outlining response and notification procedures in line with relevant international conventions. EBRD has mobilised donor funds for this Plan. The EBRD has continued to support the application of international environmental standards for its investment projects in Azerbaijan as well as fostering community development programmes to improve the living conditions of local populations affected by investment projects funded by the EBRD.24 The most discussed project was the financing of the BTC oil pipeline in 2004. Due diligence was fully achieved with the support of the principal sponsor of the project. The Evaluation Team found from field interviews that there is a lack of coordination among donors and IFIs with respect to their investment operations in the area of 22

In SME lending or microfinance, women are handicapped in loan applications because they do not know how to prepare business plans. Refugees and IDPs have access to credit. Technical assistance on access to credit is needed. 23 Poor water quality, especially of drinking water, both in rural and urban areas, caused an increase of water born diseases. Piped drinking water supply is available to less than 50 per cent of the population. The shortage of water resources is further aggravated by losses during distribution in the agricultural sector, which accounts for 70 per cent of the total water usage. 24 For example, the modernisation and improvement of the sewage system in Sangachal.

16

environment protection and safeguards. The country needs to rely more on rules that are adapted to the conditions in Azerbaijan. The country does not have the institutional capacity to immediately reach all levels of international standards, especially as they are becoming tighter. With donors’ support, however, the country would be able to reach higher standards and get closer to the international benchmarks. 7.

OVERALL ASSESSMENT AND RATING25

The Bank has played a significant role in promoting Azerbaijan’s transition to free market practices in the oil sector. It did not achieve a similar level of achievement in the other sectors of the economy. This is a departure from the strategic objectives which repeatedly focused on diversification toward private non-oil operations. The strategies tended to underestimate the unreformed business environment in the non-oil sector which became a major obstacle to implementation. While genuine attempts were made in practice to diversify the Bank portfolio away from oil over the years, investment programmes for the private non-oil sector in Azerbaijan could have been larger. The EBRD could have been more proactive in finding business opportunities with local and foreign sponsors, leading to operations that would have carried a positive demonstration effect.26 In retrospect, too much was done for the public sector through sovereign guarantee operations and not enough was done with the private sector, which would have been more risky. The Bank staff could have increased networking with the local and foreign business community, through investment conferences and other promotion means.27 The failure to achieve a transition performance in the non-oil sector in line with the strategic objectives happened in an adverse reform environment. In spite of determined efforts to increase awareness of corruption practices and help manage oil revenues in a more transparent manner, the Bank could not successfully promote private sector reforms without the close collaboration of the international community. During the 1990s, coordination with IFIs and donors was adequate at project level.. This was not enough, however, to change the pace of structural reforms. The policy dialogue became more dense and effective in 2002 when the SPPRED consultation network was established and a new government team was put in place. The main ratings for this evaluation are recalled below.

25

In line with the objective of this evaluation exercise, the overall assessment exclusively covers the Bank’s performance, as distinct from the government reform performance, which was summarised in the Relevance section of this report. 26 This finding is not specific to Bank handling in Azerbaijan. EBRD has to do more to find opportunities to invest. Most of these opportunities and the Bank’s potential clients are to be found locally. In extending its reach, the Bank should be open to work with a wider variety of intermediaries and it should be ready to undertake pilot projects to test ways of achieving greater impact in its chosen sectors. 27 The Bank is becoming more proactive in identifying projects that can attract foreign sponsors in the banking and industrial sectors and the Bank is hosting conferences to promote investment in Azerbaijan.

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SUMMARY COUNTRY STRATEGY RATINGS: Azerbaijan Main components Relevance of stated priorities 1/ Strategy implementation 1/ Transition impact Coordination with other IFIs and donors

Rating Good Satisfactory Satisfactory Good

1/Including reconstruction and development of cross border links.

8.

RECOMMENDATIONS FOR FUTURE STRATEGIES

A country strategy evaluation is essentially a retrospective exercise for determining accountability and lessons learned. Very often, the lessons learned can be extended beyond the immediate context in which they are derived, and generate recommendations for the future. In addition, the review of past strategies helps identify remaining challenges that can eventually help in the design of future strategies. 8.1

REMAINING CHALLENGES

The major remaining challenges are to selectively put enterprises in a position to pursue privatisation in industry and accelerate the commercialisation of the infrastructure and utility sectors. More specific issues, which could be initial conditions for a new strategy, have been noted by the Evaluation Team from its conversations with public and private sector counterparts during the mission of September 2004. They are the following: FINANCIAL SECTOR The banking system still needs to be restructured. The main constraint to the development of the rural non-oil economy appears to be the bank and non bank components of the financial system. The banking sector is dominated by IBA. IBA has US$ 800 million in assets, about 70 per cent of total banking assets, and capital of about US$ 20 million. The other part of the banking system comprises about 50 banks, many of which are small with a US$ 5 million capital structure each. In addition, IBA is keeping the monopoly of accounts and loans of public enterprises, including the State Oil Company of the Azerbaijan Republic (SOCAR) and of the clearing house for the unique national credit card, Azericard. Moreover, the quality of the current portfolio is believed to be uneven as a substantial share of its credit goes to public companies that may not be creditworthy, while it could be crowding out increased credit demand from private business. The major challenges facing the sector are: (a) the creation of a competitive legal environment which would give small banks access to the same financial instruments as large bank; (b) merging small banks so that they reach the scale of operations and profitability that could compete with IBA28; and (c) developing the components of the 28

The small banks with US$ 5 million should merge into larger banks with US$10-15 million in capital. In the second stage the banks with US$ 10-15 million should be further merged into banks with US$ 30-50 million

18

financial sector that could directly meet this new demand on capital29. Before restructuring the banking system and attracting FDI in the sector, financial markets should reach a minimal level of development so as to create a demand for banking intermediation including treasury bills, treasury bonds, corporate bonds, money markets and a securities market. PRIVATE SECTOR DEVELOPMENT IN RURAL AREAS Bringing rural enterprises to a competitive full market economy. A large component of the non-oil sector is the rural sector which covers 40 per cent of total employment in the country. Reliable power supplies, transport services and road infrastructure are also seriously lacking. The SPPRED of 2002 includes a regional development programme that was adopted recently.30 The government is creating incentives for integrated regional development by investing in transport infrastructure and utilities. There is a great deal of potential business in food and vegetable processing and packaging, tourism and textiles.31 INFRASTRUCTURE New opportunities need to be created in the infrastructure sector to accelerate reforms. Infrastructure development will keep presenting the same kind of challenges of commercialisation as in the past, but to a lesser degree as substantive progress was accomplished under recent IMF and World Bank programmes. Great caution should be exerted in this area to make sure that a minimum of government commitment and institutional capacity is fully present to help ensure that the policy covenants in the projects will be more effective than they were in the past. More coordination with IFIs, which have leverage at sector level through sectoral adjustment loans, should also be explored. EBRD loans could be further facilitated when the reforms are advanced enough and before ADB intervenes to a larger degree. TECHNICAL ASSISTANCE The new Bank ETC policy encourages technical assistance to break the ground for market oriented investment operations. Taking into account the lessons from an EvD evaluation of a major TC operation in the financial sector, EBRD and donor assistance experiments should be renewed, provided that real needs and an 29

.Presently, Azerbaijan has a basic bond market and a foreign currency market and will be able to borrow internationally. 30 Unemployment outside of Baku remains high and has already triggered, under the SPPRED umbrella, a number of regional policies to promote entrepreneurship and job creation. Several microfinance banks are already there. The EBRD supported microfinance bank could branch out as well and take a share of this growing market. Compared with existing schemes which are mostly subsidised, the EBRD supported financial products would be sold at market prices as the demand would be strong enough to accommodate both instruments. The ETC initiative is an extremely positive development for Azerbaijan, particularly in that it helps to diversify the economy both sectorally and regionally through SME and microfinance programmes. 31 The degree of fragmentation of agricultural properties might be an obstacle to the efficient collection of raw fruit and vegetable products for agro processing. On the other hand, some land consolidation has occurred after privatisation, as old kovkoze managers try to repurchase the land that had been redistributed in their districts.

19

appropriate degree of absorption are identified. More effective outside incentives, like good banking supervision and clear private ownership could also be significant factors of success. 8.2

RECOMMENDATIONS

The recommendations from this evaluation range from strategy design to implementation and impact. RECOMMENDATION 1: Alleviation of shortages of essential services and job creation should emerge as key priorities in post war economies. When a country in the early stages of transition is considerably slowed down by war and shortages in the supply of essential utilities, the preconditions for generating transition impact are not present. The first strategic priorities should be reconstruction, alleviation of shortages and job creation. When a minimum of market conditions are met, then the strategies should attempt to move from infrastructure and natural resource investments to more direct private sector development activities. RECOMMENDATION 2: To the extent possible, strategies in low income countries should help alleviate poverty while promoting the transition to a market economy. The poverty reality in ETCs cannot be ignored. It is important to identify the segments of society that carry the cost of adjustments toward the market economy and those that have the potential purchasing power to develop that economy. Among the various paths to transition, the ones that ensure a minimum level of welfare will provide enough of a social safety net for a durable transition to occur.32 This approach requires coordination with other members of the international community who set poverty alleviation as a primary target in these countries. The strategies of the Bank should be consistent with the private sector development component of poverty alleviation strategies prepared by the government with the assistance of the international community. RECOMMENDATION 3: Regional development within a country should be encouraged through enhancing investments in microfinance and SME activities. This recommendation is in line with the recommended policies of the SPPRED for Azerbaijan and the Bank ETC review recommendations. The Bank supported microfinance bank is creating regional branches and training more loan officers. Regional development calls for better infrastructure networks including roads, power, and water supply. EBRD could also be more involved in supporting regional 32

The rural poor should be protected in order to avoid urban migration which is too rapid and to gain their support for market oriented reforms in rural areas.

20

objectives in clustering investment programmes - or some of their components - at the regional level.

RECOMMENDATION 4: When the initial steps to transition are difficult to achieve in the context of a difficult business and political environment, the strategies should continuously focus on the few sectors that potentially carry multiple impacts. In post conflict economies, when multiple objectives are to be reached simultaneously in a wide range of areas such as transition impact, cross border links, reconstruction and private sector development for job creation, the strategies should continuously focus on the few sectors that are well enough positioned in the economy so that they can fulfil multiple goals.33 Agribusiness and supporting rural infrastructure are well positioned for future Bank interventions. RECOMMENDATION 5: In low income economies, microfinance strategic priorities should be established at early stages in order to ensure a better balance of the transition process across sectors and geographical areas. When strategies pursue both post conflict recovery objectives and transition impact and intend to achieve desired levels of employment and income generation, they should promote appropriate financial instruments. They should, therefore, rely more on microfinance programmes, through existing commercial banks (in downscaling from SME to microfinance) and non-bank financial institutions. RECOMMENDATION 6: When large areas of economic sectors remain unreformed and need substantial policy dialogue upfront, well targeted sector TC work should precede Bank investments. In the past, when institutional reforms were associated with a project in the utilities and infrastructure sectors, the restructuring and commercialisation plan was often condensed into one package that the supervisory authorities could not implement at once for lack of political willingness or institutional capability. In the future, a TC grant aimed at supporting the institution building of a large company could precede the lending phase in order to pave the way for reforms associated with future operations. The same approach is currently applied to the industrial sector for large scale restructuring and privatisation (SOCAR). RECOMMENDATION 7: Policy dialogue and donor coordination need a common formal framework among donors and local counterparts in order to operate efficiently.

33

Especially in the case of returning refugees and IDPs.

21

When sectoral reforms require many policy changes that will be difficult to implement, the Bank policy dialogue should be steadily carried out in close cooperation with other international and bilateral institutions, within a formal framework in which the government and the private sector can participate. The full ownership of the consultation process by the government, NGOs and the local business community is essential in order for the policy dialogue to succeed. The poverty reduction strategy framework could make a good forum for public and private sector reforms.

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