RAIL TRADE AND TRANSPORT FACILITATION PROJECT OF THE REPUBLIC OF AZERBAIJAN LOAN AGREEMENTS NUMBER 7509-AZ AND 8282-AZ Special-Purpose Financial Statements and Independent Auditors’ Report For the Year Ended December 31, 2017 RAIL TRADE AND TRANSPORT FACILITATION PROJECT OF THE REPUBLIC OF AZERBAIJAN TABLE OF CONTENTS Page STATEMENT OF MANAGEMENT’S RESPONSIBILITIES FOR THE PREPARATION AND APPROVAL OF THE SPECIAL-PURPOSE FINANCIAL STATEMENTS FOR THE YEAR ENDED DECEMBER 31, 2017 1 INDEPENDENT AUDITORS’ REPORT 2-4 SPECIAL-PURPOSE FINANCIAL STATEMENTS FOR THE YEAR ENDED DECEMBER 31, 2017: Special-purpose balance sheet 5 Statement of cash receipts and payments 6-7 Statement of project activities 8-10 Statement of designated and project accounts 11 Statement of expenditure and summary sheet withdrawal schedule 12 Notes to the special-purpose financial statements 13-18 RAIL TRADE AND TRANSPORT FACILITATION PROJECT OF THE REPUBLIC OF AZERBAIJAN NOTES TO THE SPECIAL-PURPOSE FINANCIAL STATEMENTS FOR THE YEAR ENDED DECEMBER 31, 2017 (Amounts expressed in the United States Dollars unless otherwise indicated) 1. DESCRIPTION OF THE PROJECT On December 18, 2009, the Republic of Azerbaijan (“Recipient”) and the International Bank for Reconstruction and Development (the “IBRD”) have agreed to lend to the Recipient, on the terms and conditions set forth or referred to in the Loan Agreement 7509 AZ (the “Loan Agreement”), a credit facility in the amount equivalent to 450,000,000 United States Dollars (USD 450,000,000) (the “Loan”) to assist in financing the project described in Schedule 1 to the Loan Agreement (the “Project”). The Project’s original completion date of September 30, 2013 has been extended to December 31, 2017 on September 17, 2013. The Project has four months grace period for disbursement beyond the completion date On June 27, 2013, the IBRD and the Government of Republic of Azerbaijan agreed to restructure the Project by providing additional financing in the amount of USD 220,000,000 and extending the closing date to December 31, 2017 (Loan Agreement 8282 AZ). The additional financing will be used for full replacement of power supply and signaling systems on the East-West Main Line. The objective of the Project is to improve railway services in the Republic of Azerbaijan, as well as the competitiveness, financial sustainability, operating and cost efficiency and capacity of the Azerbaijan Railways CJSC in particular along the east-west transport corridor. The Project consists of the following components: Component 1: Rehabilitation of East-West Main Line (a) Rehabilitation of about 240 km of mainline track; (b) Conversion of power supply on the East-West Main Line; and (c) Upgrading signaling, compatible with the new 25kV AC power supply system. On June 27, 2013, the IBRD and the Government of Republic of Azerbaijan agreed to restructure the Loan Agreement and correspondently, additional 298 km of mainline track was included in the scope of Component 1. Component 2: New Mainline Locomotives This is provision of goods and services in order to provide mainline 25kV AC electric locomotives to operate on the east-west corridor. The Recipient and IBRD agreed to finance the new mainline locomotives directly using the funds of Government of Republic of Azerbaijan and requested the IBRD to reallocate USD 202,000,000 to the rehabilitation of the East-West mainline of Component 1. Component 3: Modernization of Azerbaijan Railways Services Provision of works, goods, services and training in order to: (a) Support the implementation of the restructuring and development of Azerbaijan Railways CJSC, including, but not limited to, for the transition to the International Financial Reporting Standards and legal restructuring of the Azerbaijan Railways CJSC; and (b) Improve its oil spill prevention capacity. 13 RAIL TRADE AND TRANSPORT FACILITATION PROJECT OF THE REPUBLIC OF AZERBAIJAN NOTES TO THE SPECIAL-PURPOSE FINANCIAL STATEMENTS FOR THE YEAR ENDED DECEMBER 31, 2017 (Continued) (Amounts expressed in the United States Dollars unless otherwise indicated) Component 4: Project Implementation This is support of the PIU for effective implementation of the Project, through provision of goods, consulting services and training. 2. BASIS OF ACCOUNTING Statement of compliance The Special-Purpose Financial Statements have been prepared on the cash basis of accounting in conformity with the International Public Sector Accounting Standards (“IPSAS”) “Financial Reporting under the Cash Basis of Accounting” issued by the International Public Sector Accounting Standards Board of the International Federation of Accountants (“IFAC-PSC”) and incorporate the principal accounting policies from the relevant World Bank financial reporting guidelines. Other basis of preparation criteria The Special-Purpose Financial Statements are prepared under the historical cost basis of accounting. Source funding and government contributions are recognized when the related cash is received or paid out on the Project’s behalf. Expenditures are accounted for on the basis of actual disbursement of funds from the Project accounts. Foreign currency transactions and translation The Project uses the United States Dollar (“USD”) as its functional currency for the following reasons: a) The IBRD’s funding is received in USD; b) Budgets and financial reports for the Project are prepared in USD; Balance sheet monetary items denominated in currencies other than USD have been translated into USD using the exchange rate of the Central Bank of the Republic of Azerbaijan (“CBRA”) effective as at appropriate date. All income and expense transactions denominated in currencies other than USD are converted into USD using the exchange rate of the CBRA prevailing on the date of transaction. 3. CASH AND CASH EQUIVALENTS December 31, December 31, 2017 2016 Project Account 4,179,472 4,718 IBRD Designated Account 3,049,872 7,044,477 Cash in hand 2 2 Total cash and cash equivalents 7,229,346 7,049,197 14 RAIL TRADE AND TRANSPORT FACILITATION PROJECT OF THE REPUBLIC OF AZERBAIJAN NOTES TO THE SPECIAL-PURPOSE FINANCIAL STATEMENTS FOR THE YEAR ENDED DECEMBER 31, 2017 (Continued) (Amounts expressed in the United States Dollars unless otherwise indicated) 4. DESIGNATED ACCOUNT The Recipient has established a Designated Account at a commercial bank acceptable to the IBRD in accordance with the Loan Agreement. Designated Account is established, managed, replenished and liquidated in accordance with the IBRD’s “Disbursement Guidelines for Projects” and detailed arrangements agreed upon between the Recipient and the IBRD. The Project maintains it’s Designated Account in USD with the Kapital Bank and Azer-Turk Bank OJSC (located in the Republic of Azerbaijan). 5. BASIS OF FUNDING AND ELIGIBLE EXPENDITURE The following table specifies the categories of eligible expenditure that may be financed out of the allocations of the amounts indicated in the Loan Agreement to each category, and the percentage of expenditure to be financed for eligible expenditure in each category: Allocation of the Loan (expressed in USD) Percentage of expenditure to be financed Original Revised Additional Total Original Financing (1) Goods, works, consultants’ services, training and incremental operating costs for Component 1 of the Project 232,875,000 434,875,000 211,950,000 646,825,000 100% (2) Goods for Component 2 of the Project 202,000,000 - - - 0% (3) Goods, works, consultants’ services, training and incremental operating costs for Components 3 and 4 of the Project 14,000,000 14,000,000 7,500,000 21,500,000 85% 0.25% of the total (4) Front-end fee 1,125,000 1,125,000 550,000 1,675,000 disbursement TOTAL 450,000,000 450,000,000 220,000,000 670,000,000 6. METHODS OF DISBURSEMENT The methods of disbursement used from the inception of the financing up to and including December 31, 2017 were as follows: 15 RAIL TRADE AND TRANSPORT FACILITATION PROJECT OF THE REPUBLIC OF AZERBAIJAN NOTES TO THE SPECIAL-PURPOSE FINANCIAL STATEMENTS FOR THE YEAR ENDED DECEMBER 31, 2017 (Continued) (Amounts expressed in the United States Dollars unless otherwise indicated) Advance – the IBRD may advance loan proceeds into the Designated Account of the Recipient to finance eligible expenditure as they are incurred and for which supporting documents will be provided at a later date. Direct Funding – the IBRD may make payments, at the Recipient’s request, directly to a third party for eligible expenditure. Reimbursement procedure – the IBRD may reimburse the Recipient for expenditure eligible for financing pursuant to the Loan Agreement that the Recipient has pre-financed from its own resources. Commitment procedure – the IBRD may pay amounts to a third party for eligible expenditure under special commitments entered into, in writing, at the Recipient’s request and on terms and conditions agreed between the IBRD and the Recipient. 7. METHOD OF WITHDRAWAL IBRD Designated Account Designated Account is designated disbursement accounts of the Project to effect the payment of eligible expenditure, within defined limits, which do not require individual authorization from the IBRD. Available amounts were drawn down within the limits determined by the relevant loan agreement for the payment of eligible expenditure for sub-contractors from the Designated Account. Project Account The Project maintains a separate account where the Government funds are accumulated. The funds are further disbursed to sub-contractors based on the shares of expenditure to be incurred by each funding source. Statement of expenditure (“SOE”) Under the SOE method, the Project forwards to the IBRD an application for reimbursement of payments already made using an application for withdrawal with SOE forms as the only documentation. Cash in hand During the reporting period, the Project management did not utilize cash in hand. 8. OPERATING ENVIRONMENT The Project’s operations are conducted in the Republic of Azerbaijan. As an emerging market, at the present time the Republic of Azerbaijan is developing business and regulatory infrastructure that would generally exist in a more mature market economy. 16 RAIL TRADE AND TRANSPORT FACILITATION PROJECT OF THE REPUBLIC OF AZERBAIJAN NOTES TO THE SPECIAL-PURPOSE FINANCIAL STATEMENTS FOR THE YEAR ENDED DECEMBER 31, 2017 (Continued) (Amounts expressed in the United States Dollars unless otherwise indicated) The Azerbaijani economy contracted by 1.3% growth (year-on-year) in the first half of 2017, driven by a decline in oil GDP (7.2%) as oil revenues were decreased due to production volumes and oil prices. On the upside, and despite continued banking sector distress, the non-oil economy expanded by 1.7% for the first time in over a year, supported by the strong performance of the agriculture and manufacturing sectors. Annual inflation remained high at 13-14% during 2017, driven mainly by an increase in government-controlled tariffs for electricity, water, and gas, and in domestic food prices. Citing inflationary pressures, the Central Bank of the Republic of Azerbaijan continued to tighten the monetary policy stance during 2017 by scaling up liquidity absorption operations. The manat has appreciated by 4.4% against the U.S. dollar since end-2016, reflecting its stronger external position and increased liquidity absorption operations. The troubled financial sector continues to exert a negative impact on the economy. Credit contracted by 15.6% in the first half of 2017, and the quality of assets continued to deteriorate. Per official statistics, the nonperforming loan ratio reached 13% in June 2017 compared to 9% at end-2016. Although manat deposits grew in the second quarter of 2017, the client deposits (corporate and household) shrank by 4.4% during the first seven months of 2017. Starting from February, 2016 the Central Bank of the Republic of Azerbaijan has gradually increased refinancing rate from 5 to 15% during 2017 and the minimum capital adequacy ratio was lowered from 12% to 10%. In February 2018, Standard & Poor’s, international credit agency, affirmed long and short -term sovereign credit rating of Azerbaijan in foreign and local currency at 'BB+/B' upgrading rating outlook from negative to stable. The Azerbaijani economy is vulnerable to market downturns and economic slowdowns elsewhere in the world. While the Government has introduced a range of stabilization measures and plans to expedite reforms and support to banking system in response to current economic challenges. The Management believes it is taking appropriate measures to support the sustainability of the Project’s business in the current circumstances, unexpected further deterioration in the areas described above could negatively affect the Project’s results and special-purpose financial statements in manner not currently determinable. The future economic growth of the Republic of Azerbaijan is largely dependent upon the effectiveness of economic, financial and monetary measures undertaken by the Government, together with tax, legal, regulatory and political developments. The Management is unable to predict, all developments in the economic environment which would have an impact on the Project’s operations and consequently what effect, if any, they could have on the special-purpose financial statements of the Project. Amidst the ongoing crisis, the government of Azerbaijan shifted its oil-oriented economic policy, dominated for two decades, to the diversification of the economy. For that purpose, a “national strategic roadmap” was adopted to formulate a correct development strategy covering 11 sectors. The implementation of the “national strategic roadmap” was assigned to the newly formed “Center for Analysis of Economic Reforms and Communications,” the aim of which is analyzing the effectiveness of conducted reforms and making new proposals. Significant measures have been taken in custom services and taxation as well. As of August 1, 2016, new regulations to ensure more operative and transparent custom clearance (a “green corridor” and other access systems) were implemented. The new simplified procedures are intended to stimulate imports and provide favorable conditions for business and external trade. As a continuation of reforms in customs, the reception of e-declarations is introduced minimize the contact of citizens with government officials. In order to amend the existing tax system, the decree approving the 17 RAIL TRADE AND TRANSPORT FACILITATION PROJECT OF THE REPUBLIC OF AZERBAIJAN NOTES TO THE SPECIAL-PURPOSE FINANCIAL STATEMENTS FOR THE YEAR ENDED DECEMBER 31, 2017 (Continued) (Amounts expressed in the United States Dollars unless otherwise indicated) “Directions of Reforms in Taxation for 2016” was signed. The presidential de cree requires the Ministry of Taxes to ensure that on-site and off-tax audits are performed within short periods of time and extend the coverage of electronic tax audits to limit face-to-face contacts with taxpayers. Another important amendment on monopolistic actions was made to the Criminal Code. Besides, the latest changes in December 2016 to Taxes Code “transfer pricing” will be applied against artificially exaggerated expenses and “voluntary tax disclosure” notion included in the Code which is highl y practicable in greatest economies. Furthermore, in order to prevent additional exposure to financial sanctions by the tax authority because of tax liability miscalculation, the mechanism of “determination of tax liability in advance” principle will be in force. Along with them, implementation of electronic invoices will play an important role in prevention of tax evasion and will impact positively on tax system optimization. Azerbaijan is also trying to benefit from regional connectivity initiatives to boost transit and trade. In particular, the country is one of the sponsors of the East–West and North–South transport corridors. Construction of the Baku–Tbilisi–Kars railway line, connecting the Caspian region with Turkey, was completed in 2017. The Trans-Anatolian Natural Gas Pipeline (TANAP) and Trans-Adriatic Pipeline (TAP) will deliver natural gas from Azerbaijan’s Shah Deniz gas field to Turkey and Europe. The economy is expected to expand from 2018 onward, supported by an acceleration of oil GDP as the Shah Deniz gas field-one of the largest gas fields in the world-begins production. Non-oil output will continue to grow at a slow pace due to limited credit growth and the weak business environment. 9. EVENTS AFTER THE REPORTING PERIOD The bank balances in IBRD Loan Number 7509-AZ and 8282-AZ Designated Account and Project Account as at December 31, 2017, subsequently were disbursed under the following Project categories: For the period Cumulative from January 1, April 30, 2018 to April 30, 2018 2018 EXPENDITURE IBRD Loan Number 7509-AZ and 8282-AZ Consultants’ services (564,864) (19,020,528) Goods - (6,749,999) Civil works (1,978,080) (393,458,525) Incremental operating costs (9,894) (927,848) Training (375) (61,873) Subtotal IBRD Loan expenditure (2,553,213) (420,218,773) Government of Azerbaijan Civil works (2,706,530) (86,772,360) Consultants’ services (187,625) (5,523,963) Goods - (2,630,797) Incremental operating costs (18,057) (392,011) Training (142) (14,959) Subtotal Government of Azerbaijan expenditure (2,912,354) (95,334,090) TOTAL EXPENDITURE (5,465,567) (515,552,863) 18