Report No. 25818-AZ Azerbaijan Building Competitiveness An Integrated Non-Oil Trade and Investment Strategy (INOTIS) (In Two Volumes) Volume II: Background Papers November 20, 2003 Poverty Reduction and Economic Management Unit (ECSPE) Europe and Central Asia Region Document of the World Bank CURRENCYEQUIVALENTS (Asof August 1,2003) Currency Unit = Manat ( A m ) US$1 = AZM4,914 FISCAL YEAR January 1 to December 31 ACRONYMSAM) ABBREVIATIONS ADB Asian DevelopmentBank MOA Ministryof Agriculture ADDY StateRailway Company MOC Ministry of Communications ADR Alternative DisputeResolution MOEd Ministry of Education AZERPRO Trade and TransportFacilitationCommittee MOF Ministry of Finance AZPLAC Azerbaijan Policy and Legal Advice Center MOFA Ministry of Foreign Affairs BEEPS BusinessEnvironmentand Enterprise MOH Ministry of Health PerformanceSurvey MOJ Ministry of Justice CIS Commonwealth of Independent States MOT Ministry of Transport EBRD EuropeanBank for Reconstruction and MOTax Ministry of Taxes Development MRA Mutual RecognitionAgreement EU EuropeanUnion NBA National Bank of Azerbaijan EU TACIS EuropeanUnion TechnicalAssistance to NGO Non-Governmental Organization Commonwealthof Independent States OECD Organization for Economic Cooperationand FDI Foreign Direct Investment Development FIAS Foreign InvestmentAdvisory Services PRSC Poverty Reduction SupportCredit FTA Free Trade Agreement PRSP Poverty Reduction StrategyPaper GDP Gross DomesticProduct SCAC State Constructionand ArchitectureCommittee GOA Government of Azerbaijan SCC State CustomsCommittee GOST Gosstandart(State Committeeof the scs StateCommitteefor Securities Russian Federation for Standardizationand SFD StateFire Department Metrology) SME Small and MediumEnterprises GSP General Systemof Preferences SMME Small, Medium and MicroEnterprises GTZ German Agency for TechnicalCooperation SPPRED StateProgrammeforPoverty Reductionand IAS InternationalAccounting Standards Economic Development ICT Informationand Communication ssc State SecuritiesCommittee Technologies SSMA State Standardsand MetrologyAgency IDPs InternallyDisplacedPeople STATCOM State StatisticalCommittee INOTIS IntegratedNon-Oil Trade and Investment svc StateVeterinaryCommittee Strategy TBT Technical Barriers to Trade IPR IntellectualPropertyRights TRACECA Transport Corridor-Europe,Caucasus,Asia IsDB IslamicDevelopmentFund TRIPS Trade RelatedIntellectualProperty Rights IS0 InternationalStandardsOrganization UNDP United NationsDevelopment Program MED Ministry of EconomicDevelopment USAID United States Agency for International MENR Ministryof Ecology and Natural Resources Development MFBA Micro Finance Bank of Azerbaijan USTDA United StatesTrade DevelopmentAgency MFN Most FavoredNation Status WB World Bank MLSPP Ministry of Labor and SocialProtectionof WTO World Trade Organization Population - Vice President: ShigeoKatsu Country Director: Donna Dowsett-Coirolo SectorDirector: Cheryl W. Gray TeamLeader: Christian E. Petersen Republic of Azerbaijan BuildingCompetitiveness . An IntegratedNon-OilTrade andInvestment Strategy (INOTIS) Volume I1. Background Papers Table of Contents ANNEX 1: AZERBAIJAN: RECENT ECONOMICDEVELOPMENTSAND ECONOMIC OUTLOOK .................................................................................................. 1 I BACKGROUND 1 I1 .. ......................................................................................................... RECENT ECONOMIC PERFORMANCE ......................................................................... 3 I11 MACROECONOMIC .................................................................................... . POLICIES 7 III.a. Fiscal Policy.................................................................................................. 7 III.b. Monetary and Exchange Rate Policies ......................................................... 11 III.c. Financial Sector Policies ............................................................................. 12 v. IvIILdFINANCIAL . . Trade and Investment Policies ..................................................................... 13 DISCIPLINE AND COST RECOVERY INTHEUTILITIES SECTOR ................ 15 16 V I 17 VI1 CONCLUDINGREMARKS ........................................................................................ .. ENABLING BUSINESS ENVIRONMENT COMPETITIVENESS................................. AND SOURCESOF GROWTH ........................................................................................... 22 ANNEX 2: COMPOSITIONOFAZERBAIJAN'S FOREIGNTRADE ...................24 I INTRODUCTION . I1 .................................... 25 I11 EXCESSIVE .. ...................................................................................................... 24 AZERBAIJAN'S INTEGRATION INTO THE GLOBALECONOMY Iv 28 32 V COMPOSITIONOFEXPORTS .................................................................................... 34 V I 36 VI1 FACTOR .... RELIANCEON OIL EXPORTS ................................................................. LIMITED SUCCESS INGEOGRAPHIC REORIENTATION OFEXPORTS ........................... COMPARISON OFNON-FUEL EXPORTSCIS ANDEUMARKETS............................ TO VI11 AGROPROCESSING I X .. INTENSITY OF EXPORTS ............................................................................ 38 ................................................................................................. 39 CONCLUSIONS....................................................................................................... 44 ANNEX 3: MARKETACCESSISSUES FORAZERBAIJAN .................................. 51 I SUMMARYANDCONCLUSIONS 51 I1 .. ............................................................................... MARKET ACCESS CONDITIONS IN MAJORMARKETS ............................................... 58 II.a. TheEU ........................................................................................................ 58 II.b. 62 111 REGULATORYREQUIREMENTS. STANDARDS ANDEXPORTS . TheImpact of EU Enlargement.................................................................... FROMAZERBAIJAN TO MAJOR MARKETS .................................................................................................. 66 ANNEX 4: I S ACCESSIONTO THE WTO INECONOMICINTEREST OF AZERBAIJAN? ................................................................................................................ 69 I INTRODUCTION I1 .. ...................................................................................................... 69 AZERBAIJAN'S FOREIGN TRADE REGIME INCREASINGLYINLINEWITHWTO RULES .. ............................................................................................................................. 70 111 . COSTSAND BENEFITSOF MEETING THEWTO RULES............................................ 73 II1.a. Benefits........................................................................................................ 74 1II.b. Costs............................................................................................................ 76 II1.c. IV. What can be done to maximize benejh? -Pitfalls to be avoided................. 79 TARIFF STRUCTURE:THEINCREASE INTHEPOTENTIAL FORDISTORTIONS .............80 IV.a. Increase in tariff protection over 1997-2001................................................ IV.b. Characteristics of 2002 tariff structure in comparative perspective..............81 81 W.C. Overall tariff level and differential treatment of industrial and non-industrial products....................................................................................................... 83 IV.d. Differential treatment in terms of processing................................................ 85 IV.e. Information technologyproducts.................................................................. 87 lV.$ Tariff schedule: opportunitiesfor corrupt behaviour.................................... 88 89 V.1V.g.CONCLUSIONSAND Concluding observations.............................................................................. POLICY RECOMMENDATIONS................................................... 89 STATISTICALANNEX ................................................................................................... ANNEX 5: BUSINESSENVIRONMENTAND COMPETITIVENESS ...................91 95 I INTRODUCTION -THECOMPETITIVE CHALLENGE.................................................. 95 I1 .. BUSINESSENTRY REGULATION ...................................................................... AND 99 II.a. InvestmentRegime....................................................................................... 99 II.b. BusinessRegistration and Licensing .......................................................... 100 Access to Land and Site Development........................................................ 104 I11 POLICIES AND RELAnoNs........................................................................ 110 IV TAXATIONAND INCENTIVES ................................................................................ 112 V ACCESS FINANCEAND CREDIT ........................................................................ TO 116 VI 119 VI1 CONTRACTENFORCEMENTDISPUTERESOLUTION ......................................... .... II.c.LABOR . COMPETITION POLICY ......................................................................................... AND 120 VI11 SMMEDEVELOPMENT IX X.. .PUBLIC ....................................................................................... 123 SECTORGOVERNANCE ............................................................................ 123 MICROECONOMIC COMPETITIVENESS ................................................................... 125 ANNEX 6: AZERBAIJANADMINISTRATIVE BARRIERSANALYSIS ............136 I INTRODUCTION 136 OVERVIEW .......................................................................................................... .................................................................................................... I1 138 I11 ... ESTABLISHING A BUSINESS .................................................................................. 139 1II.a. Company Registration ............................................................................... 140 146 IV ........................................................................................... 149 V.. III.b. Other Mandatory Registrations.................................................................. BUSINESSLICENSING LOCATING A BUSINESS ......................................................................................... 152 V.a. Land Acquisition ........................................................................................ 152 V b VI .. . Construction and Occupancy Permits ........................................................ 159 ENTRY AND EMPLOYINGWORKERS ..................................................................... 168 VI., . Obtaining Business Visas........................................................................... 168 VI.b. Obtaining Work Permits ............................................................................ 169 V l c . 171 VI1 OPERATING A BUSINESS...................................................................................... . Hiring and Termination ............................................................................. 175 VII.a. Reporting Taxes......................................................................................... 175 VU.b . Other Reporting Requirements................................................................... 181 VI11 IMPORT ...................................................................... . AND EXPORT PROCEDURES 184 ANNEX 1: AZERBAIJAN: RECENTECONOMICDEVELOPMENTS AND ECONOMIC OUTLOOK* I. BACKGROUND 1. Azerbaijan's early transition to an independent, market-based economy has been tumultuous, entailing significant economic costs and social impacts. Following independence in 1991, Azerbaijan was subject to massive economic shocks resulting Figure 1.1 Output Performance of Azerbai.ian from the disintegration of the Soviet Union's managed system of Output Performance of Azerbaijan Relative to production, trade, and fiscal transfers. Average Output Performance of CIS and CEEC 140 , Cumulative Index of RealGDP Growth, 1989 = 100) The conflict in Nagomo-Karabath 1 made the situation unbearable for 100 many Azeris. The economy was 80 characterized by hyperinflation, real 60 currency depreciation, and a dramatic 40 drop in output-on average much 0 4 I greater than that experienced by other transition economies during the same period. By 1995, it is estimated that -Azerbaijan -- -CIS, average - - - -CEEC, averag GDP was less that 40 percent of its CIS- Countriesof IndependentStates, CEEC- Centraland EastemEuropean 1989level and household consumption Countries declinedby approximately 50 percent. Source: EBRDTransition report 2000,2001 andauthors' calculations 2. Yet, unlike many transition economies, sound economic reforms since 1995 have enabled Azerbaijan to achieve macroeconomic stability and resumption of growth relatively quickly. Since 1995, the inflation rate has been kept below 2 percent, falling to 1.5 percent in2001. The budget deficit has been cut from 10percent of GDP in 1994 to between one and two percent. The privatization program has contributed to the growth of the private sector, which now accountsfor more than 71percent of GDP. Landreformwas implemented, with 1.3 million hectaresof agricultural land distributedto rural residents. Between 1995 and 2001, GDP increasedby a factor of 2.5, industrial production by 3.5, andforeign trade by 2.2. 3. The surging output of the oil sector accounted for more than 60 percent of the increase in GDP between 1995 and 2001. While output in the oil sector increasedby over 200 percent between 1995 and 1999, output in the non-oil sector decreased by about 39 percent inthe same period. That the oil sector i s the main driver of growth can be seen in the decline of almost every other branch of industrial production. In 2001, the oil sector accountedfor more than 67.5 percent of all industrialproduction. * This Annex waspreparedby EminZamin OgluHuseynov(ECSPE) INOTIS-Integrated Non-Oil Trade and lnvestinent Strategyfor Azerbaijan 4. Despite these important achievements, Azerbaijan's economy is facing critical challenges in the medium- to long-term to facilitate sustainable and equitable economic development and poverty reduction efforts. The key challenges i s to: (i)maintain macroeconomic stability, while trying to avoid potential negative impacts of the "resource curse" (Boxl. 1). Overall, economic developments and prospects of recent years reaffirm the key strategic objectives of the recently approved State Program of Poverty Reduction and Economic Development (SPPRED). SPPRED has identified six strategic medium-term objectives: (i) enabling income-generatingopportunities andjobs in the non-oil sector; (ii) macroeconomic stability; (iii)eauitv in health and education: (iv) immoved infrastructure; (v) better targeted social protection; and (vi) better conditions for refugees and IDPs. These objectives can be achieved through: (i)continued transformation of economic activity from the public to the private sector; (ii)a sound legal and regulatory framework, reducing administrative barriers to private investment and Small and Medium Enterprises (SME) development; (iii) good corporate governance principles (International Accounting Standards IAS, auditing, effective commercial dispute resolution mechanisms); (iv) export development (industry clusters, market access, transport and trade facilitation, customs and tax policies and administration); and (v) access to finance and fostering entrepreneurship. 5. In many ways Azerbaijan is a country of three economies-a large and growing oil and gas sector that has driven rapid economic expansion, but has resulted in few employment opportunities; a small non-oil economy, where employment growth has been modest, or may have actually contracted over the past few years; and a hidden and growing informal economy, whose size i s large even by standards of most transition and emerging countries. The economy is facing a dual macroeconomic challenge: to maintain macroeconomic and monetary stability while strengthening competitiveness of the non-oil sector, and to complete the transition agenda of structural reform, which may see some traditional activities disappear or stabilize at much lower levels of output and employment. Maintaining macroeconomic achievements may represent a greater challenge to the authorities inthe coming decade. Both the transition process and the booming oil sector will lead to large restructuring of the economy. 6. The oil and gas windfall will be of undoubted benefit to the country and its citizens if combined with a very careful macroeconomic policy and fiscal stance, as well as steadfast implementation of the structural reform program and poverty reduction strategy. The experience of other resource rich countries has often been disappointing and left large strata of the population in continued poverty. Balanced growth between the new oil sector and 2 INOTIS-Integrated Non-Oil Tradeand InvestmentStrategyfor Azerbaijan the traditional non-oil sector is a major challenge-adapting to Azerbaijan's increasing integration into the world market, creating productive employment opportunities, and reducing poverty. Excess supply of foreign exchange may lead to appreciation of the exchange rate, and excessive fiscal spending may lead to inflation and inefficiency-"Dutch disease" symptoms that hampercompetitivenessand growth of the non-oil sector. 7. The exchange rate does not appear to hamper competitiveness as of now, but remains a future challenge. There i s significant evidence that suggests that the real exchange rate i s not overval~ed'~,and that structural factors are hampering competitiveness. However, maintaining an adequate exchange rate will become a challenge, once the oil windfall would materialize. Given the fact that the private sector i s liquidity constrained (the capital market i s underdeveloped), fiscal policy will provide the main policy tool to manage the oil windfall successfully, as well as accumulating the excess oil revenues in the Oil fund abroad, will provide a fiscal sterilization, thus avoiding excessivereal exchangerate appreciation. 8. In this context, defining the future opportunities for growth and prosperity in Azerbaijan lies in building upon the competitive advantages of the country. The competitiveness of a nation is based upon the competitive position of its firms or industries. They, rather than nations, compete for market share and resources. At its core, national competitiveness i s linked to productivity and the ability of a country to raise living standards over time (Box 1.2). 9. The objective of this Chapter i s to discuss recent economic developments and the medium-term outlook. Section I1 will highlight most important recent economic developments, while Section I11 will look at different macroeconomic policy issues and highlights main developments and reform agenda. Section IV and Section V review developments in utilities sector and business environment respectively. Prospects of non-oil trade and investments growth are discussed in Section VI. Finally, concluding remarks are highlighted inSection VII. 11. RECENTECONOMIC PERFORMANCE 10. The past decade can be clearly distinguished in two very different periods. The early post-independence period of 1990 - 1995 uas characterized by the complex set of shocks associated with the collapse of the Soviet Union and its traditional supply channels, and the transition to a market-oriented economy, which were further complicated by the armed conflict with Armenia and a large refugee population. This period was accompanied by bothhyperinflation and drastic declines in output. In sharp contrast, the period since 1995 l5This i s evident by the fact that real exchange ratehas even depreciated with about 20 percent during 1997 -2002. Robust growth of the non-oil sector, especially agriculture during the last five years provides further evidencethat the real exchange rate is not overvalued. Furthermore, according to the analysis of the impact of exchange rates of transition economies on their competitivenessprovided by EBRD (EBRDTransition report, 2000, pp. 62) which comparesdollar wages in transition economies to dollar wages of countries of similar levels of productivity, wor!dorce skills and comparable economic structures, for Azerbaijan, the ratio of actual dollar wages to comparable dollar wages was 0.6 in 1999, which implies that the real exchangerate is not overvalued. (See Azerbaijan Public ExpenditureReview, April 2003). 3 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan has been one of both macro-economic and financial stabilization and the renewal of economic growth, stimulated by oil-related activities and much intensified structural reforms. 11. As already mentioned above, for Azerbaijan, the social and economic costs of the "transition" to a market-oriented economy were far in excess of what had been anticipated. Prices, as measured by the consumer price index (CPI), increased by 23,000 times between 1990 and 1995. The worst single year was 1994. Gross official foreign reserves at the end of 1994 were less than $4 million. In that year, the state budget deficit exceeded 10percent of GDP. The high rates of inflation during the 1990-1995 period were accompanied by large changes in relative prices. It was an environment in which rational economic and financial management was practically impossible. The official national accounts estimates indicate that, when adjusted for inflation, GDP in 1995 was only 44 percent of the 1990level. 12. Stabilization efforts initiated in 1995 succeeded in slowing the increase in the CPI to 84 percent in the twelve months ending in December 1995. Also in 1995, the Government initiated an economic program including monetary, fiscal and structural reform policies that were intended to bring about both financial stabilization and the renewal of economic growth. The program adopted was supportedby the IMF, with drawings from its Systemic Transformation Facility, and by the World Bank with an International Development Association (IDA) Rehabilitation Credit. The Government's 1995 economic program was preceded by a contract, signed in September 1994, with foreign oil companies under which they would invest an estimated $7.5 billion to develop offshore oil deposits in the Caspian Sea. The economic reform process initiated in 1995, together with the stimulus to the economy from the investments in the petroleum sector, succeeded in both of the principal objectives-restoring overall financial stability andrenewing aggregateGDP growth. 13. Otherwise impressive macroeconomic performance between 1996 and 2001 was slowed in 1998 with short-lived and relatively moderate deterioration caused by the crisis in Russia and the lower oil prices in international markets. As such, competitiveness of Azeri exports to Russia was moderately hit, while oil exports revenues turned much lower, which combined slowed the real GDP growth and caused higher fiscal and current account deficits as share of GDP in the next year of 1999 (Table 1.1). The real effective exchangerate appreciated3.6 percent appreciation. 14. Nevertheless, prudent and well-coordinated fiscal and monetary policies, as well as recovered world oil prices allowed Azerbaijan to improve the macroeconomic stance quickly. In 2000, exports and real GDP reached the highest growth rates in the post- independence period, while gross reserves increased by about 50% since 1998. Economic developments have continued to be positive. Despite a generally weak international economic environment, high oil prices, significant growth in investments in the oil and gas sectors, combined with good economic performance in other sectors, led to 10.6 percent real GDP growth in 2002. Prices remained fairly stable, with end-period consumer price inflation of 3.3 percent. Therefore, this analysis briefly reviews the recent sector growth performancesnext. 15. The most significant recent development inthe real sector was the sanctioning by the investors of the Baku-Tbilisi-Ceyhan (BTC) main oil export pipeline, as well as the associated full field development of the Azeri-Chirag-Guneshli (ACG) oil field. Together with the Shah Deniz gas field and related gas export pipeline (which was sanctioned inearly 2003), these and other energy sector projects will result in over US$8 billion ininvestments 4 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan over the period o f 2002-2004. This alone will contribute to rapid growth in energy sector output and exports. Thus, inorder to achieve rapid expansion of non-oil sector output it will be critical in the next few years to avoid the adverse "Dutch Disease" effects. Table 1.1. Azerbaijan: SelectedEconomicand FinancialIndicators, 1996-2002 Annual percent change GDPat constant prices 1.3 5.8 10.0 7.4 11.1 9.9 10. O f which: oil sector 0.9 0.1 42.3 30.6 2.4 7.9 3.9 other sectors 1.4 6.8 4.6 2.1 13.7 10.4 12.3 Consumer price index (DecembedDecember) 6.7 0.4 -7.6 -0.5 2.2 1.3 3.3 Exports f.0.b. 16.0 2.5 -16.1 51.3 75.5 13.7 12.7 Of which: oil sector 56.6 13.0 -0.9 78.0 89.7 21.1 11.1 Importsf.0.b. 40.2 2.7 25.4 -16.9 7.4 -4.8 24.5 O f which: oil sector 610.0 20.3 38.8 -45.2 -24.8 -5.5 142.7 Real effective exchangerate(- deprec.) 0.0 4.5 3.6 -1.7 -9.8 -6.1 -8.3 InpercentofGDP Total revenue 17.6 19.1 19.6 18.5 21.2 21.5 22.5 Total expenditure 20.4 20.8 23.8 23.6 20.8 20.3 22.9 Overall fiscal deficit (includinggrants) -2.8 -1.6 -3.9 -4.7 -0.6 0.9 -0.5 urrentaccount (- deficit) -25.9 -23.1 -30.7 -13.1 -3.6 direct investment 17.5 26.5 21.4 7.8 0.9 External debt outstanding 14.7 10.2 11.4 21.0 22.2 22.2 22.6 InmillionsofUSdollars,unlessotherwiseindcated Gross official external reserves 213.9 468.8 448.7 672.6 679.6 725.0 720.8 Nominal GDP (in manat billion) 13,662.3 15,791.1 17,172.2 18,875.3 23,590.5 26,578.0 29,601.8 Nominal GDP 3,176.5 3,962.6 4,438.4 4,581.2 5,272.6 5,707.6 6,123.7 Nominal GDP per capita 405.9 502.3 558.1 571.5 652.5 700.8 745.9 Manat per US$ ( periodaverage) 4,301.0 3,985.0 3,869.0 4,120.2 4,474.2 4,656.5 4,860.8 16. Agriculture remains an important source of the non-oil growth and job creation. Initially, agricultural output fell by almost 50 percentbetween 1990-95 due to the break-up o f the traditional relations inside the FSU.Agriculture accounted for about 20 percent of GDP during 1997-2001and for more than 30 percent of total employment. Landreform took off in 1997. In 1998 and 1999agriculture grew at 10and 7 percent per annum, whereas in2000 and 2001 growth reached 12-13 percent. This rapid recovery was largely a result of successful land privatization. Sustained recovery of output and productivity, however, are still clouded by the lack of rural credit, and an urgent need o f rehabilitation and modernization o f the irrigation system. 5 INOTIS-Integrated Non-Oil Tradeand InvestmentStrategyfor Azerbaijan Table 1.2. Azerbaijan: Sectoral GDP at constant 1995 prices (inblnmanat) 1995 1996 1997 1998 1999 2000 2001 200 ercentage change Agriculture - -13.0% 3.0% -6.9% 6.1% 7.1% 12.1% 11.1% 6.4% Hydrocarbons 0.0% 0.9% 0.1% 42.3% 30.6% 2.4% 7.9% 3.9% Construction and public works -36.0% 11.0% 66.1% 52.1% 0.8% 2.6% 5.9% 81.0% Commerce& Social Services 20.3% 17.3% 9.1% 11.6% 12.0% 12.0% 3.5% 17. Although it is difficult to account for the Non-Oil Industry in GDP, trends in industrial production growth rates by sectors, does suggest that there are problems with competitiveness Figure 1.2 RealGDPGrowthby Sectors - of the non-oil industry. According 225- to Table 1.3, indeed the textile - - znn # I r production i s yet to recover, while 0 -# I the growth in machine building 17s- I and chemical industries, on the 150. I other hand, proved to be short- lived. Agro processing and metallurgy, on the other hand, registered positive growth rates for 75 7 199s 1996 1997 1998 1 9 9 2000 2001 2002 the last four years. Production of -GDP - - - Oiland Gar -*-hon.Oil -Aviculture construction materials also grew during the last three years, perhaps as a result of rapid oil and gas sector exploration and development. The energy sector, excluding upstream oil and gas activities, did not perform well and i s yet to recover. Table 1.3. Realgrowthrate of Industrialproduction Productiongrowth rates I997 1998 I999 2000 2001 2002 Total industry 0.5 2.2 4.2 6.9 5.1 4.4 Energy -1.6 7.0 5.3 1.8 3.0 3.6 olw oil andgas 0.2 7.5 7 5.2 5.9 4.1 Metallurgy 364 -54.6 61.3 150 41.7 51.7 Machinebuilding 0.7 -30.4 -55.7 95.8 5.4 -25.1 Chemical and petro-chemical -28.2 -11.4 8.9 23.2 -8 -78.6 Constructionmaterials 4.4 -22.2 -21.6 19.7 11.1 205.0 Textiles -13.8 -44.2 -34.6 22.5 -11.6 16.0 Agroprocessing 11 6.6 -2.7 3.9 2.2 11.1 6.4 Agriculture 6.1 6.2 7 12.1 11.1 6.41 1/ Available data on Agroprocessingindicatesan identical to Agriculturaloutput growthrate Although questionable, there is no better alternativeestimation of Agroprocessinggrowth Source: State Statistics Committee,IMFStaff Estimates 6 INOTIS-Integrated Non-Oil Tradeand InvestmentStrategyfor Azerbaijan 18. After a decline of 72 percent between 1990 and 1995, the construction sector has playeda dominant role in the economic recovery during the secondhalf of the 1990s.. During 1996-97, the sector grew at more than 80 percent, driven mainly by the oil sector developments. Although the growth rate moderated during 1999-2001, construction has acceleratedagain in 2002, and it i s expectedto receive another sizeableboost during the next three years, as a result of the rapidoil and gas sector development. 19. The services sector plays an important role for job creation, as it accountedfor more than 50 percent of total employment during the second half of the 1990s, and i s expected to account for more than 40 percent during this decade as well. Services (including commerce, social services, transport and communication) have grown steadily since 1995, registering strong growth of 9.2 percent on an annual average basis. Within the sector, commerce and social services registered rapid growth (12.3 percent on an annual average basis), though slowing to 3.5 percent in 2002. Transport and communications also registered a strong growth during 1997-2002(11percent on an average annualbasis). 20. Despite the strong economic performance in recent years, poverty remains a serious problem in Azerbaijan. A Poverty Assessment by the World Bank basedon results of the 2001 HouseholdBudget Survey (HBS) was releasedinlate 2002 indicating that almost 4 million people or about 50 percent of population of Azerbaijan lived in poverty in 2001, consuming less than AZM 120,000 (about US$25.8) per capita per month. Among these, a group of 1.3 million persons, or 17 percent of the total population, lived inextreme poverty, with monthly consumption below AZM 72,000 (about US$15.5) per capita per month. Thus, combating poverty remainsthe key economic challenge facing the country. 21. Overall, positive developments in recent years reaffirm two of the key six primary objectives of the SPPRED: enabling income-generating opportunities andjobs in the non-oil sector, while preserving macroeconomic stability. It is now critically important to maintain the pace of structural reforms to further the progress in these areas. Going forward, the main challenge facing the country will be enhancing structural reforms aimed at developing non-oil trade and investments and creating non-oil sector income generating opportunities andjobs, while maintaining macro stability. 111. MACROECONOMIC POLICIES 1II.a. Fiscal Policy 22. Fiscal policy was modestly expansionary in 2002, and consistent with the authorities' intentions to very gradually increase their use of oil revenues. During2000-2002, the non-oil deficit grew from 4.7 percent to 5.1 percent of non-oil GDP, which i s still well below the medium-term sustainable level of non-oil deficit. This is consistent with the authorities' desire to save a large share of oil wealth, and the practical needto be cautious in spending oil revenues while the institutions for managing and spending that wealth are in stage of development. 23. While the deficit was in the line with projections, there was a change ,in the composition of the expenditures and financing.. Current expenditures were well below forecast levels, largely reflecting a cautions decision to postpone a wage increase in light of revenue uncertainties. Capital expenditures (excluding BTC) exceeded forecast levels by a 7 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan similar magnitude, primarily due to the higher than anticipated disbursements under foreign financed projects. As a result, external financing covered a larger than anticipated share of the deficit. Table 1.4. Selected Indicatorsof PublicFinance Sources: Azeri authorities andIMFstaff estimates. 24. With regard to revenues, 2002 saw modest tax reforms - primarily the adoption of the destination principle for VAT on all trade, and a reduction in the payroll tax rate from 33 to 30.5 percent. Inthe 2003 budget, a further reduction - to 28.5 percent- was approved, as well as a reduction (from 27 to 25 percent) inthe enterprise profit tax, offset by tightening of depreciation allowances, in line with the authorities' intention to gradually broaden the tax base while reducing tax rates. In an effort to stimulate regional development and contrary to FundandBank staff advice, the governmentintroduced regional andsectoralvariations inthe enterprise profit tax (EFT), with the rate as low as 10 percent in some regions. The authorities have committed to submit to parliament in the context of the 2004 state budget proposals to reunify the enterprise profit tax rate, at a level determined in the context of the budget preparation andbasedon their analysis of the 2003 experience. 25. Perhaps the most significant development in public finance in recent years in Azerbaijan has been the establishment of the Oil Fund. The Government has made a commitment to exercise considerable caution over the use of the expected oil and gas windfall and to ensure that the benefits resulting from the exploitation of this natural asset would accrue to all citizens and to future generations. This cautious approachi s deemedeven more essential given the fiscal institutional reforms presently underway and the need to implement SPPRED and an integrated Medium-Term Expenditure Framework and Public Investment Program (PIP). 26. The Government has recognized the need for a radical overhaul of the institutional arrangements affecting public expenditure management. The Treasury system introduced in 1998 i s functioning well and represents a significant advance. Its full computerization i s currently underway. The new Budget Systems Law (BSL) approved by the Parliament in the beginning of 2003 addresses many of the deficiencies of the past, including the incorporation of off-budget expenditures as well as consolidated monitoring andreportingrequirements. 27. Formulation and implementation of a sustainable public expenditure envelope requires an institutional framework that would allow for consolidated and coordinated fiscal management based on macroeconomic, sector and budgetary information. While coordination of key Government agencies - Cabinet of Ministers (COM), Ministry of 8 INOTIS-Integrated Non-Oil Trade and InvestmentStrategyfor Azerbaijan Finance (MOF), Ministry of Economic Development (MED) and the ANB - has been strengthened, there is a need to empower key line ministries to effectively participate in the budget preparationprocess. 28. Stronger links should be made between budgetary finance allocation decisions and operational outcomes. This requires strengthened financial analysis capabilities in the line ministries and the Public Investment Appraisal Department of the MED. State budgets should be much more explicit indefiningthe responsibilities and accountabilities of spending units in the implementation of the budget. This will improve clarity in the delineation of responsibilities for budget execution between the MOF and the line ministries. Output indicators of performance and the quality of service delivery should be defined and monitored. 29. Interms of accountability, Azerbaijan has made considerable progress inthe legal framework surrounding public procurement. The new Public Procurement Law (PPL) developed by the State Procurement Agency (SPA) and based on UNCITRAL'6 was enacted in December 2001 with implementing regulations promulgated by Presidential Decree No. 668 in January 2002. It i s the view of the recently completed CPAR that "in terms of substanceand degree of development, the PPL i s one of the better such laws inthe region."17 30. The supreme audit institution reporting to Parliament was properly established in 2001 with the enactment of the amended Law and Charter on the Chamber of Accounts. This Chamber is now vestedwith the necessaryauthority andrights to enable it to audit all public sector entities, including all budgetary and extra-budgetary organizations and funds, and to publishits results. 31. The old inspectiodcentral departments were abolished as they represented obstacles to development. Probity and integrity of public expenditures is gradually being strengthened. The recent Country Financial Accountability Assessment (CFAA) recommends to establish proper internal audit departments within all budget organizations, including ministries, localgovernments, andstate enterprises." 32. The authorities intend to pursue the following other key reform measures in the area of fiscal policy and administration: (a) to provide greater coherence to the process of determining VAT exemptions; (b) improve procedures for revenue forecasting; (c) continue efforts to improve tax and customs administration; (d) continue efforts to eliminate all quasi- fiscal activities. Prospects 33. The Government of Azerbaijan has adopted a pragmatic and measured approach to the development of the country's oil and gas resources, which has brought internationaltechnical and marketing expertise to bear on oil and gas development and exploitation. Conservative estimatesof Azerbaijan's proven oil reservesin2000 amounted to 900 million tons. However, technical estimates suggest that without major new oil discoveries and, given the current production schedule, oil production will peak at about 65 million tons in 2011, followed by a relatively short plateau of peak production and thereafter l6United Nations Commission for International Trade Law. l7See "Azerbaijan: Country Procurement Assessment Report," World Bank, 2002. l8See "Azerbaijan: Country Financial Accountability Assessment,", World Bank, forthcoming. 9 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan decline rapidly from 2013 to less than half its peak level in 2018 and to about a quarter of its peak level in 2024 when oil resources will be depleted. 34. The Role of the Oil Fund will be a crucial ingredient in managing the hump-shaped oil boom. The establishment of the State Oil Fund(SOFAR) provides a financial mechanism for separating commercial decisions on oil extraction from public spending decisions. The Box 1.3 provides details of this important initiative. It grants the Authorities considerable flexibility to "smooth" public expenditures over time in a manner that can maintain monetary stability. It also allows the Government to maintain a degree of continuity infiscal programs, especially with regard to the implementation of committed investment projects and programs. And it aims at greater transparency inthe use of oil revenues. Given the hump-shapedprofile of oil production, prudent oil windfall management inAzerbaijan requires an accumulation of large savings in the form of financial assets abroad, which i s necessary to avoid large and destabilizing oil related inflows leading to excessively rapid growth in government expenditures and loss of competitiveness of their non-oil sectors. Box 1.3. InstitutionalFrameworkfor theState OilFundof the AzerbaijanRepublic(SOFAR)' Supervisionand Control 9 The three level management structure consists of the President, SOFARS Executive Director, and Supervisory Board. Members of the Supervisory Board and the Executive Director are appointed by the President. 9 The Board consists of key government officials (Prime Minister, ministers), two parliamentary members (nominated by the Speaker), and academia. It is entrusted with the functions of internal supervision to oversee the composition of the Oil Fund's assets and compliance with the expenditure rules. Investment Strategy and Operational Management of Assets 9 The investment strategy is annually approved by the President based on recommendations of the Executive Director, taking into account recommendations of the Supervisory Board. 9 Operational management is delegated to the Executive Director, who chairs the Investment Board (internal structure of the Fund). 9 Professionalportfoliomanagersmaybecontractedfor acertainportionofthe Fund's assets. 9 Investment portfolio guidelines determine currency composition, the balance between liquid (up to 40 percent of the portfolio) and long-term investments, and fixed and equity income instruments. Preference i s given to fixed income instruments, while equity income instruments (corporate securities and stakes) are banned unless a highly reputable professional investment manager is hired to handle them. Transparency,Accountability, and External Oversight 9 A highly reputableinternational auditor is selectedto conduct an annual audit of the OilFund's accounts. The results from the annual report on the use of the funds and the external audit report are published inthe mass media. Pursuant to the Azeri laws, the Chamber of Auditors may also audit the Fund. 9 Quarterly reportsproducedby the ExecutiveDirector shall besubmitted to the Supervisory Boardandthe President. 9 The annual report is preparedincoordination with the MOF. After recommendations of the Supervisory Board are incorporated, it shall be submitted to the President. The annual report i s posted on the official website of SOFAR. Governanceof Revenues/ExpenditureRules > Whilst the ultimate decision-making capacity rests with the President, Oil Fundexpenditures (other than its own operating expenses) are consolidated with the state budget with the monies allocated to the budget and usedfor purposes that are consistent with the public investment program. 9 Allinvestmentexpendituresaretobeexecutedthroughthe Treasury. 9 Useofthe fundsis subject to the StateProcurementLaw, which governsallbudgetaryexpenditures. 9 Investmentsshouldbemadeinprojects of national importance; while criteriafor project selection are stil to be developed, project investments have to be part of the governmental PIP and MTEFand consisten1 with the PRSP. __ Annual Report 2001, State OilFundof the Republic of Azerbaijan, and www.oilfund.az. 10 `9 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan 1II.b. Monetary and ExchangeRate Policies 35. Monetary policy of recent years have been consistent with the authorities' goal of maintaining domestic price stability, while accommodating the rapid real GDP growth. Net international reserves have been growing consistently, largely due to higher oil prices. Similarly, broad money growth was almost entirely due to increased foreign currency deposits. ANB allowed higher reservemoney in 2002 and with non-oil GDP growing faster than expected and manat velocity in line with projections, this higher reserve money growth was consistent with the inflation target. Table 1.5: SelectedMonetary Indicators Memorandumitems ExchangeRate (endof period) 3,890 4,378 4,565 4,775 4,893 ExchangeRate(periodaverage) 3,869 4,120 4,474 4,657 4,861 CPIInflation (endof period) -7.6 -0.5 2.2 1.3 3.3 36. Despite impressive achievements in the area of monetary and financial stabilization, the recovery in money demand in Azerbaijan has been more modest than in other FSU countries. Since the start of the stabilization program in early 1996, the M3/GDP ratio in Azerbaijan grew by a moderate 35 percent, lower than in most FSU countries. This i s an indicator of generally slow progress in structural reforms, including in enterprise, financial sector, and judicial system reforms. One important characteristics of monetization process inmany FSUcountries, including Azerbaijan i s that it has taken place mainly through an increaseinforeign currency deposits (FCD) with the banking system, with the growth in domestic currency deposits lagging behind the growth of nominal GDP. Dollarization in Azerbaijan has been particularly intensive, with FCD/total deposits increasing from 0.52 at end-1998 to about 0.84 at end-2002, and FCD/M3 ratio increasing almost twice from 0.26 at end-1998 to about 0.48 at end-1998. However, it is also clear that while dollarization complicates the conduct of monetary policy, and may also exacerbate the situation in the case of a financial crisis, direct measures aimed at curbing dollarization should be avoided. The most effective "de-dollarization" measure is for the authorities to focus on the development of domestic financial markets, while maintaining strong macroeconomicpolicies. 11 INOTIS-IntegratedNon-Oil Tradeand Investment Strategyfor Azerbaijan 37. In view of difficulties in predicting money demand in Azerbaijan, the ANB continues to use the exchange rate as a nominal anchor for monetary policy. This policy has in effect led to informal exchange rate targeting, allowing for a modest nominal depreciation vis-&vis the U S dollar within a narrow band. It i s agreed that this exchange rate policy has served Azerbaijan well - contributing to low single digit annual inflation since early 1996 and growth in international reserves. In addition, in light of the strong growth in 2002 of non-oil exports, there i s no evidence of competitiveness problems, and thus, the current exchange rate policy is deemed appropriate. 1II.c. Financial Sector Policies 38. Notwithstanding delays in some important areas financial sector reforms continue in Azerbaijan. New large and small value payments systems have been introduced, enabling banks to offer a wider range of services to their clients. Non-viable banks - particularly those not able to meet the new US$2.5 million capital requirement - have been closed, with the number of banks in the country having declined from over 70 in 1999 to 46 today. Inaddition, the ANB has prepared- in consultation with the WIE;- a new draft Banking System Law, which when passed by parliament, will provide a solid legal foundation for a modern banking system. The ANB is also in the process of drafting a new Central Bank Law and revising the Bankruptcy Law, as well as the rules and regulations related to the registration and use of collateral to bring the legal framework governing financial sector in conformity with the international standards. Progress on restructuring of BUSBank -the last wholly state-owned bank i s on track, being closely supervised by the ANB, as well as the Ministry of Finance. International Bank of Azerbaijan (IBA) - the dominant bank inthe system, which remains 39. Nevertheless, there has been little progress toward the privatisation of the 51 percent state owned. The Bank was recapitalized recently and according to a recently approved timetable for a full privatisation of the IBA, it i s expected that 20 percent of the bank's shares will be sold to EBRD, with full privatisation to be completed by end-2004. 40. The authorities have also been closely working on reforms to strengthen the state securities market for treasury bills, and develop manat financial markets more generally. The system of registration of treasury bills and ANB bonds i s to be reviewed and simplified. Inaddition, the following reformefforts should be pursued: (i) access to T- equal bill markets for all potential participants should be provided, (ii) types of securities new denominatedin local currency should be considered; (iii) enhanceddisclosure of information relatedto the state securities market should be ensured. 12 INOTIS-Integrated Noiz-Oil Tradeand Investment Strategyfor Azerbaijan 41. In order to further strengthen confidence in the banking sector, the authorities also intend to introduce a deposit insurance system, but not earlier than January 2005. The fulfillment of the preconditions for introducing deposit insurance, including the capacity of bank supervision to meet international standards, will be assessed in close consultation with IMFandthe World Bank staff. To that end, during 2003 and2004 the ANB will continue to strengthen bank supervision and will review the current draft deposit insurance system, with assistancefrom both institutions. 1II.d. Trade and Investment Policies 42. Azerbaijan has been enjoying a liberal trade policy since early transition. Additionally, in recent years, the authorities have been trying to complete replacement of specific ad valorem customs duties, and further reduce the weighted average tariff rate. Accession to the World Trade Organization (WTO) i s a high priority for the government and this process i s being acceleratedat the moment. 43. Unlike most CIS countries, the trade balance remains positive and Azerbaijan has beenquite successful inattracting foreign direct investment (FDI).However, most of this activity is focusedon the oil and gas sector. The sector accounts for almost 80 percent of FDI inflows, and is set to increase even further as the anticipated massive investments associated with the oil and gas pipeline project materialize. Azerbaijan's exports are excessively concentrated,even by standards of major oil exporters inthe world. In2001, fuel exports constituted over 91 percent. 44. Although current account deficits were large and volatile, they have been financed by large oil-related FDI and modest official borrowing. Specifically, current account deficits have tended to swing sharply due to volatility both in imports related to oil sector investments and oil prices: for example, the current account deficit declined from over 13 percent of GDP in 1999 to 3.6 percent in 2000 and 0.9 percent in 2001, before increasing to 12.6 percent in 2002. Cumulative FDIinflows mainly to the energy sector, amounted to $3.7 billion. The Oil Fund's assets are projected to grow from 11percent of GDP in 2002 to 80 percentof 2002 GDP in 2010, improving dramatically the country's net asset position. 45. Cautious expenditure and borrowing policieshave meant that the present levels of external debt are relatively low (20.7 percent of GDP and 47.6 percent of exports) and are projected to decline to 15 percent of GDP and 24 percent of exports by 2010. The authorities intend to strengthen their debt management system, through assigning responsibility for maintaining a database on debts to an appropriate state body, in coordination with the State Statistics Committee. Current rules limit the scope for ministries, other than the Ministry of Finance, to borrow funds. However, according to existing rules, there are circumstances under which line ministries may borrow from domestic banks, and under which borrowed funds can be spent outside the treasury system. 46. Non-oil exports grew by 25% in 2002, and are about five times bigger to the CIS than to the EU. Machinery and transport equipment, crude material except fuel, beverages and tobacco, chemicals, and food are areas of high growth. There may be an important point here, Despite the general slowdown in Europe and the U.S., Azerbaijan i s able to expand non-oil exports by 25%, because its markets to a greater extent are high growth dynamic markets of the CIS and the rest of the world. 13 INOTIS-IntegratedNon-Oil Tradeand InvestmentStrategyfor Azerbaijan 47. However, the medium-term balance of payments outlook is subject to an unusually high degree of risk stemming from the economy's heavy reliance on oil and gas exports. In many important ways, this risk has declined with sanctioning of the key energy sector investment projects, which appear to be on track for completion in late 2004 or 2005, but with roughly 90 percent of exports coming from oil and gas, the recentvolatility in oil prices emphasizes the uncertainties facing Azerbaijan. More importantly, continuing growth inthe non-oil sectors will dependon the effective managementof the oil wealth. 48. The dominance of the oil and gas sector and the reliance on traditional markets is also evident in foreign trade patterns. While Azerbaijan has reoriented a substantial share of its trade toward the EU and other OECD markets over the past decade (in 2001, almost 70 percent of Azerbaijan's exports went to the EU), the shift has beenless dramatic in the case of non-oil exports, which remain destinedlargely for Russia and other CIS countries. Only 12 percent of non-oil exports were sent to the EU and less than one quarter of non-oil exports went to OECD countries as a whole. More important, over the last five years, Azerbaijan's exports have been shifting away from its new markets in the EU. Over this period, non-oil exports to the CIS markets increasedby 18 percent, while non-oil sales to the EUandthe restof the world went down by 12and 14percent, respectively. Table 1.6-Geographic Orientationof AzerbaijanExports, by Sector, 2001(percent) Manufactures 30.5 7.4 23.6 10.4 23.1 5.1 Unclassified 0.0 0.0 0.0 99.6 0.3 0.1 100.0 Total 69.5 2.9 1.0 3.4 6.3 16.9 100.0 Total Non-Oil 11.9 9.4 4.5 32.7 22.2 19.3 100.0 49. The government has contracted a diagnostic study of the investment environment by the Foreign Investment Advisory Service (FIAS), a joint IFC-World Bank facility in 2002. This study made the following recommendations to improve F D I environment and attract more investments, particularly to the non-oil sectors: (i) reduce administrative impediments to investment; (ii) establish effective policy and institutional frameworks; (iii) improve the legal and regulatory framework of the investment environment; and (iv) provide institutional support for investors. 14 e INOTIS-IntegratedNon-Oil Tradeand Investment Strategyfor Azerbaijan 50. The authorities, in consultation with the IMF and World Bank staffs, intendto revise the 1992 L a w on Protection of Foreign Investments along the lines recommended in the above-mentioned FIAS report. Also, to assist potential investors, and to help in conveying information to them regarding the government's efforts to improve governance and the business environment, as well as to give investors a channel to convey their concerns in this regard to the government, the Entrepreneurs Council (EC) and the Investment Promotion and Advisory Agency (IPA) have beenrecently established. Iv. FINANCIAL DISCIPLINEAND COSTRECOVERYTHEUTILITIES SECTOR IN 51. Less than adequate financial discipline, non-payments, explicit and implicit subsidies, and large quasi-fiscal deficits in the electricity (Azerenergy), gas (Azerigaz), and water (ARWC for Baku) sectors constitute possibly the most serious and difficult problem facing the economy of Azerbaijan. In 2000 the resulting quasi-fiscal deficit was estimated inthe order of 20 percent of GDP. The resulting high economic and social costs are manifested in increasing inefficiencies and consumer losses caused by frequent systems breakdown, as well as direct impact on health and poverty. Resources that could have been used to rehabilitate the economic infrastructure and combat poverty were instead being wasted in indiscriminate subsidization of inefficient energy consumption, while inter- enterprise and tax arrears were growing. Recognizing these enormous human and economic costs, the Government has designeda comprehensivereform program to strengthen financial discipline and improve service delivery in utility sectors. 52. The quasi-fiscal deficit originates from three main sources: (i) implicit subsidies, resulting from charging below market prices for fuel oil andnatural gas supplied by SOCAR to Azerenergy and Azerigaz for domestic consumption; (ii) non-payments for gas and electricity supply; and (iii) excess of technical losses and theft. The same situation is observed in the water supply sector. The quasi-fiscal deficit there originates from similar sources: (i) non-payments for water supply (collections in 2000 were only 36 percent of billings-a substantial drop from previous years caused inpart by the recent policy change to eliminate noncash forms of payments); (ii) excess of technical losses and wastage (estimated to be higher than 50 percent of water production) closely linked to deferred maintenance of the network and no metering of the domestic consumption; and (iii) implicit subsidies, resulting from tariffs being charged below operations and adequate maintenance costs. A rough quantification of the quasi-fiscal deficit in the water supply services (only in Baku) amounted in 2000 to about $68.5 million or 1.3 percent of GDP in 2000. Accumulation of quasi-fiscal expenditure on such a scale signals a lack of financial discipline, has potentially destabilizing macroeconomiceffects, and createsbarriers to entry of the private sector. 53. Efforts in the utilities sector have focused mainly on four objectives: (i) making explicit the previously quasi-fiscal subsidies, so as to enhance transparency and facilitate decision making; (ii) increasingpayments for utility services; (iii) improvingthe efficiency of the State Oil Company of Azerbaijan Republic (SOCAR); and (iv) improving efficiency of electricity, gas, water and wastewater, and heating sectors. These reforms have been quite successful; from 22 percent of GDP in 2000, the subsidies (fiscal and quasi-fiscal) in the energy sector alone were reduced to an estimated 11percent in 2002, and are expected to decline further in2003. Inaddition, SOCAR has recently been granted tax credits for all fuel delivered to the electricity and gas companies, while domestic and estimated long-run 15 INOTIS-Integrated Non-Oil Tradeand InvestmentStrategyfor Azerbaijan world market prices of natural gas, crude oil and most oil products were unified - measures aimed at fiscalization of implicit andquasi-fiscal subsidiesin the energy sector. 54. The Government's medium-term objectives for the utilities sector are primarily to: (i) ensure efficient and equitable delivery of services to consumers at cost-reflective prices; (ii)protect low income consumers, especially during the transition to cost-reflective tariffs and pricing; (iii)increasevolume of investmentsfrom public and private sources; (iv) accelerate reforms aimed at developing utilities sector and minimize negative environmental and social impacts of utility sector reforms. 55. The Government of Azerbaijan has recognized the need to develop institutional arrangements meeting international standards to provide economic regulation and consumer protection of utility services. A regulatory framework, adequate for requirements of a market economy, to regulate the utility sector i s of critical importance in order to facilitate the execution of the Government's policies inthis area. To develop the regulatory framework of the utility sector in line with the market economy, the Government will create a Utility Regulatory Agency to beresponsiblefor: (i) price and tariffs regulation of utility services; (ii) technical service regulation; and (iii) customer service regulation. 56. The Government will submit the appropriate enabling draft legislation to the Parliament for passage and will endeavor to have the new regulatory agency establishedby the end of 2005. In parallel, the Government will work on the development of a medium- term tariff policy for the utilities. One of the end-results of the policy will be to fully recover utility supply costs through the tariffs. The new tariff policy shall be implemented from not later than mid 2005, supported by the World Bank and other international financial institutions in relation to the development of implementation plans for protection of vulnerable consumers. v. ENABLING BUSINESSENVIRONMENT COMPETITIVENESS AND 57. The Government has taken measures recently that have resulted in a significant reduction of obstacles for private sector development. The licensing regime was reviewed and improved, and the legal basis for a market economy has been introduced based on the new constitution and reforms in the legal system. The introduction of modem criminal, civil and tax codes lighten the burdenandinject objectivity into the tax regime. 58. The Government has also taken measures to address corporate governance issues, which often greatly impede private investment, and especially foreign direct investment. In this regard, the Government has already required international accounting standards (IAS) infinancial sector, andas part of the upcoming structural reformagenda, will require alljoint stock companies over a threshold level of turnover to produce accounts inline with IAS, and set a timetable for requiring that an annual report including the accounts i s made publicly available. 59. Recent surveys indicate some progress, particularly concerning corruption and the business environment. The most comprehensive govemance/investment climate surveys, including EBRD/IBRD'sBusiness Environment andEnterprise Performance Survey 16 INOTIS-IntegratedNon-Oil Tradeand Investment Strategyfor Azerbaijan (BEEPS)19, FIAS, PRS Group's International Country Risk Guide andHeritage Foundation's Economic Freedom Survey have all reported improvements in Azerbaijan's investment climate, particularly in the last three years, albeit from a low base. The 1999 BEEPS ranked Azerbaijan at the bottom of 20 transition economies on measures of state capture and administrative corruption, although the country did considerably better on other criteria, and on the overall Governance Index it ranked 11* among the 20 countries. The 2002 BEEPS shows quite a significant improvement, notably in those areas where Azerbaijan scored poorly in 1999. These trends and those reported in other surveys are encouraging, and provides a promising platform for continuing efforts to improve the governance, anti- corruption, business environment nexus. 60. Achieving the necessary expansionof the non-oil sector will be a challenge, given the dramatic contraction of the non-oil sector at the beginning of the transition. According to the recent BEEPS, firms are operating substantially below capacity and close to 50 percent of firms surveyed are operating at below 40 percent capacity. This i s reflected in the evidenced decline in labor productivity (as measuredby output per worker), which remains well below 1990 levels. While physical capacity i s still inplace, the challenge remains to increase the competitiveness of Azerbaijan's non-oil sectors in the marketplace.Given the small size of the domestic market-both in terms of production resources and consumption-access to foreign markets, through trade and investment, will be critical to achieving economic diversification that will ultimately bring increased employment, more regionally balanced development, and encourage innovation. VI. SOURCES OFGROWTH 61. Recent macro projections suggest double-digit oil sector growth rates after 2005, provided the oil and gas potential i s fully realized. This will depend on four major projects: full development of the Azeri-Chirag-Guneshli oil field; construction of the BTC oil pipeline; development of the Shah Deniz gas field and a gas pipeline from Baku to Turkey. Initially, this implies large current account deficits, as a consequence of higher imports for oil-related FDI, to expand the capacity of the oil and gas sector. With careful macroeconomic management of the oil windfall and assuming a steady implementation of structural reforms, the non-oil sector i s projectedto grow at about 9 percent annually during 2003-05 and then to moderate to about 5 percentannually by the end of this decade, as oil-related FDIdries up.2 62. With over $8 billion in oil and gas investment in the next 3 years, the BTC oil and Shakh Deniz gas pipelines will expand revenues almost explosively by 2005. With currently known reserves, oil and gas revenues are expected to peak at $8 billion annually in 2012. A large share, through, will go to capital andprofit repatriation of the oil companies. 63. Assuming a very conservative oil price, World Bank projections imply that GDP is expected to increase almost 2% times by 2010 relative to 2002. The non-oil sector i s expected to grow at about 5-6 percent per year, which is the same rate as GDP if we subtract profit and capital repatriation (GNP adjusted). l9 EBRD and World Bank, Business Environment and Enterprise Performance Survey, 2002. Approximately 200 firms in Azerbaijan were surveyed in this comprehensivesurvey covering private sector perceptions of the businessenvironment and firmperformance. See Azerbaijan Public Expenditure Review for more details about the non-oil GDP growth projection. 17 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan 2000 2001 2002 2003 2001 2005 2008 2007 2008 2009 2010 2031 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2025 2024 /OBudgel mot1Fund DAlier-Tax P ~ o l ~ t o ~ C ~ n t m cmCapiIal Rscovcw ClOperatlng Expenese t o ~ 1 Source: WorldBankprojections 64. Government revenues will increase almost 3 times, which leads to the question: how do you spend this wealth in a productive way, that leads to balanced and more equitable growth and the creation of goodjobs for the 50 percent of the populationthat currently live in poverty. The answer is to gear public expenditures to the sustainable development of the non-oil sector. Inother words, it will be critical to keep the ratio of public expenditures to non-oil GDP relatively constant, although at a higher level. 65. The potential for growth of the non-oil sector is significant, and can be Figure 1.5 AccumulatedGrowth greatly catalyzed by the increasing economic impact of the oil and gas activities. However, doing so will require 280 1 maintaining macroeconomic stability and 260 240 ~ accelerated structural reforms to eliminate 220 .o 8 200 infrastructure bottlenecks, to improve C 180 business environment for private sector 160 development, and to promote trade and 140 120 trade facilitation. The present report 100 formulates an integrated and actionable 2002 2003 2004 2005 2006 3001 2008 2 strategy, and a realistic implementation +GDP #S YowOIIGDP -x&-C\Padpsted -+Gav't Rcvenucs +Gov'IExpmbhres - c h v Conrumpboi plan that builds on existing and planned Government anddonor-fundedactivities. Source: World Bank projections 66. Agriculture, Irrigation and Rural Development. Agriculture contributes about 18% of GDP andprovides income and employment for 40% of households. Almost all crop production comes from irrigated land. The SPPRED puts the development of agriculture in the context of an integrated rural development policy including linkages to non-farming activities such as ago-processing, industry, handicrafts, retail, distribution, transport, construction and other aspects of rural infrastructure, taking into account environmental concerns. Azerbaijan has been amongst the leaders in the CIS in farm privatization and registration of arable land, which resulted ina rapidrecovery of the sector. 18 INOTIS-IntegratedNon-Oil Tradeand Investment Strategyfor Azerbaijan 67. Nonetheless land rights and responsibilitiesfor pasture and forest landremain unclear. Major challenges in the sector include development of sustainable irrigation and applied research and extension systems; evolution towards higher value added crops, livestock and agro-processing; improving rural infrastructure and social services; and sustainable delivery of affordable ruralfinancial services. 68. Fruit and Vegetable Processing. Azerbaijan has enormous agricultural resources- nine "micro climates," fertile land, abundant supply of range of fruits and vegetables. The potential to enhance export-oriented fruit and vegetable processing activities is considerable, especially in the Russian market, as i s already occurring. A more diffuse and longer-term export opportunity comes from the expanding international market for "green" products grown without the use of chemical fertilizers, herbicides, or insecticides. Because much of the Azeri agricultural land lay fallow or at least had no chemicals applied over the last decade, foods grown on that land could qualify for green product designation. There are currently some 50 processingcompanies, of which five are successfully supplying a range of products (juices, dehydratedfruits, wine, jams, etc.) to local and export markets. 69. Butthere are a large number of factors to address to achieve this potential. These include weak factor conditions (e.g., inadequate supply of raw materials; price competition from fresh produce markets; unreliable power supply and other infrastructure constraints); demand conditions (preference for imported products; poor product quality and packaging); significant gaps in supporting industry (e.g., collection networks, post-harvest facilities, glass containers, testing facilities, irrigation infrastructure); and an unfavorable micro business environment (lack of contract enforcement, duties on packaging materials, predatory business practices, etc.). 70. Another sector exhibiting good potential is the domestic energy sector. Aside from the over-arching issue of oil revenue management, the energy sector is crucial both as an input for non-oil growth and jobs and as a consumption item for poor households. The sector issues include implicit subsidies (estimated at 11%of GDP in 2001) resulting from a combination of non payments, tariffs which do not reflect full economic costs, tariff cross- subsidies and excessive operating losses. These are now being addressed with initial focus in the non-payments issue. 71. While notable progress is being made with energy sector reforms, some additional important measures are under consideration by the Government, including restructuring of SOCAR, further reduction of implicit subsidies beyond the SAC I1 program and concomitant social assistance reform, which would be supported through the proposed follow-on Poverty Reduction Support Credits (PRSCs). There are significant environmental issues in the energy sector with its outdated technologies, malfunctioning equipment, limited pollution control mechanisms, inadequate waste management and poor quality raw materials. Moreover, environmental degradation has been growing as many households have attempted to cope with reduced gas supplies by switching to fuel, wood or oil. Incontrast to the considerable emphasis on attracting investment to the upstream oil and gas sector, the Government's attention to the domestic energy sector i s more recent and the actions, commitments and stated policies include: (a) the transfer of the power distribution business to the private sector; (b) actions to reduce energy sector non payments; (c) proposals to increase tariffs (along with a safety net for the poor); (d) the stated intent to transfer Azerigaz and power generation into private hands; and (e) a commitment to restructure SOCAR. 19 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan 72. Trade and Transport. Another near-term potential for Azerbaijan is in the trade and transportation services sector. Azerbaijan lies on the most direct route from the Black Sea to the Caspian Sea, and onwards to the Central Asian Republics. Demand for trade facilitation services in Azerbaijan i s accelerating as oil and gas activities in the Caspian increase in scale and scope. Already, it serves as a major conduit point for oil and oil products from Caspianto the ports in the west. According to a recent World Bank report on trade and transport facilitatioq2' transit cargo volumes are set to increase dramatically in line with the oil-related investment. The main components of West-East transit trade will include oil equipment; containerized consumer goods; and a variety of machinery and equipment for SMMEs. East- West trade i s likely to be dominated by oil and gas (LPG) exports. 73. Given its favorable geographical location as the only major urban area on the Caspian, Bakuhas the potential to become a hubto serve markets inthe Caspian region more cost-effectively. At present, several companies based in Baku serve regional markets by storing, sub-dividing, mixing, and re-packaging goods in European locations, such as Frankfurt. Much of these types of activities can be conducted inBaku. On the other hand, the transport sector in Azerbaijan still operates without proper separation between (i) and policy legal framework; (ii) regulatory functions; and (iii) operation and ownership. This applies particularly to air (AZAL), maritime (Caspian Shipping Company), and rail transport. As a result, Azerbaijan has experienced difficulties in defining a coherent national and international transport infrastructure network. By controlling all legal and regulatory aspects and infrastructure, state-owned operators have a defacto monopoly on their market and can restrict competition as they see fit. The lack of competition removes the most essential incentive to improve service quality and cost. The high shipping cost across the Caspian Sea and the high level of profitability of the Azeri Railways demonstratethis phenomenon. 74. Many issues remain to be resolved to realize these opportunities. At present, major physical, administrative, and institutional factors raise effective trade and transportation costs, especially when all unofficial payments and delays are taken into account. Azerbaijan also lacks basic facilities such as bonded commercial warehouses and free zones2' that would greatly facilitate development of these activities. 75. A recent Bank study on trade and transport facilitation in the South Caucasus (TTFSC) highlighted both the current impediments and the future potential for economic growth and increased revenues. A strategy and action plan has been developed and a public-private committee to support trade and transport facilitation has been established. 76. Aside from impediments in the overall business environment, a variety of administrative barriers raise effective transport costs and penalize importers and exporters. Would-be exporters suffer from a shortage of information on regional and international markets and market access requirements and the lack of capacity to meet the demand of quality-conscious markets. Inadequate transport infrastructure is another major obstacle. The Ministry of Transport i s new; regulatory and commercial functions are not yet properly separated; and there is no framework to develop an integrated transport policy andeffective regulation for the sector. 2o "Trade andTransport Facilitation in the South Caucasus-Azerbaijan,'' World Bank Policy Note, November 2002. 21 Detailed regulations on bonded warehouses exist but the scheme was effectively abolished through a recent deregulation decree of the President, which removed the needfor bondedwarehouses to be licensedby the State CustomsCommittee. 20 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan 77. The SPPRED actions involving the transport sector include: (i) restructuring and modernization of sector institutions, including the newly-established Ministry of Transport; (ii) rehabilitation of the East West Highway; (iii) improvement of rural roads, including their management and financing; and (iv) facilitating trade. IDA'Son-going road project focuses on the rehabilitation of crucial sections of the East-westHighway. It also includes five small pilot subprojectsfor ruralroads. 78. Telecommunicationsand IT services. Azerbaijan also has the potential to attract investments and boost growth in a range of information and telecommunications services. With the growth of economic activity associated with the oil and gas industry development, demand for a wide range of value-added telecommunications and networking services will increase significantly. These include local loop and long distance telephony services; cellular paging and satellite services; data access services; Internet services; and private network services. Growth of corporate networks will provide demand for software and infrastructure integration services; Internet security applications; and web hosting services. There i s also potential, eventually, for the expansion of advanced media services, such as digital content creation and paid access services. With the right infrastructure and skills development program, Azerbaijan could also develop an export-oriented software and ITservices industry. 79. But the development of these services is deterred by significant legal, regulatory and institutional obstacles. At present, limited competition has been allowed in the telecommunications market-there are two cellular telephony providers (one ajoint venture with the Ministry of Communications); the national telecommunications operator, Aztelecom has a monopoly over fixed line telephony (voice and data), as well as a broad range of telecommunications services. Internet service providers are under a number of restrictions that limit the potential for web hosting services. The basic laws governing communications and broadcasting have a number of problems including content controls. The Ministry of Communications i s both the regulator and an operator. Privatization of Aztelecom should be advancedrapidly. 80. Oil- and Gas-Related Industries. The full implementation of the pipeline projects and related oil and gas activities has the potential to stimulate development of a variety of products and services to be delivered locally." These include basic equipment and machinery; metalworking; upstream industries; specialized chemicals and solvents; and the provision of a range of technical and business services (e.& repair and maintenance, waste management and environment, transportation services, food services, among others). The Enterprise Center set up under the aegis of the Enterprise Development Committee has already taken the lead to define and realize these potentials, aimed at Azeri-owned and operatedcompanies.23 81. While this i s an immediate and tangible opportunity for local suppliers, several issues needto be addressed. A number relate to the high quality standards, large average orders, and delivery requirements of western oil companies that are difficult for most local suppliers to meet. Other issues arise from the production sharing agreements that regulate the oil business. They implicitly contain an import bias inthat local businesses 22 Initial supply chain studies undertaken by BP identified some 12 industries with potential to support the oil and gas industry. 23 The Center provides information on supplier capabilities, resources available to suppliers, current and future supply opportunities, BP's expectations for Health, Safety and Environment, quality and business conduct, required technical standards, pre-tender meetingsand other related areas. The Center also provides supplier training and consultancy services. 21 INOTIS-IntegratedNon-Oil Trade and Investment Strategyfor Azerbaijan are not protected by them and frequently cannot raise bank funding. Other opportunities are found in upstream oil and gas-related processing industries, including various chemical and petrochemical industries.The viability of these, however, needs to be carefully established, including an assessment of long-term global demandand supply trends. 82. Any strategy for generatingjobs and economic growth needs a regional dimension. Political tensions have led Azerbaijan and its neighbors to forego many opportunities for trade and cooperation on infrastructure. The BTC pipeline is an example of the benefits that cooperation on energy infra-structure can bring to the countries of the sub-region. Extending this cooperation on energy to Kazakhstan and other Caspian neighbors offers another potential area for economic growth. Azerbaijan could generate additional employment and economic benefits by serving as a transit corridor for trade to Central Asia. More efforts are needed to ease trade and transport barriers to regional trading partners, especially major potential markets such as Russia, Turkey and Iran. To support this regional outlook, IDA is engaged in non-lending initiatives in trade promotion and trade facilitation, in addition to multi-country initiatives to promote regional cooperation in telecommunications, tourism andenvironmental protection. 83. Summing up, the existing potential to develop a range of non-oil sectors is substantial, but Azerbaijan's competitiveness in export markets and as a location for inward investment in the non-oil sectors is adversely affected by a number of factors. Initial reforms have created an important foundation for the development of a competitive market-based economy, various legal, institutional, and infrastructure challenges remain, which include (i) streamlining trade policy and increasing market access; (ii) enhancing transport and trade facilitation; (iii) improving macro- and micro-business environment; (iv) developing competitive industry clusters; (v) privatizing commercial activities; and (vi) broadening access to finance. VII. CONCLUDINGREMARKS 84. Although still a low-income country, Azerbaijan has strong potential to grow rapidly in the years ahead because of the oil and gas resources which it is currently developing. These resources are considerable, but finite, peaking in about a decade and then declining rapidly. The most difficult challenge Azerbaijan faces, which i s well understood by the Government, is to avoid the path followed by many natural resource rich countries, wherein their citizens derive little benefit from the influx of oil revenues. This will require designing and implementing a policy agenda that leads to poverty reduction and improves incomes as well as equity for current and future generations, while maintaining macroeconomic and financial stability. Strong institutions are essential to tackle this challenge, yet Azerbaijan has had little more than a decade in which to build the government institutions and the civil society networks to support a market-basedeconomy. 85. The potential for growth of the non-oil sector i s significant, and can be greatly catalyzed by the increasing economic impact of the oil and gas activities. However, doing so will require the formulation of integrated and actionable strategy, and a realistic implementation plan that build on existing and planned Government and donor-funded activities. The proposed Integrated Non-Oil Trade and Investment Strategy (INOTIS) provides a framework and recommendations for improving the environment to increase non- 22 INOTIS-IntegratedNon-Oil Tradeand InvestmentStrategyfor Azerbaijan oil sector trade and investment. The proposed strategy i s broken down into four broad components: Improving the Trade Policy Regime and Market Access. Key strategies include accelerating Azerbaijan's accession to the WTO, increasing access to regional markets and the European Union; improving access to finance; streamlining administrative procedures. Enhancing Trade Facilitation. Key strategies include streamlining and strengthening customs procedures and improving the quality and capacity of Azerbaijan's transportation infrastructure. Improving the Macro BusinessEnvironment. Strategies to improve the macro business environment cover a wide range o f issues impacting on private sector development, including improving business registration and licensing; land acquisition and site development; labor market policies; taxation; access to credit; support for SMMEs; contract enforcement and dispute settlement; and public sector governance. Developing Competitive Industry Clusters. A pilot study inthe ago-processing cluster points to industry-specific strategies for improving inter-firm cooperation, promoting innovation and quality, encouraging specialization and strengthening supply chains. 86. The Government is moving rapidly forward with a wide range of structural reforms aimed at strengthening governance and removing impediments to non-oil sector development. These reforms are particularly important in order to create more jobs and equity in the Azeri society. 23 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan ANNEX 2: COMPOSITION OF AZERBAIJAN'S FOREIGN TRADE* I. INTRODUCTION 1. Achieving a more balanced growth by promoting development of non-oil sectors i s one of the greatest challenges facing Azerbaijan in the coming years. Given the small size o f the domestic market, increasing non-fuel exports may be necessary in order to attain this goal. Some conclusions about the future of Azerbaijan's exports may be reached by examining the past developments in this area, which i s the objective of this chapter. 2. This note examines developments in Azerbaijan's international trade which have taken place since mid-1990s with a particular emphasis on non-fuel exports. To place the analysis in perspective, we begin by comparing Azerbaijan's openness to trade and success in attracting foreign direct investment (FDI)to the experiences of other successor states of the Soviet Union. We analyze the performance of fuel and non-fuel exports, changes ingeographic composition of trade and factor content of non-fuel sales. We also compare the composition of CIS- andEU-oriented exports and devote a section to foreign sales of agro-processing products. Finally, we describe the pattern of Azerbaijan's imports. Several conclusions emerge from the analysis P Unlike most CIS countries, Azerbaijan enjoys a positive trade balance and has been quite successful inattracting foreign direct investment. Most o f FDIinflows have been, however, directed into the oil sector with hardly any inflows into non- oil manufacturingindustries. > Azerbaijan's exports are excessively concentrated, even by standards o f major oil exporters in the world, and its reliance on fuel exports has increased since the mid-1990s. While fuel exports increased almost fivefold between 1996 and 2001, non-fuel sales abroad went up by only two percent during the same period. In 2001, fuel exports constituted over 91 percent of foreign sales. > While Azerbaijan's imports have shifted away from CIS economies, the country has made limited progress in geographic reorientation of its exports. More than half of non-fuel foreign sales were destined for CIS markets in 2001. > Apart from fuel sales, the largest export categories include machinery and transport equipment (1.8 percent of total exports in 2001); inedible crude * This Annex was prepared by Beata Smarzynska (DECRG). The statistical analysis was conducted by Frances Ng(DECRG) 24 INOTIS-IntegratedNon-Oil Tradeand Investment Strategyfor Azerbaijan materials, except fuel (1.65 percent); beverages and tobacco (1.2); chemicals and related products (1.14) and food and live animals (0.98). > There are some similarities between the composition of Azerbaijan's exports destined for the EU and CIS markets. In both cases, machinery and transport equipment constitute the largest export category, followed by crude materials. In both markets, exports of food and live animals are important. Beverages and tobacco products as well as animal and vegetable fats, are however, sold only to the CIS. > In terms of factor content of non-oil exports, Azerbaijan sells abroad mainly natural resource based products and capital intensive goods. These two categories account for over 80 percent of non-fuelexports. P Agricultural products, both raw and processed, play a significant role in Azerbaijan's foreign trade, accounting for about 36.4 percent non-fuel exports. Agro-processing exports to the EU consist of a very small number of products. For instance, in 2000 edible nuts accounted for 44 percent of non-oil exports to the EU. 11. AZERBAIJAN'SINTEGRATIONINTOTHE GLOBAL ECONOMY 3. W e start our analysis by comparing Azerbaijan to other former Soviet republics in terms of openness to trade, measured by the ratio of exports plus imports to GDP. As has been the case for most countries in this group, the openness to trade increased in Azerbaijan during the period of 1995-2001 (from 50 to almost 66 percent). Azerbaijan has remained, however, less open to trade than the average country in the region, especially given its relatively small size, as this ratio tends to be higher for smaller economies in the world. It i s also worth pointing out that the ratio is higher for the most successful countries in the group (e.g., the Baltic states). At the same time, this measure has also increased significantly for countries that experienced severe output collapse during transition. Nevertheless, almost all countries shown in Chart 2.1 have a higher trade to GDPratio that the average for low income countries.24 24 In2000, the average ratio was equal to 35 percent for all low income countries and to 46.6 when India and Indonesiawere excluded from the group. 25 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan ! ~ Chart 2.1 Trade to GDP Ratio 1995 and 2001 - Sources: Trade data from IMF Direction of Trade Statistics database and GDP data World Bank World Development Indicators file. 4. Unlike the other former Soviet republics (with the exception of Russia and Kazakhstan), Azerbaijan has achieved a positive trade balance in 2000 and 2001. This trend also continued during the first half of 2002, which the latest period for which the figures are available. The volume of exports exceeded that of imports by 42 percent according to the balance of payments figures (and 62 percent based on the Customs figures). See Box 2.1 for a discussion of differences in data collection methodology between the two sources. 26 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan Table 2.1. Azerbaijan's Foreign Trade as Reported by the State Customs Committee and the Azerbaijan National Bank 13381 13751 1724/ 14331 1537 14651 793 I Customs data (mnUS$) I Exports 631 781 606 929 1745 2314 919 Imports 961 794 1076 1036 1172 1431 715 I ! BOP= 100 Exports 98 97 89 91 94 . 111 98 Imports 72 58 62 72 76 98 90 5. Azerbaijan has also done well in term of attracting inflows of foreign direct investment. A vast majority of FDI inflows has been received by the oil sector where multinational corporations operate under the Production Sharing Agreements. Since significant amount of capital repatriation, stipulated in these agreements, has been taking place in recent years, there i s a substantial difference between gross and net FDI flows (see Table 2.2). For instance, during 1995-2001 Azerbaijan received US$ 688 in per capita gross FDIinflows, but only US$494 in net per capita inflows. When we consider net FDIinflows, Azerbaijan still ranks very high. Only the Baltic states and Kazakhstan have done better in per capita terms. As far as the cumulative volume of FDI i s concerned, only Russia and Kazakhstan enjoyed larger inflows while Ukraine attracted a comparable amount of investment. 6. Investors involved in the oil sector include large multinationals, such as BP Amoco Group (UWUS), Exxon (US), Agip (Italy), TotalFina Elf (France), Statoil (Norway), Lukoil Overseas (Russia), just to name a few. Foreign investors have also been active in oil equipment industry and related services. Companies operating in this sector include Halliburton (US), Schlumberger (France), Kvaemer (Norway) and Aker Maritime (Norway). 27 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan Table 2.2 ForeignDirect Investment Inflows inAzerbaijan and Other CIS Countries, 1995-2001 FDIInflows($million) Cumulative FDI 1995-2001 1995 1996 1997 1998 1999 2000 2001 ($million) I ($percapita) I , 155 519 1111 1404 754 692 904 5535 688 (b) Net F [ Estonia 202 150 266 581 305 387 600 2491 1820 Latvia 180 382 521 357 348 407 257 2451 1033 Lithuania 73 152 355 926 487 379 600 2971 847 Kazakhstan 964 1137 1321 1151 1587 1250 2600 10011 673 Azerbaijan 282 662 1115 1023 510 119 265 3976 494 Georgia 8 40 243 265 82 131 120 889 177 Armenia 25 18 52 221 122 104 70 612 161 Russian Fed. 2016 2478 6638 2764 3309 2714 2921 22840 157 Turkmenistan 233 108 108 64 80 100 100 793 153 Belarus 15 105 352 203 444 116 100 1335 133 Moldova 26 24 76 86 34 128 150 523 122 Ukraine 267 521 623 743 496 595 800 4045 82 Kyrgyz Republic 96 47 84 109 44 -2 20 398 81 Uzbekistan 115 55 285 140 121 75 100 891 36 Tajikistan 15 16 4 30 21 24 20 130 21 Sources: FDIdata from UNWorld Investment Report (2002),except for Azerbaijan. Figures on Azerbaijan`s gross FDIcome from the Ministry of Economy and the net FDIdata from the IMFInternational Financial Statistics; population data are from the World Bank World Development Indicators 2002. 111. EXCESSIVE RELIANCEONOILEXPORTS 7. The most prominent characteristic of Azerbaijan's international trade i s its very highreliance on oil exports even by the standards of major fuel exporters. As is evident from Table 2.3 below, fuels constituted 85 percent o f Azerbaijan's foreign sales in 2000 as compared to 51 percent for Russia, 64 for Norway and 83 for Oman. Only five other non-African fuel exporters, including Saudi Arabia and Iran, had a higher ratio. As will be discussed below, Azerbaijan's reliance in fuel sales increased in 2001 with the ratio reaching 91percent, the level comparable to that of the Saudi Arabia.1 28 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan Table 2.3: Major Fuels Exporters inNon-Africa Countries, 2000 Country FuelExportsas % of Total Ex~orts H Alperia 1I 97 IR Yemen Rep. 93 SaudiArabia 92 1 Iran I 89 II Venezuela 86 Azerbaijan 85 II Oman I 83 1 Turkmenistan 81 Kuwait 79 Syria 76 Trinidad& Tobago 65 /I Norwav I 64 Kazakhstan 54 Source: World BankWDI 2002. 8. Given the fact that most of Azerbaijan's exports consists of oil, it comes as no surprise that the country also tops the charts in terms of export concentration. Table 2.4 lists two popular measures of export concentration used in the literature. The first one i s the number of product categories exported (at the 3-digit SITC Rev. 2 level). With 95 products in 1999, Azerbaijan ranks ninth among ten countries listed in the table. While this proxy is not ideal for comparisons between large and small economies, it is worth pointing out other small economies such as Estonia and Lithuania exported over two hundred different goods duringthe same period. The secondcommonly used measure i s the so called Hirschmann index, whose values range from zero to unity, with higher numbers corresponding to greater c~ncentration.~~By this measure, Azerbaijan appears to have by far the most concentrated export structure. Its value of the Hirschmann index i s equal to 0.5 as compared to 0.4 for Kyrgyzstan (ranking second), 0.2 for Latvia and 0.1 for Belarus and Lithuania. 25 Hi = where xi is the export value of commodity i,X is the value of total exports, and ni s the number of products at the 3 digit SITC level (239 product groups). 29 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan 9. High concentration of exports makes the economy vulnerable to demand and price shocks in world markets. Thus, revenues from exporting are likely to fluctuate significantly from year to year and thus require an introduction of a stabilization mechanism, such s, an oil fund. Given that oil extraction i s a highly capital intensive activity, it creates fewer employment opportunities that would exporting of non-oil products. Table 2.4: Concentration Indices of Exports inAzerbaijan and Selected Countriesin 1999 0.353 Armenia 0.349 RussiaFederation 0.261 Moldova 0.250 Latvia 0.211 Estonia 0.124 Belarus 0.113 Notes: l a Based on numbers of products exported at the SITC Revision 2 3-digit level that the export values are greater than $100,000 or more than 0.3% of the country's total exports. Source: UNCTADHandbook od Statistics, 2000 and 2001. 10. Azerbaijan's reliance on oil exports has grown since the mid-1990. While fuel exports increased almost fivefold between 1996 and 2001, non-fuel sales abroad went up by only two percent. Thus, the share of fuel intotal foreign salesjumped from 69 percent in 1996-98 to 91percentin2001. At this time foreigntrade figures are available only for the first six months of 2002 and since foreign sales, especially those of agricultural products, are seasonal, it is difficult to assess the country's export performance during the full year. Nevertheless, a radical change is unlikely to have taken place. The partial figures indicate an 89 percent share of fuel intotal exports. 11. As Chart 2.2 below illustrates, non-fuel exports experienced a decline duringthe time of the Russia crisis (1998-9) but rebounded significantly increasing from US$ 199 million in 1999 to US$ 260 million in 2000. This rebound was short-lived as non-fuel exports amounted to only US$ 201 million in 2001. However, according to the balance of payments figures (which as discussed in Box 1 are not directly comparable), non-oil sector exports increased by US$ 23 million in the first half of 2002 relative to the first half of 2001. 30 INOTIS-IntegratedNon-Oil Tradeand InvestmentStrategyfor Azerbaijan Chart 2.2 Fuelvs. Non-fuel Exportsof Azerbaijan 120 2500 100 2000 80 1500 -2 A $? 60 Y 40 1000 3 20 500 E 0 0 1996 1997 1998 1999 2000 2001 2002 (1st half) I 10Fuels("A)0Non-Fuels(%)+Fuels +Non-Fuels1 12. The developments inforeign trade are closely mirroredby the statistics reflecting the economic activity in the country. As Table 2.5 indicates, the extractive industry experienced strong growth during the period 1998-2000, with its output increasing to fifty percent above its 1995 level. The manufacturing sector, on the other hand, was undergoing a steady decline throughout the last decade and didnot beginto rebound until 2000. In2000 manufacturing output in Azerbaijan was equal to less than a quarter of its 1990 level. 13. The domination of the oil sector is also reflected in the FDI statistics (see Chart 2.3 below). Seventy-eight percent of cumulative gross FDI inflows during 1995-2002 was directed to the oil sector. Inflows into non-oil sectors have been unimpressive. Outside the oil industry, foreign investors have been active in telecommunications (Azercell Telecom - Finland, Bakcell - Israel, US), banking (Kocbank Azerbaijan JsB - Turkey), construction (Kenan Construction and Trade Co., Ahsel Construction Undertaking and Trade, Enka Insaat ve Sanayi A.S. - Turkey) and hotels (Baku Hotel Company -UK). The presence of foreign investors in manufacturing has been limited, rare examples include Garadagh Cement (cement -- Switzerland), Castell (brewing - France), Baku Steel (steel mill- UK),Coca-Cola. Notable is also the lack of interest on part of foreign investors inagro-processing sector. 31 INOTIS-IntegratedNon-Oil Tradeand Investment Strategyfor Azerbaijan Chart 2.3 FDI Inflows into Azerbaijan 1995-2001 1600 x.rm- I 1995 1996 1997 1998 1999 2000 2001 Iv. LIMITEDSUCCESSINGEOGRAPHICREORIENTATION OFEXPORTS 14. Since strategies for development of the non-oil sector are the primary interest of this report, the rest of this chapter will focus mainly on the non-hydrocarbon trade. 15. During the past decade, the most successful transition economies experienced a dramatic shift in their trade from their traditional markets in the region towards the European Union (EU) and other OECD countries. For instance, in 2000 EU-oriented exports accountedfor about two-thirds of Estonia's and Latvia's total exports and almost half of Lithuanian foreign sales. The increasing ability of these countries to sell their products in the highly demanding EU markets is an indication of continuous upgrading and improvements inthe competitiveness of their producers. 16. While for many former Soviet Republics CIS countries remain natural trading partners, prospects for expansion of sales to the region are limited by the relatively low purchasing power of its consumers. Thus increasing sales to industrialized country markets may in short term be a better strategy for export-led growth. Breakinginto these markets is, however, more difficult due to greater competition, trade barriers and product standard requirements. Unlike CIS countries which mutually recognize their product certifications based on the old Soviet GOCT system, this i s not the case in the EU. Complying with the EU requirements in this respect may be especially challenging in agricultural and agro-processing sectors (see Evgeny's Chapter for a detailed discussion). 17. Azerbaijan has remained very dependent on its trade with the CIS countries. While during the last five years, non-oil exports to CIS increased by 18 percent, non-oil sales to the EU and the rest of the world went down by 12 and 14 percent, respectively. In2001, 57 percent of Azerbaijan's non-oilexports were directed to CIS, as compared to 49 percent five years earlier. EUaccountedfor 12 percent of such exports in 2001 down from 14 percent in 1996. Note, however, that in 2001 an economic slowdown began in the EU which may have adversely affected the import demand. A declining pattern i s also evident with respect to the rest of the world (see Table 2.6). 32 INOTIS-IntegratedNon-Oil Tradeand Investment Strategyfor Azerbaijan 18. This picture is a sharp contrast to the developments on the import side, where non-fuel purchases from the EUand rest of the world increasedby over one-third and 84 percent, respectively, during the period 1996-2001. This change took place at the expense of imports from CIS which declined by one-fifth with their share falling from 37 to 32 percent. Table 2.6: Direction of Trade of Non-Fuel Product inAzerbaijan, 1996-2002 Sources: UNCOMTRADE Statistics and Azerbaijan's Government data. 19. As far as individual trading partners are concerned, in 2000 the Russian Federation accounted for 29 percent of Azerbaijan's non-oil exports, as compared to 22 percent in the case of Kazakhstan's non-oil exports and 8.2 percent in the case of Turkmenistan. Duringthat year Azerbaijan sold only one-tenth of its non-fuel exports to the EU, which exceededthe corresponding figure for Turkmenistan (4.6 percent) but was far below the share enjoyed by Kazakhstan (27.5 percent). See Annex Table 1for more details. 33 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan v. COMPOSITION OFEXPORTS 20. As mentioned above, while Azerbaijan's total exports increased almost threefold during 1996-2001, this change was almost entirely due to a rise in hydrocarbon exports. Some interesting patterns can be, however, observed within the non-oil foreign sales. As illustrated in Table 2.7, Azerbaijan's sales of food and live animals (SITC 0) went up during this period, with 2000 being a particularly successful year. An increase was also observed in exports of animal and vegetable oils and fats (SITC 4), beverages and tobacco (SITC 1). To keep things in perspective, note, however, that these three categories accounted for only 2.3 percent of total exports in2001. 21. Positive developments were also observed in exports of chemicals and related products (SITC 5) and machinery and transport equipment (SITC 7),where the volume of exports increased by 36 and 29 percent, respectively. At the same time other manufactured goods (SITC 6 and 8) suffered a decline in their export value. The combined share of these four categories dropped from 14 to 4 percent during 1996-2001. Note that three of these groups experienced an increase in export volume in 2000 followedby a decline in 2001. 22. How does the structure of Azerbaijan's exports compare with those of other oil exporters in the region, namely Kazakhstan and Turkmenistan? Among the three countries, fuels account for the largest share of exports in Azerbaijan. Moreover, while Azerbaijan's foreign sales of manufactured goods (SITC 6) are limited and declining in importance, they constituted more than a quarter o f Kazakhstan's exports in 2000. Their value also increased in Turkmenistan, where in 2000 they constituted for 4.3 of total exports. Note that in the case o f Turkmenistan these sales consisted mainly of textiles and yarns. See Annex Table 2 for more details. 34 - 3 0 0 N 3 4 4 3 00 N - e C sz C Q c2ca il: 1 i .c c faC c cU e- 2c v Q S .C fQa p1 4 tt e INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan VI. COMPARISONOFNON-FUEL EXPORTSCIS ANDEUMARKETS TO 23. There are some similarities between the composition of Azerbaijan's exports destined for the EUand CIS markets. Inboth cases, machinery and transport equipment constitute the largest export category, followed by crude materials. In both markets, exports of food and live animals are important. Beverages and tobacco products as well as anima4 and vegetablefats are, however, sold only to the CIS (see Qart 2.4). Chart 2.4 Azerbaijan'sNon-FuelExportsto CIS and EU markets in 2001 24. To learn more about specific products sold to each destination, Table 2.8 presents major 4 digit export categories traded with CIS countries and the EU. The top three products on the CIS list are natural resource based and include tobacco, cotton, and aluminum ores and concentrates. While exports of cotton come from domestic cultivation, some of the tobacco is imported (see Annex Table 3). Similarly, inputs for production of aluminum concentrates are imported. The same i s true of tea - imported tea i s mixed with domestically produced tea and then shipped to CIS countries - with imports of tea exceeding the value of exports sevenfold. The list also includes nuts and spirits as well as chemical products (polyethylene, inorganic bases) and special purpose motor lorries (note that lorries themselves are imported as well). 25. Two items, namely nuts and parts of machinery and construction, also appear on the list of major items exported to the EU. The list further includes some crude materials (ash and residues), machinery (pumps, electrical apparatus, motors and generators), chemical products and preparedor preservedfish. 36 INOTIS-IntegratedNon-Oil Tradeand Investment Strategyfor Azerbaijan Table 2.8: Azerbaijan's Major Non-Fuel Exports to CIS Countries and the EU,1996-2002. I Exports to CIS Export Value (US$ '000)/b 2634 Cotton, carded or combed 2873 Aluminumores and concentrates 342 423 328 11171 21263 8027 Partsof the machinery of 7239 construction 2080 2574 1997 2455 4979 0577 Edible nuts, fresh or dried 2634 3261 2530 3790 3799 5590 161 5831 Polyethylene 587 727 564 1168 3720 5505 2158 7822 Special purpose motor lorries and veh 304 377 292 758 3282 3062 0741 Tea 2327 2881 2235 4019 2504 3055 1863 7449 Parts of the loadingmachinery 79 98 76 2107 1752 3008 2026 1.3 1124 Spirits; liqueurs,other spirituous 8453 10463 8117 5338 5707 2646 5225 0th. inorg. bases & metallic oxid. 1706 2111 1638 1234 1452 2285 i. 6581 Sacks and bags, of textile materials 1303 1613 1252 2709 2195 2002 1457 11above goods 30204 37386 29005 48589 71084 63937 20135 28.16 to 9 111goods !47906 306859 238068 216176 250962 227057 9096~ 100.0~ I / Exports to EU Export Value (US$ '000) /c Export share (%) 0 0 0 0 0 3420 0.21 5847 7238 5615 7135 11291 2921 619 1869 2313 1794 2491 17239 1489 2787 Ip..tsof the machinery of construction 2291 2836 2201 1811 1122 2238 1665 0.1 pumpsfor liquids& liquidel 7 9 7 0 25 1232 112 app. suchas switches, relays 104 129 100 0 18 1005 40 50 39 0 1 735 0 0 0 0 0 688 0.0 17 21 16 1608 1662 613 934 0 0 0 1061 913 518 11above goods 10175 12595 9772 14106 16521 16155 890 136910 169467 131477423443 1053665 160800159514q 1 0 ~ : ~ ~ I Notes: /a Trade data in 2002 include Janurary to June only that it basedon the concordance from HS 6-digit I I I INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan 26. Selected output statistics, presented in Table 2.9, are consistent with the picture painted by the trade figures. For instance, between 1999 and 2000 output of tobacco products increasedfourfold, while production of chemicals and other transport equipment rose by forty percent. In all these industries, output level in 2000 was way above the 1995 levels, which is in sharp contrast to developments in many other industries (for instance, food andbeverage). 27. Nevertheless, a positive trend has been observed in food and beverage sector since 1999. Companies with foreign capital have contributed to increased activity in the industry and possibly also exports. They include Teksun oil industry (vegetable oil), Coca-Cola (soft drinks), BM-SUN (packed tea), Azeri-Caste1 (beer), Sickendick (sausage), Barakat (skimmed milk products), and AJG Investments (juice and tomato products). European Tobacco has been active in manufacturing o f cigarettes and tobacco products. Table 2.9. Production of Selected Products 1996-2000. 1996 1997 1998 1999 2000 Percentage change 1995 = 100 between 199 and2000 Foodandbeverage 84.7 80.7 59.3 61.6 66.2 107.4 Tobacco products 55.9 87.7 49.2 49.5 193.3 390.5 Chemical products 108.2 87.6 79.3 97.3 139.5 143.4 Non-metal mineral substance 121.6 142.0 125.3 132.3 169.7 128.3 Production of other transport equipment 124.6 137.7 158.2 139.5 199.5 143.0 VII. FACTOR INTENSITY OFEXPORTS 28. In terms of factor content of non-oil exports, Azerbaijan sells abroad mainly natural resource based products and capital intensive goods. These two categories account for over 80 percent of non-fuel exports (see Table 2.10). Within the natural resource based category, the major 4 digit SITC product categories sold to CIS markets were tobacco (unmanufactured, manufactured as well as cigarettes), cotton and cotton seed oil, nuts, fruits, tea and alcoholic beverages. The top EU-oriented export items in this group were non-ferrous metal scrap, nuts, fish, aluminum and oil seeds.26 As for capital intensive exports, Azerbaijan sells, among others, construction and mining machinery, pumps and centrifuges, measuring devices and hydrocarbon derivatives to both CIS andEUmarkets. 29. Human capital intensive products constitute about one-tenth o f non-oil exports. The main items are special purpose lorries, tubes and pipes, recorded tapes, etc. The share of unskilled labor intensive goods is negligible, which contrasts sharply with the export structure of other transition countries. For instance, in 1999 such products ~~ 26Notethat further metalscrap exportshavebeenprohibitedby a governmentdecree of April 16,2001. 38 INOTIS-Integrated Non-Oil Tradeand Investment Strategy for Azerbaijan accounted for 40 percent of Lithuania's exports to the EU. Moreover, the share of these products inAzerbaijan's exports has been declining over time. 30. On the other hand, capital and human capital intensive goods experienced a significant increase in foreign sales. The export value of the former group went up by 44 percent during 1998-2001,while the corresponding figure for the latter was 19percent. Table 2.10: Azerbaijan's Non-Fuel Exports and Imports by Factor Intensity, 1998-2001 ExportValue ($ `000) Share (in %) /b Annual Exports growthrate 2001 FactorIntensity 1998 1999 2000 2001 1998 1999 2000 2001 1998-2001 1998= Non-FuelNatural ResourceBased 109266 107835 126295 88144 58.0 54.2 48.5 43.9 -6.9 81 UnskilledLabor /a 8156 8480 6410 4605 4.3 4.3 2.5 2.3 -17.3 56 CapitalIntensive 52636 68737 88076 75665 27.9 34.6 33.8 37.7 12.9 144 Skilled labor 18267 13840 13146 21828 9.7 7.0 5.0 10.9 6.1 119 All Non-Fuel goods 188325 198892 260375 200689 100.0 100.0 100.0 100.0 2.1 107 32. The most prominent category, constituting over 11percent of non-oil exports in 2001, is food. Most of food exports consist of unprocessedproducts. In2000, the value of processedfood exports was equal to US$3.3 million, as compared to US$ 19.3 million of unprocessedfood sales. However, processedfoods experienced a faster growth rate of 43 percent (as opposedto 2 percent for unprocessedproducts) between 1996-2001. 33. Within food, the largest export items include edible nuts, tea, vegetable products and fresh or dried fruit. Edible nuts are sold to both CIS and EUmarkets. Their exports experienced a large jump in 2000 increasing in value to US$ 18 million only to fall by almost half in the following year. In 2000 nuts accounted for 44 percent of non-oil exports to the EU, but in 2001 their share dropped to 12 percent. In CIS markets, they constituted less than five percent of non-oil sales in 2001. Tea and fruit, on the other hand, are sold mainly to CIS countries. As discussed above, most of tea leaves are imported and then subsequently mixed with domestically produced varieties. Vegetable 39 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan products, sold mainly to CIS, were one of the most dynamic export items with exports increasing from US$ 0.6 million in 1996 to US$ 2.2 million in 2001. As far as EU markets are concerned, there are only four lund of food products with exports exceeding US$ 40 thousand in 2001. Besides nuts, these are prepared or preserved fish, fruit and vegetable juices and flours, meals and flakes of potatoes. Note that exports of the last three items began only duringthe past few years. See Annex Tables 4 and 5 for top agro- processing products sold to each destination. 34. Another important agro-product category i s beverages and tobacco accounting for almost 14 percent of non-fuel exports. This group includes tobacco, cigarettes, spirits and wine, all of which are exported to CIS markets but not to the EU. Note, however, that Azerbaijan i s also a large importer of tobacco with purchases of unstripped tobacco amounting to US$ 14.3 million in 2001. For comparison, the total value of exported tobacco products was equal to US$24.6 million during the same year. 35. Other agricultural raw materials, mainly cotton, constitute another important export group. Exports of carded and combed cotton amounted to 7.2 percent of non-fuel foreign sales in 2001, but their value was, however, less than half of the 1996 As was the case with nuts, cotton exports more than tripled between 1999 and 2000 (from US$9 to 31.7 million) only to drop to US$ 14.4 million in2001. Inthe same year, out of US$ 14.4 million of total exports of carded or combed cotton, US$ 10.4 was destined for CIS markets. Cotton is not among significant export categories to the EU, where the sales of Azerbaijan's other agricultural raw materials amounted to less than US$ 0.6 million in2001. 36. Finally, other agro-processing products deserving a mention are hides and sluns and oils and fats. The volume of exports involved here is, however, very small not exceeding one million dollars (with the exception of one category - cotton seed oil). e nuts, fresh or dried 10156 12572 9753 13311 18009 98 5.18 6.92 4.9 3636 4501 3492 4095 2628 31 1.85 1.01 1.5 etable products, roots 626 775 601 1576 1499 21 t, fresh or dried, n.e.s. 944 1169 907 1688 2242 149 883 1093 848 883 680 104 27 The sharp drop in cotton pricesin world markets during the recent years was partially responsible for plummeting cotton production in Azerbaijan. The Liverpool Index price of cotton halved between 1995 and 2001(Em,Azerbaijan's Country Profile 2002). 40 INOTIS-Integrated Non-Oil Tradeand InvestmentStrategyfor Azerbaijan 255 316 245 212 538 48 4 1 9 ~0.13 0.21 0.2d 0 0 0 0 0 1771 1 0.00 0.00 0.od 56 70 759 939 23 28 22 55 1134 119 528 0.01 0.44 0.06 18940 23444 8189 22814 29331 19276 102 9.66 11.27 9.60 2301 2848 2209 4912 4424 3295 143 1.17 1.70 1.64 6211 7688 5965 11793 8742 11808 19d 3.17 3.36 5.88 146 180 140 330 1866 10298 >lo00 0.07 0.72 5.13 9894 12246 9501 5339 5707 2646 27 5.05 2.19 1.32 co, manufactured 5090 6300 4888 9181 1010 2470 49 2.60 0.39 1.23 3007 3722 2888 651 320 360 12 1.53 0.12 0.18 6335 7841 6084 11870 8827 11834 187 3.23 3.39 5.9C 18147 22462 17427 15515 9027 15876 87 9.25 3.47 7.91 & equine hides (other 514 636 494 657 557 624 121 0.26 0.21 0.31 ins, raw (fresh, salted, 1695 2098 1628 283 253 374 22 0.86 0.10 0.19 & lamb skins with wool 1208 1495 1160 584 588 319 26 0.62 0.23 0.16 ep & lamb skins without tht 255 315 245 47 218 168 66 0.13 0.08 0.08 3683 4559 3537 1576 1618 1566 43 1.88 0.62 0.78 29973 37100 28783 9111 31663 14442 48 15.28 12.16 7.20 853 1056 819 1257 1035 1366 160 0.43 0.40 0.68 other than linters),not 18933 23436 18182 12163 4633 449 2 9.66 1.78 0.22 th. rubb.lat.; synth. rubb. 624 773 600 102 239 415 67 0.32 0.09 0.21 seeds and oleaginous fruit. 1 1 1 0 0 341 >lo00 0.00 0.00 0.17 clothing and other old 955 1183 918 796 252 281 29 0.49 0.10 0.14 45 55 43 211 541 271 608 0.02 0.21 0.14 119 148 115 71 196 167 140 0.06 0.08 0.08 53837 66639 51700 24752 39881 18340 34 27.45 15.32 9.14 41 INOTIS-integrated Non-Oil Tradeand investment Strategyfor Azerbaijan Oils and Fats 4233 Cotton seed oil 1494 1850 1435 1248 1075 1282 86 0.76 0.41 0.64 4249 Fixed vegetable oils, n.e.s 34 43 33 662 1595 823 >lo00 0.02 0.61 0.41 4236 Sunflower seed oil 6 7 6 858 629 578 >lo00 0.00 0.24 0.29 4235 Olive oil 64 79 61 0 38 147 232 0.03 0.01 0.07 All oils and fats 1661 2056 1595 3351 3598 2892 174 0.85 1.38 1.44 Memo Item All Non-Fuel Products 196096 242728 188313 198828 260348 200687 102 100.00 100.00 1OO.OC Imports 37. Azerbaijan's imports have been steadily increasing since 1997 (with the exception of a minor dip in 1999). Note, however, that the figures presentedbelow underestimate the total value of imports as they do not include imports of oil companies operating under the Production Sharing Agreements(see Box 1for a discussion). In 2001 CIS countries accounted for almost one-third of Azerbaijan's imports, while about one-fifth of foreign purchases came from the European Union (see Chart 5). In2000, the top import sources were the Russian Federation (21.2 percent), Turkey (11), the United States (lO.l), Germany (5.8), UnitedKingdom (5), Kazakhstan (4.9) and Iran (4.9). Chart 2.5. Azerbaijan'sImports1996-2001 f 1600 1400 = 1200 u- 1000 CIS Countries 0 800 2 600 400 Rest-of-World 200 0 38. To learn more about the composition of Azerbaijan's products, we break them into so called `end-use' categories classified by the US Bureau of Economic Analysis. The figures presentedin Table 2.12 indicate that over one third of imports consists of capital goods (excluding automobiles), over a quarter is accounted for by consumer goods and less than one-fifth by food and feeds. Imports of industrial materials are negligible. The composition of Azerbaijan's imports has changed only slightly over the period 1996-2001with a drop in the share of consumer goods and autos and an increase incapital goods andindustrial materials. 42 INOTIS-IntegratedNon-Oil Tradeand InvestmentStrategyfor Azerbaijan Table 2.12: Azerbaijan'sImports by End-Use Product, 1996-2002 Jan-Jun 1996 1997 1998 1999 2000 2001 2002 Import Value (mnUS$) 172 142 193 222 237 252 124 10 9 12 10 43 24 7 apital Goods, excl. auto 320 264 358 388 417 508 193 67 55 75 42 48 42 29 334 277 375 308 369 388 194 904 747 1013 970 1114 1215 547 Fuels 57 47 64 66 58 216 164 All Goods 961 794 1076 1036 1172 1431 711 Import Share (in %) ,FoodandFeed I 17.9 17.9 17.9 21.5 20.2 17.6 17.4 1.1 1.1 1.1 0.9 3.6 33.3 33.3 33.3 37.4 35.6 7.0 7.0 7.0 4.1 4.1 34.8 34.8 34.8 29.7 31.5 27.1 on-FuelProducts 94.1 94.1 94.1 93.7 95.1 5.9 5.9 5.9 6.3 4.9 ~ 1Goods 1 I100.0 100.0 100.0 100.0 100.0 100.0 1oo.q Note: The classifications are basedon products inSITC Revision2, Food & feed (0+1+2+4-27-28); Industrial materials (27+28+68); Capital goods, excl automobiles (7-78),Roadautomobiles (78), Consumer goods (5+6+8+9-68), Fuels (3), Non-fuels (0to 9 less 3), and All goods (0 to 9). Sources: UNCOMTRADE Statistics and Azerbaijan's Government data. 39. Chart 2.6 below illustrates the industry composition of Azerbaijan's imports. The largest and growing import category i s machinery and transport equipment, followed by manufactured goods and food and live animals. The fastest growing import categories during 1996-2001 were mineral fuels and lubricants and beverages and tobacco (both experienced almost fourfold increases) with the share of former category increasing from 4 to 15 percent duringthe period. 43 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan +Beverages and tobacco Crude materials,inedible,exceptfuel -W- Mineralfuelsandlubricants +Animal andvegetableoils and fats +Chemicals and related products +Manufactured goods -Machinery andtransport equipment 1996 1997 1998 1999 2000 2001 -Miscellaneous manufactured ~ articles IX. CONCLUSIONS 40. Outside the oil sector, Azerbaijan's export performance has been disappointing. Between 1996 and 2001 non-fuel exports increased by only two percent. Little progress has been made in geographic reorientation of exports. In 2001, more than half of non- fuel foreign sales was directed to CIS markets. 41. Interms of factor content, Azerbaijan sells abroad mainly natural resource based products and capital intensive goods with these two categories accounting for over 80 percent of non-fuel exports. The human capital endowment of Azerbaijan is not reflected inits foreign sales, as skilled labor intensive products constitute about 11percent of non- fuel exports and the share of unskilled-intensive goods are negligible. 42. Agricultural products, both raw and processed, play a significant role in Azerbaijan's foreign trade, accounting for about 36.4 percent non-fuel exports. Given its endowment of fertile soil and favorable climatic conditions, Azerbaijan could strive to increase its exports of agro-processing products. Attaining this goal is not going to be easy, as in CIS such exports will face competition from other cheap producers in the region and in the EU and other industrialized country markets they will be subject to strict product and phytosanitary standard requirements. Currently, agro-processing exports to the EUconsist of a very small number of products with edible nuts accounting for 44 percent of non-oil exports to the EUin 2000. 43. While expanding sales to other CIS countries is a commendable goal, one should keep in mind that prospects for export expansion to the region are limited by the relatively low purchasing power of its consumers. Thus, expanding sales to the region should be accompanied by the challenging process of entering the markets of industrialized countries. Breakinginto these markets will be more difficult due to greater competition, trade barriers and product standard requirements. Unlike CIS countries which mutually recognize their product certifications based on the old Soviet GOCT 44 INOTIS-IntegratedNon-Oil Tradeand Investment Strategyfor Azerbaijan system, this i s not the case in the EU. Complying with the EU requirements in this respect may be especially challenging in agricultural and agro-processing sectors. 44. Improving business environment and actively attracting foreign direct investment into manufacturing sectors should be a vital component of the country's efforts to promote growth of non-oil sectors. Multinational companies can offer Azerbaijan not only capital, new technologies and management skill but also access to international distribution networks, knowledge of customer preferences and production techniques assuring compliance with standard requirements prevailing in western markets. Thus attracting FDImay be the fast and most cost efficient way o f entering world markets for non-fuel products. 45 a I c .d 0 .= INOTIS-IntegratedNon-Oil Tradeand Investment Strategyfor Azerbaijan Annex Table 2: Comparisonof Exportsfrom Azerbaijan, Kazakhstan and Turkmenistan, 1996-2000 Exports in 2000 Export Share(in %) 1745 276 100.0 100.0 100.0 100.0 1OO.C 34 159 3.4 3.4 3.4 3.0 1.9 verages and tobacco 18 73 3.9 3.9 3.9 2.9 l.C 83 139 9.4 9.4 9.4 4.9 4.7 fuels, lubricants and related 1485 341 68.9 68.9 68.9 78.6 85.1 and vegetable oils, fats 4 217 0.3 0.3 0.3 0.4 0.2 als and related products, n.e.s. 34 177 3.1 3.1 3.1 2.5 2.0 17 72 3.8 3.8 3.8 2.5 1.0 3 57 0.9 0.9 0.9 0.4 0.2 63 195 5.1 5.1 5.1 3.8 3.6 8 58 2.2 2.2 2.2 1.4 0.5 0 28 0.2 0.2 0.2 0.0 0.0 0 18 0.0 0.0 0.0 0.0 0.0 260 133 31.1 31.1 31.1 21.4 14.9 9116 154 100.0 100.0 100.0 100.0 100.0 582 90 11.0 11.0 7.6 7.3 6.4 19 40 0.8 1.1 0.4 0.2 0.2 664 151 7.4 8.5 8.6 6.2 7.3 era1fuels, lubricants and related 4827 248 32.9 34.1 38.1 40.9 52.9 and vegetable oils, fats 1 85 0.0 0.0 0.0 0.0 0.0 als and relatedproducts, n.e.s. 226 42 9.0 6.7 6.1 6.1 2.5 2382 129 31.1 31.8 32.1 30.2 26.1 5 17 0.5 0.2 0.2 0.1 0.1 194 50 6.6 4.7 3.8 4.9 2.1 46 90 0.9 0.6 0.4 0.5 0.5 4 34 0.2 0.1 0.1 0.1 0.0 175 1228 0.2 1.5 2.9 3.6 1.9 .. 100.0 100.0 100.0 100. od and live animals 0.4 0.9 0.4 0. 0.4 0.3 0.0 0. ials, inedible, except fuel 13.6 26.1 19.6 10. s, lubricants and relate 76.5 58.5 64.1 81. 0.0 0.0 0.0 0. 1s and related products, n.e.s. 0.6 0.7 0.6 0. 7.9 11.8 8.5 4. 6.0 9.5 8.2 4. 0.1 0.2 1.6 0. 0.5 1.6 1.4 1. of apparel and clothing 0.2 1.5 1.3 1. dities and transactions not else .. ...................... 0.0 0.0 3.7 1. Source: UNCOMTRADE Statistics. 47 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan Annex Table 3: Azerbaijan's Major Non-FuelImports by SITC 4-Digit Products,1996-2002. ImDort Value ($ '000)/b 1 ISITC-4 broduct 1996 1997 1998 1999 2000 2001 2002/d 7149 rts of the engines & motors 899 743 1007 2152 33776 80916 31712 0412 her wheat (including spelt) 34627 28632 38805 56864 78314 63124 38814 6782 "seamless" tubes and pipes 19860 16422 22256 9102 27880 38827 4570 7239 of the machinery of mining 17533 14498 19648 16442 27584 36348 13795 7649 of apparatusof telecom. 20866 17254 23383 8956 11464 30758 2428 7810 enger motor cars, for transport 19976 16518 22386 17023 21949 26081 11785 0741 2996 2477 3357 5682 6513 22091 6587 5417 icaments(inc1uding veterinary) 24163 19980 27079 22716 37198 21139 5526 0612 sugars and other products 8925 7380 10001 9957 13430 16791 8095 7643 egraphic & radiotelephonic 15416 12747 17276 28378 43798 16132 11600 6783 es and pipes, of iron or steel 17324 14325 19414 7819 8366 15966 2590 7284 appliances for specialize prod 7014 5800 7860 20624 25856 15356 0114 try, dead & edible offals 13787 11400 15451 11075 15330 15140 3714 1212 cco, wholly or partly stripped 0 0 0 0 2200 14261 3469 7162 motors & generators 5006 4140 5610 6921 6703 12967 3033 2482 ood of coniferous species 13041 10783 14614 13338 14099 12004 5343 6612 landcement, cement fondu 12858 10632 14409 16846 18658 11984 2055 6911 ctures & parts of struc.; irods 5486 4536 6148 45329 18380 10964 16818 bllabove goods Z39777 198267 268706 299224 411499 460848 1719331 to9 bllgoods 960601794300 1076497 1035662 1172033 1430877 7111401 Notes: la Trade data in2002 include January to June only that it based on the concordance of H S &digit products. /b Include imports at least $10millionin2001and$2 million in2002 (first half), excluding aircraft industry (7922). Sources: UNCOMTRADE Statistics and Azerbaijan's Government data. 48 INOTIS-Integrated Non-Oil Trade and investment Strategyfor Azerbaijan Annex Table 4: Azerbaijan's Major E! orts of Agro-processing Products in CIS Countries, 1996-2001 SITC-4Product ExportValue ($ '000) Share inNon-fuel Exports (in %) 1996 1997 1998 1999 2000 20011 1996 1997 1998 1999 2000 2001 Food 577 Edible nuts, fresh or dried 741 Tea 579 Fruit,fresh or dried, n.e.s. Vegetables, frozen or in 546 temporary p 585 Juices; fruit & veget. 814 Flours & meals, of meaufish, Meal and flour of wheat and 460 flour o 574 Apples, fresh 545 Other fresh or chilled vegetables 571 Oranges, mandarins, clementines Edible products and preparations 980 i"- All non-processed foodproducts All processedfood products Beveragesand Tobacco 1211 Tobacco, not stripped 1124 Spirits; liqueurs, other spirituous 1222 Cigarettes 1223 Tobacco, manufactured 1121 Wine of fresh grapes ep & lamb skins with wool 3699 4579 3552 6515 2403 449 3.82 3.82 3.82 6.93 1.69 0.39 th. rubb.lat.; synth. rubb. 618 765 593 72 230 396 0.64 0.64 0.64 0.08 0.16 0.35 9446 11693 9071 8979 14824 11621 9.76 9.76 9.76 9.55 10.45 10.16 1494 1850 1435 1248 445 1282 1.54 1.54 1.54 1.33 0.31 1.12 34 43 33 662 869 823 0.04 0.04 0.04 0.70 0.61 0.72 6 7 6 858 629 578 0.01 0.01 0.01 0.91 0.44 0.51 1656 2050 1590 3290 2193 2729 1.71 1.71 1.71 3.50 1.55 2.39 Note: The major products includethose agi exportsat least $100,000 in 2001. Source: Based&SITC Revision 2 from UNCOMTRADE Statistics. 49 - 3 0 2I-20 2 0 N - 3 0 m o 0 2 0 y o N 0 0 0 m Q\ 0 0 0 2 8 8 8 00 a\ 2 m I- 2 w 2 m - 8 4 S d m 0 a - N 0 o w m 0 I- 0 0 8 m m 4 d v) 3 m m O m N m 2 d mN 0 m + w z o o 0 3 Q\ w O Z 8 W e L 2 m d w w Q\ I- ocooo 2 m O Z $ % N m vr I- w w 0 - c o m m h - a\ 2 zr-000 m d " 0 -2 K C 0 e 2 0 c) 0 Q 1 a fi L INOTIS-Integrated Noiz-Oil Tradeand Investnzent Strategyfor Azerbaijan ANNEX 3: MARKET ACCESS ISSUESFORAZERBAIJAN* I. SUMMARYANDCONCLUSIONS 1. This paper exploresmarket access issues for Azerbaijan inthe context of the objective of diversification away from oil exports. Inparticular, we seek to address the issue of whether constraints upon access to overseas markets are hampering the development of non-oil exports from Azerbaijan. We start by briefly reviewing the country and product structure of current exports from Azerbaijan to assess whether export sales of particular product groups are concentrated in specific country or regional markets. The subsequent aim being to identify whether there are policy engendered constraints on market access that can explain why certain products are sold in some markets but not others. We then proceed to discuss the nature of market access to the key export markets of Azerbaijan: the EU, Russia and the CIS. The broad conclusions from this analysis are that: 0 Azerbaijan's exports of non-oil products are highly concentratedon a narrow range of products. 0 The structure of exports to the key overseas markets is very different - Azerbaijan appears to be selling different products inRussiato those sold inthe EU. 0 The current structure of exports to Russia and the EU entails that there is not intense broadly basedcompetition from other suppliers to these markets. 0 Azerbaijan's non-oil exports are eligible for substantial benefits under the GSP scheme of the EU.However, only one quarter of these preferences are being utilized. Understanding why these preferences are not being utilized would be invaluable in assessing appropriate measures to stimulate non-oil exports from Azerbaijan. Issues relating to rules of origin, the nature of the processing requirements and the difficulties and costs of obtaining the required documentation, are likely to be at the heart of the explanation. 0 Azerbaijan should consider with its CIS partners in petitioning the EU to allow for CIS regional cumulation under the rules of origin. Azerbaijan should also contemplate the additional preferences that are available under the EU's scheme for countries which implement core E Oprovisions on basic labor rights. 0 Access to the Russian and key CIS markets are governed by free trade agreements. However, the value of these agreements is weakened by potential exclusions, which can be introduced unilaterally and changed from year to year. This leaves considerable scope for the parties to restrict trade and creates a degree of uncertainty concerning future market access. At present, the exclusions cover only a small percentage of intra-CIS trade but the agreements do not guarantee that this situation will persist. In addition to the border barriers discussed above effective market access in many sectors i s also governed by the ability of producers to comply with the relevant regulatory requirements of overseas markets, for example, in regard of health and * This Annex was preparedby PaulBrenton(PRMTR) andEvgenyPolyakov(ECSPE). 51 INOTIS-Integrated Nori-Oil Tradearid Investment Strategyfor Azerbaijan safety. In addition, ability to comply with voluntary standards, such as those defining quality control and management systems, is often necessary in practice to be able to access western markets. For these reasons the standards regime in Azerbaijan is of utmost importance. However, it appears that mandatory GOST standards still dominate and the standards system, including the infrastructure for testing and conformity assessment, requires substantial upgrading. The current system, whilst facilitating trade with CIS partners i s likely to be a major constraint upon the diversification of exports to western markets. The challenge for Azerbaijan i s to modernize the systemof standards without compromising trade with the CIS. The Country and Product Structure of Azerbaijan's Exports. 2. The penultimate line of Table 3.1 shows that in 2001 almost 70 per cent of Azerbaijan's exports went to the EU, around 10per cent were recorded as destinedfor Russia and the CIS countries, 3 per cent to Turkey, 1per cent to the rest of the OdCD and almost 17 per cent to the rest of the world. The final line of the table shows the share of each region in non-oil exports and a totally different picture. Russia and the CIS countries dominate non-oil exports, accounting for 55 per cent of the total in 2001. Only 12 per cent of non-oil exports were sent to the EUand less than one quarter of non-oil exports went to the group of OECD countries as a whole. Table 3.1: Share of each CountryIRegion inAzerbaijan Exportsby Sector in2001 Source: WITS Database 3. The table shows that exports of fuels go primarily to the EUand the rest of the world. Exports of other basic commodities, food, beverages and tobacco, crude materials and animal and vegetable oils are sold mainly in the Russian and CIS markets, which are also the main destination for chemical products. The dominant market for basic manufactures is the rest of the world. Machinery and transport equipment go mainly to Russia and the CIS although a substantial proportion of exports does go to the EU and the rest of the world. Finished manufacturesare mainly sold inEUand other OECD countries. 52 INOTIS-IntegratedNon-Oil Tradeand Investment Strategyfor Azerbaijan 4. We now discussthe importance of each product sector inoverall exports andexports to eachregion. Table 3.2 shows the dominance of exports of fuels, accountingfor over 91 per cent of the value of total exports in2001. Fuels accountfor 98 per cent of exports to the EU but only 15 per cent of exports to Russia.Fuels are the dominant export to all other regions. EU Turkey Rest of OECD Russia Restof CIS Rest World MineralFuels 98.5 72.1 62.1 15.3 69.4 90.1 91.3 5. Table 3.3 looks at the share of other sectors in total non-fuel exports and non-fuel exports to each region in 2001. The table shows that at this very broad aggregate level total non-fuel exports are distributed fairly broadly amongst the various categories. Machinery and transport equipment has the highest share with 21 per cent. Looking at the structure of exports to the EU, the share of food, machinery and transport equipment and finished manufactures i s higher than in the structure of aggregate exports. On the other hand, beverages and tobacco and chemicals are under-representedrelative to the average. Crude materials and basic manufactures comprise similar shares of EU and total exports. For Russia, beverages and tobacco are over-represented whilst machinery and transport equipment, basic manufactures and finished manufactures comprise a much smaller share than intotal exports. Table 3.3: Shareof ProductSector inNon-FuelExportsof Azerbaijan to EachRegionin2001 Source: WITS Database 6. Table 3.4 presents the pattern of the growth of exports to each region between 1998 and 2001. The final rows of the table show the changes for total exports and total non-fuel exports. Overall non-fuel exports have grown very moderately by just over 2 per cent per year on average. However, this reflects strikingly different performance in OECD and CIS markets. Non-fuel exports to all the OECD countries have fallen during the past 3 years, precipitously to Turkey and the rest of the OECD but much more moderately to the EU (by only 8 per cent). On the other hand, exports to Russia, the rest of the CIS and the rest of the world of non-fuel products have increased. 53 INOTIS-IntegratedNon-Oil Tradeand InvestmentStrategyfor Azerbaijan 7. At the sectoral level, exports of crude materials and basic manufactures have declined, whilst exports of all other sectors have risen. The fastest growing sectors have been chemicals and machinery and transport equipment. Animal and vegetable oils have grown strongly but from a much lower base. The decline in exports of basic manufactures i s common across all regions except for the rest of the world. This would suggest general problems of competitiveness in this sector, which i s somewhat puzzling given that with relatively low labor costs and a reasonably educated workforce this should be a sector where Azerbaijan has a potential for export growth. I t i s typically this sector which provides the basis for initial expansion of manufacturing trade in lower income countries. Table 3.4: Growth inExports by Sector and Region in per cent, 1998-2001(sectors where initial or final share lessthan 1per cent are excluded) Total 1123.0 -50.4 -26.0 -26.7 15.0 427.4 281.8 Total Non-Oil -8.0 II -52.3 -42.0 25.7 II 27.9 1I 91.4 II 6.6 8. Exports of machinery and transport equipment to all regions, on the other hand, have increased, which implies that problems within the manufacturing sector are not broadly based but appear to be sector specific. Looking at specific markets, exports of food, crude materials, basic and finished manufactures to the EU have declined whilst exports of chemicals and machinery and transport equipment have increased. Exports to Russia have increased in most sectors except basic and finished manufactures, whilst exports to the other CIS countries have risen inall sectors except basic manufactures. 9. What this brief picture of the structure of Azerbaijan's exports suggests i s that although non-fuel exports to the EU have declined this has not been common across all sectors. Similarly, although aggregate non-fuel exports to Russia have increased exports of certain manufactures have declined. Hence, general issues of competitiveness cannot be the sole explanation of trends in Azerbaijan's exports and there i s a need to understand why particular sectors have performedbetter incertain markets and not others. 10. Table 3.5 shows that Azerbaijan's non-oil exports to the main overseas markets are highly concentrated on a very narrow range of products. For example, in 2001 Azerbaijan exported only 285 products (defined at the 6 digit level of the HS) to the EUwhich amounted to only 5 per cent of the available 5326 product categories. B y way of comparison in 2001 Slovakian exports to the EU were recorded in 3287, or 62 per cent, of the available product categories. Although exports of non-fuel products to Russia were 3 times greater than exports to the EU, the number of product categories in exports to the EU was higher. In 2001 54 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan Azerbaijan exported in only 4.7 per cent of the categories to Russia. It is interesting to note that in aggregate exports to all regions 19.5 per cent of all product categories are covered. This much higher figure than in the individualmarkets suggests that Azerbaijan is exporting different products to different markets. We return to this issue below when indicators of the similarity of the structure of exports to different markets are presented. USA TUR GEO RUS EU15 ProductCoverage(Percentageof 6-digit product categories(total number 5326) with exports) 2.72 4.62 3.04 4.73 5.35 Share of top 10productsexported(at 6 digit level of HS) 93.30 78.97 54.64 73.01 65.89 Similarity with Exportsto Russia (at 6 digit level of HS - maximumvalue 100) 11.22 24.90 11.40 14.81 11. The table also shows that the top 10 exported products accounted for a very large proportion of exports to the main regions, accounting for almost two-thirds of exports to the EU and around three-quarters of exports to Russia and Turkey. For comparison, the top 10 products exported by Slovakia to the EU in 2001 accounted for about one third of total exports to the EU. Thus, although overall exports of non-fuel products are highly concentrated on a small number of products there i s no indication that exports to Russia, the main market for non-fuel exports, are more diversified than exports to other major markets such as the EU. In fact the evidence suggests that they are slightly more concentrated than exports to the EU. 12. The final row of Table 3.5 provides a measure of the similarity of the product structure of Azerbaijan's exports to the different countrieshegions. The similarity index i s used here to compare the structure of Azerbaijan's exports to Russia, r, with that of other overseas markets, j, such as the EUmarket where wrl i s the share of product 1in Azerbaijan's exports of non-oil products to Russia, and wjl i s the share of the same product inexports to country j. The higher the value of the index the more similar are the structures of exports to the two markets. On the other hand, if products which are important in exports to one market are of little si nificance in exports to the other market, then the value of the index will tend towards zero.2' The data in Table 3.5 suggest very little overlap between the structure of exports to different markets. Even though Azerbaijan exports a relatively narrow range of products overall it tends to export a different mix of products to different markets. 28The index was calculatedusingdata at the 6 digit levelof the Harmonized System (HS). 55 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan 13. Figure 3.1 shows the extent of the similarity of the structure of Russian imports from Azerbaijan with Russian imports from other countries, although here the index is calculated at a higher degree of aggregation (the 4-digit level of the HS) and for the year 2000. The highest degree of similarity with Russian imports from Azerbaijan i s provided by imports from Kyrgyz Republic and imports from Greece. Inboth cases this high degree of similarity reflects the importance of two groups in Russian imports from these countries: fruit and nuts and tobacco. In general there appears to be a low degree of similarity between Russian imports from Azerbaijan and imports from countries which are specialized in a diverse range of manufacturedproducts. 14. Figure 3.2 shows the similarity between EUimports from Azerbaijan and EUimports from other countries (again computed at the 4-digit level of the HS for 2001). The highest degree of similarity is that with Georgia, where almost one quarter of EU imports from Azerbaijan are matchedby imports from Georgia. This reflects inlarge part the importance of nuts in EU imports from both countries. Elsewhere the degree of similarity of import structures i s rather low suggesting that current exports from Azerbaijan to the EU are not facing intense broad basedcompetition from a wide range of sources. By way of comparison the degree of similarity between EUimports from Hungary and EUimports from the Czech Republic was 53 per cent in 2001 and the degree of similarity between EU imports from Hungary and EUimports from Turkey was 33 per cent. 56 INOTIS-Integrated Non-Oil Trade and lnvestinent Strategyfor Azerbaijan Figure 2: Similar& befween EUImports o f Non-Oil R o d u s r r FromAzerbaijan and Imports from Other suppliers in2001 15. Finally, in Table 3.6, we look at a very small group of products which comprise a significant proportion of exports to both the EUand to Russia.29Specifically we compare the unit price of exports to Russia with the unit price of exports to the EU. For the agricultural and the chemical products the unit values are relatively close in both the markets. However, for the manufacturedproducts the unit value for exports to the EUis considerably higher than that for exports to Russia. If these data are reliable then they suggest that even within fairly narrow product categories Azerbaijan i s selling different products, in terms of quality and design, in Russia and the EU. Table 3.6: Comparisonofunitvalue of exportsto Russiaandthe EU Russia- Russia- EU-Value EU-Unit RelativeUnit Value ($000) UnitValue Value Value (RussialEU) 3136.49 1.91 2816.40 2.99 0.64 Isopropyl 991.06 0.30 612.97 0.3 1 0.98 alcohol (HS 367.97 0.32 442.36 4.83 0.07 and drill pipe, of a kindused in drilling for oil or pas fHS 730420) Parts for boring 3779.51 1.35 2237.88 44.2 0.03 or sinking machinery (HS 843143) Parts and 68.62 93.44 473.30 178.50 0.52 accessoriesof surveying I 901590) instruments (HS Source: WITS Da.tabase ~~ 29This section shouldbe treatedwith a high degreeof caution since there are substantialdifferences betweenthe data reported as exports from Azerbaijan and mirror statistics in the EU and Russia. Although the values for total trade are broadly similar there appear to be important differences inthe classification of certain products. .ir 57 INOTIS-Integrated Non-Oil Tradeand InvestmentStrategyfor Azerbaijan 16. So in general Azerbaijan appears to be exporting a different mix of products to the EU than to Russia and the CIS markets and this may provide some of the explanation of the different performance of particular sectors across markets shown in Table 4. For this paper the relevant issue is whether this reflects the structure of protection in different markets and the impact of other factors affecting market access, such as technical regulations and standards, or i s it a consequence of supply constraints in Azerbaijan which preclude effective competition inparticular markets? 11. MARKET ACCESSCONDITIONS INMAJORMARKETS 1I.a. The EU 17. Azerbaijan i s a beneficiary under the EU's GSP scheme, although fishery products and iron and steel are excluded. The GSP i s a scheme that allows for duty reductions on certain products from particular countries subject to the products meeting the requirements stipulated by the EU, these include the rules of origin which stipulate the degree or nature of processing that must be undertaken in the beneficiary for the product to qualify for preferential access to the EUmarket. Prior to 2002 products were classified according to four headings according to the extent of duty reductions: very sensitive, where the duty applicable was 85 per cent of the MFNrate; sensitive - 70 per cent of the MFNrate; semi-sensitive, - 35 per cent of the MFN rate; and non-sensitive, where products entered duty free. Some products, mainly agricultural, were not included inthe scheme. 18. A revised scheme was introduced from January 2002 and will apply until the end of December 2004. Now there are only two categories of products: non-sensitive, for which duties are suspended, and sensitive. Certain agricultural products remain excluded. For the sensitive products there i s now a flat rate reduction of 3.5 percentage points from the MFN rate (although ifthe percentage reduction under the previous scheme leads to a lower rate then that i s maintained under the new scheme). A major exception i s made for textiles and clothing products where a reduction of 20 per cent of the MFNrate i s applied. Specific duties are reduced by 30 per cent (except for ethyl alcohol for which the reduction i s 15 per cent). However, when duties comprise both ad valorem and specific components the specific duties are not reduced. When minimumduties are specified in the Common Customs Code these no longer apply. Finally, if the tariff reduction provisions result in a preferential duty of 1 per cent or less then the duty i s suspended. The changes made to the GSP scheme should improve market access conditions in the EU for Azerbaijan's exporters for a range of products. We now proceed to discuss the impact of the GSP in 2001 and make an assessment of the implications of the new scheme in 2002. 19. There are two key elements to the impact of trade preferences on a countries total exports: The proportion of exports which i s eligible for preferences and the extent to which exports eligible for preferences are actually granted preferential access. Table 3.7 shows that in 2001, exports from Azerbaijan to the EU which were eligible for GSP preferences accounted for only 3.2 er cent of total exports. The remaining exports are subject to zero MFNduties in the EU?' Nevertheless, exports eligible for the GSP comprised almost two- thirds of total exports excluding oil products with zero MFNduties. Thus, the GSP covers a 30 A currently very small amount of exports from Azerbaijan are in those agricultural products which are excludedfrom the GSP. 58 INOTIS-Integrated Non-Oil Tradeand InvestmentStrategyfor Azerbaijan substantial proportion of Azerbaijan's non-crude oil exports.31However, the Table also shows that in 2001 only one quarter of exports eligible under the GSP preferences actually entered the EU on a preferential basis. This implies that the remaining three-quarters of eligible exports paid the full MFN tariff. This suggests that the potential impact of the GSP for Azerbaijan i s significantly weakened. This i s highlighted in the final rows of the Table which show that in 2001 the GSP provided an implicit transfer of 236 thousand Euro to A~erbaijan.~~However, if GSP preferences had been fully exploited the implicit transfer would have been over 1.7 million Euro. Only 14 er cent of the potential transfer under the GSP was actually delivered to Azerbaijan in 2001. & Total Exportsto EUminuszero duty oil products(000 Euro) 52951.61 ~~ ~ ExportsEligiblefor GSP(000 Euro) 34906.61 Shareof GSPExports inTotal Exportsto the EU(Per cent) 3.16 Shareof GSP ExportsinTotal Exportsto the EUminuszero duty oil products (Per cent) 65.92 ExportsGrantedGSP(000 Euro) 8465.19 Share of ExportsGrantedGSPto ExportsEligible for GSP(Per cent) 24.25 Imdicit transfer underthe GSP (000Euro) 236.38 ~~ PotentialTransfer under GSP (000Euro) L - 1738.69 patio of actual to potentialtransfer (Per cent) 13.60 20. Table 3.8 looks in more detail at the impact of the GSP on the average structure of tariff protection facing Azerbaijan's exports to the EU. The first rows of the Table show the unweighted average MFN tariffs on the products exported by Azerbaijan to the EU in total and on those eligible under the GSP. Thus in 2001 the unweighted average tariff on total exports to the EUwas 3.37 per cent. This will fall slightly in the next few years as remaining tariff reduction commitments under the Uruguay round, in textiles and clothing for example, and implemented. The unweighted MFN tariff on exports that are eligible for the GSP was higher at over 4.4 per cent and falls to 4.2 per cent in 2005 due to the implementation of the Uruguay Round and the introduction of the new EUGSP scheme in2002. 21. The Table then shows the average MFN tariff when weighted by the composition of trade in 2001. For total trade the average tariff i s very small, 0.2 per cent, reflecting the dominance of zero-tariff oil products. Products eligible for the GSP are concentrated in relatively high tariff products as the trade weighted average MFNtariff is considerably (over 40 per cent) higher than the unweighted average tariff. The next set of rows inthe table show the unweighted tariff on Azerbaijan's exports to the EUunder the GSP. This i s considerably lower than the unweighted MFW tariff. The final rows of the Table then show the trade weighted average tariffs under the current take up of preferencesunder the GSP and the trade weighted average tariff that would have arisen if GSP preferences had been fully taken up. 31 There are some oil based products which are subject to duties which are eligible for GSP preferences and included here inthe total for the GSP (see Table 3.7). 32 Calculated (at the tariff line level and then summed) as the difference between the GSP and the h4FN tariff multiplied by the amount of exports which enteredthe EUwith preferences. 33 Of course this transfer may not necessarily accrue to Azerbaijan but to importers in the EU.The low level of the ratio of actual to potential transfer relative to the ratio of exports granted preference to those eligible for preferences reflects that the take-up of preferences tends to be lowest in products where the margin of preference is the greatest. 59 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan Thus, in 2001 the trade weighted average tariff on actual trade was 5.67 er cent but this would have fallen to 1.36 per cent if GSP preferences hadbeen fully utilized.P4 22. Thus in principle the GSP offers Azerbaijan considerable improvements in access to the EU market. If Azerbaijan were to pay the MFNtariff then the average tariff on products which are actually eligible for the GSP would have been over 6 per cent. If GSP preferences were fully taken up the average tariff on these products would have been 1.36 per cent, a preferential margin of 5 percentage points. However, due to the lack of take-up of preferences the actual average tariff on GSP products in 2001 was 5.67 per cent, a margin of preference of only 0.68 percentage points. It i s worth noting that changes to the GSP in 2002 offer the scope for even greater margins of preference infuture years. Table 3.8: Duties on Azerbaijan's Exports to the EU(Per cent) /Total Exports to bxports to the EU I the EU under the GSP UnweightedAverage MFNTariff 2001 3.37 4.41 2002 3.32 4.34 2005 3.21 4.18 Trade Weighted Average MFNTariff 2001 0.20 6.35 2002 0.20 6.32 2005 0.20 6.27 ake-Up of Preferences I 20011 0.04 1.36 II 2006 0.03 0.82 20051 0.03 0.79 23. Finally, inTable 3.9 we provide a breakdown by sector of Azerbaijan's exports to the EUin 2001, the sectoral average tariffs and implicit actual and potential transfers under the GSP. It is interesting to note that the take-up of preferences varies greatly across sectors, with almost complete utilization of preferences in the chemicals and plastics sector to zero utilization in sectors such as textiles, clothing and footwear and basic metals. This suggests that an element of the explanation for the low-take-up of preferences i s sector specific. A prime suspect inthe case of the under-utilization of GSP preferences i s the rules of origin that the EUapplies. 34These results are driven partly by what may have been an erratic export in 2001 of `used road tractors for semi-trailers'. Although there were substantial exports in 2001 (as revealed in EU import statistics) there were no exports to the EUinprevious years and also no apparent recordingof this trade in Azerbaijan export data for 2001. The MFNtariff for this product is 16 per cent and the GSP tariff is 0. None of the exports in 2001 entered at the preferential rate. Nevertheless, when this particular product category i s excluded all the main features of the resultsremain. 60 INOTIS-Integrated Non-Oil Trade and InvestmentStrategyfor Azerbaijan Table 3.9: Sectoral Breakdown of Azerbaijan Exports to the EUunder the GSF Source: Eurostat, WTO and TARIC 24. There are two elements to the constraining impact of rules of origin. Firstly, there i s the nature of the rules themselves which can be very difficult to meet whilst remaining competitive on the EU market. In other words, rules of origin which force producers to source inputs from expensive domestic or EU sources undermine the preferences that are being offered. Secondly, there i s the issue of the costs of providing the necessary documentation to prove origin. If these exceed the margin of preference then the GSP i s redundant. Ascertaining the importance of these different factors in Azerbaijan would be useful. If there are particular difficulties in obtaining the required official certification of origin statementsthen this could be dealt with ina relatively simple and straightforward way. Ifit is the natureof the rules of origin that areproblematic then itmight be worth discussing 61 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan with the EUthe possibility of regional cumulation amongst the CIS countries (or a sub-set of those countries). 25. Initial and brief consultations in Azerbaijan suggest the following factors, related to the documentary requirements of the GSP, contribute to the low utilization of preferences: 0 Ignorance about the GSP and its documentary requirements on the part of Azeri exporters and foreign importers. 0 Administrative constraints and bribes associatedwith obtaining the certificate of origin required under the GSP (Certificate A). 0 A desire of exporters to conceal as much as possible of their foreign trade activities from the Government in order to minimize taxes and to avoid administrative andcriminal harassment. 26. In order to satisfy the rules of origin requirements under GSP, the Consumer Goods Certification Center under the Ministry of Economic Development i s given the authority to issue the certificate of origin A acceptedin all the countries administering the GSP. Charges for issuing the certificate are determined by the Center and the exporter on a contractual basis. No set charges are fixed by the Government. The fact that certificates of origin are only issued by the Ministry in the capital, Baku, may entail a significant additional cost on small enterprises which could benefit from the scheme but which are not located in the vicinity of Baku. 27. Finally, we note that under the current EUGSP there are special incentives regarding the protection of core labor rights. Additional tariff preferences can be granted to countries which incorporate into national legislation and effectively apply the substance of L O conventions on forced labor, freedom of association and right to collective bargaining, non- discrimination in employment and on child labor. These additional preferences amount to a further 5 percentage point reduction in the tariff rate (in addition to the standard 3.5 percentage point reduction), again the exception being textiles and clothing where a total reduction of 40 per cent of the MFNrate is available (compared to the standard 20 per cent reduction). At present Moldova i s the only country which has requested and been granted these additional special tariff incentives. If Azerbaijan were to apply for and be granted such incentives then the average tariff on non-oil exports to the EU (assuming full take-up of preferences) would be 0.48 per cent. Under the special labor clause exports in 145 of the 164 dutiable product categoriesin which Azerbaijan exported to the EUin2001 would have zero tariffs (only fruit juices and clothing would be subject to duties). Further, a whole range of products not currently exported by Azerbaijan would also face zero duties, providing some stimulustowards trade diversification. Of coursethesebenefits would only be available to the extent that it is feasible for firms to satisfy the rules of origin and that the costs of proving origin are small relative to the benefits that are available. 1I.b. The Impactof EUEnlargement 28. For industrial products the impact of trade policy changes following enlargement of the EUwill tend to be positive for CIS countries. There will be no change inmarket access to the current EUmarket since all tariff and non-tariff barriers on imports from the CEECs have already been removed. Market access in the CEECs will improve as tariffs in the largest markets, Polandand Hungary, will decline as these countries implement the common external 62 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan tariff and adopt the EU's GSP. There may also be a shift in processing activity to lower cost CIS countries as labor costs in the CEECs increase and as they adopt EUoutward processing regulations. 29. With regard to non-border policies the CEECs will have access to the Single Market (for some sectors for certain countries they do so already) the impact will vary sector by sector according to the importance of technical barriers to trade and government procurement decisions. In sectors where technical regulations are important, CEEC exporters will have improved access to the EU market. However, in the main these are sectors where the CIS countries, through lack of FDIand technological capabilities are not effectively competing at present, hence the direct impact on competition for products from the CIS will be very muted. 30. For agricultural products relative market access conditions may considerably worsen and there may be substantial trade diversion away from agricultural exporting CIS countries as the CEEC countries, especially Poland, are given substantial preferences in the EU. A Doha round which leads to a major reduction in EUborder protection in agriculture would help to alleviate this. For Azerbaijan, the impact of EU enlargement on current agricultural exports will be limited. The major agricultural export at present i s shelled hazelnuts (accounting for 77.5 per cent of agricultural exports to the EU), which is not exported by those countries in Central and Eastern Europe which are joining the EU. The main issue for this product i s the full exploitation of EU preferences under the GSP. The MFN tariff is currently 3.2 per cent whilst under the GSP the relevant duty i s 0. However, in 2001 only 18 per cent of the exports of hazelnutsto the EUactually enteredduty free! 31. The main agricultural export which is likely to be affected by EU enlargement i s apple juice, which accounted for 10 per cent of agricultural exports to the EUin 2001. Here the CEECs, especially Poland are major suppliers of the EU market, and current tariffs are high, ranging from 18 per cent for low density juice to 30 per cent of high density juice. Under the GSP, Azerbaijan could export at rates of 15.3 per cent for low density juice and 25.5 per cent for highdensity juice, although in 2001 none of the exports from Azerbaijan of apple juice entered the EU at reduced duties. It is worth noting that the EU has already granted Poland duty free access for these products, whilst for other applicant countries there are reduced duties under preferential quotas. 32. Thus, at present Azeri producers are competing with suppliers in the applicant countries which have a 30 per cent margin of preference. This could be reduced slightly if Azerbaijan were to exploit the preferences available under the GSP (and even further if Azerbaijan were to comply with the labor provisions of the EU scheme). Nevertheless, high duties in the EU on processed agricultural products and substantial preferences towards competing suppliers in the Central and Eastern European countries is likely to be a major constraint upon the expansion of exports of existing products and diversification into a wider range of processed agricultural products in Azerbaijan. This i s an issue that Azerbaijan should raise in its bilateral discussions with the EU under the Partnership and Cooperation Agreement that the two countries have entered into to. An objective could be to persuadethe EU, when considering the extension of the GSP scheme after 2004, to classify a larger number of processed agricultural products as non-sensitive under the GSP and therefore eligible for zero duties. This would have to be backed up by strong efforts to identify and alleviate constraintson the take-up of GSPpreferences. 63 INOTIS-IntegratedNon-Oil Tradeand InvestmentStrategyfor Azerbaijan 33. Plans to establish a CIS free trade area were initiated in 1992. However, two multilateral free trade agreements among the CIS countries -- signed in 1992 and 1994 -- have never been ratified by the parliaments of Russia and Georgia and therefore remain ineffective. Over the last decade, these agreements have been supplemented by a web of bilateral free trade agreements among the CIS members. Azerbaijan has four free trade agreements in effect, with Russia, Ukraine, Georgia, and Kazakhstan, and three more free trade agreements signed but awaiting ratification, with Uzbekistan, Moldova, and Turkmenistan. No country outside the CIS has signed a free trade agreement with Azerbaijan. The texts of the signed free trade agreements are similar. The agreements stipulate duty-free trade inall goods, with unspecifiedpotential exclusions, and free transit of goods through the signatories' territories. Free trade regime i s in practice honored by the signatories. The customs charges are comparable to international norms - 0.15 percent of the customs value of the consignment if processed at the Customs post during business hours and 0.30 percent otherwise. 34. The exclusions from the free trade regime are introduced in the protocols to the above free trade agreements; these protocols are considered as inseparable parts of the agreements and are defined annually by bilateral trade committees. Currently, exclusions from the free trade are in effect in trade between Azerbaijan and Kazakhstan and between Azerbaijan and Russia, as specified in the respective protocols (see Table 3.10). As seen from the Table, these exclusions are not symmetric, i.e. different products may be excluded by bilateral partners. Trade between Azerbaijan and Ukraine and between Azerbaijan and Georgia does not currently have exceptions from the free trade regime. 35. The free trade agreements also stipulate the possibility of temporary protection and safeguard measures including quantitative restrictions. Temporary quantitative restrictions for imports or exports can be introduced unilaterally for up to two years in case of an acute shortage of the goods in question on internals markets, large deficits in the balance of payments, realized or potential injury for domestic producers, and re-export control measures. No quantitativerestrictions are ineffect at this time. Table 3.10: Goods excludedfrom free trade under free trade agreementsbetweenAzerbaijan and other CIS countries), as of 2002 (HS codes inparenthesis). Exportsfrom Exportsfrom Exportsfrom Exports from Russia to Azerbaijan to Kazakhstan to Azerbaijan to Azerbaijan Russia Azerbaijan Kazakhstan Goods Fermented Sugar (1701 99 Alcoholic Beveragesand beverages 100); ethyl beverages(2203, spirits(heading (2206);ethyl alcohols (2207, 2204,2205, 22 with alcohols(2207, 2208 90 910, 2206, exceptionfor 2208 90 910, 2208 90 990); 220710000,2208 2201,2202, 2208 90 990); cigarettes(2402). -alargenumber 2209);tobacco cigarettes (2402). of detailed and substitutes subgroups within (24). this group omitted here); cigarettes (240220000). Source: Protocols to ie FTAs between Azerbaiian and Russia(Ifective as of November 29,2000) and between Azerbaijan and Kazakhstan(effective as of June 10, 1997). 64 INOTIS-Integrated Non-Oil Tradeand InvestmentStrategyfor Azerbaijan To conclude, the main problems with bilateral trade agreementsare: Potential exclusions from the free trade regime are not specified in the free trade agreements, which leaves considerable scope for the parties to restrict trade and thus creating a degree of uncertainty concerning future market access. At present, the exclusions cover only a small percentage of intra-CIS trade but the agreements do not guarantee that this situation will persist. Exclusions from the free trade regime can be imposed unilaterally. Bilateral or multilateral leverage i s rather weak. Exclusions may be non-symmetric. The agreements lack permanency. Each bilateral agreement i s subject to annual changes (in the case of the exclusion of goods from free trade), or even more frequent changes (in the case of safeguards). Unlike multilateral agreements that cover the entire CIS, bilateral free trade agreements do not. Thus extra complexities inagreement application arise. 36. The rules of origin applicable in the CIS free trade area were established by the Decision of the CIS Government Heads on The Rules of the Determination of a Country of Origin of Goods in 2000. The signatories elaborated a certificate of origin of a special type for the CIS free trade area (type ST-1). This certificate i s issued inAzerbaijan by the Ministry of Economic Development or the Chamber of Commerce. 37. According to the rules of origin, exports subject to the free trade treatment must be conducted by tax residents in the free trade area. This i s important for it implies that under certain circumstances the exports of foreign owned companies can be denied duty free treatment.35The basic criterion of sufficient processingltreatment i s change infour-digit code of the CIS Trade Nomenclature, which i s concordant with the Harmonized System up to the six-digit level. This i s the default principle; however, a long list of goods specified in the Annex to the Rules of Origin are exempted from this rule. The Annex includes two other rules, which are applied either separately or incombination, as specified by product: Ad valorem rule: Specified shares of imported materials or value added in the price of final production should be met, as detailed by the product. The specified share of value added in the free trade area in the final price of the product i s normally set at 50 percent. Required technological operations: Specified technological operations should be performedinthe free trade area. 38. The ad valorem rule allows for full cumulation of origin amongst all 12CIS countries, notjust those countries with whom Azerbaijan has signed a free trade agreement. Hence, all originating materials in the CIS area can be included to satisfy requirements concerning sufficient domestic processing. This is an important arrangement providing incentives for trade integration amongst the CIS countries and avoiding the adverse effects of the hub-and- spoke model whereby, in the absence of a comprehensive set of free trade agreements between a group of countries, the dominant center (Russia) can capture most of the benefits of bilateral free trade with the individualmembers of such a group. The rules of origin are specified by product and are based on the following principles: 35 We know of at least one such case when a Swiss company exported flour from Ukraine to Georgia, which have a bilateral FTA. The shipment was denied free trade treatment and the company lost the case in the Georgian court. 65 INOTIS-Integrated Non-Oil Tradeand InvestmentStrategyfor Azerbaijan a Change in trade classification: A change in four-digit code of the CIS Trade Nomenclature, which i s concordant with the Harmonized System up to the six- digit level. (Thisis considered the main principle.). a B y technological operations: Specified technological operations should be performed inthe free trade area, as spelledout for the product. a Ad valorem rule: Specified shares of imported materials or value added in the price of final production should be met, as detailed by the product. The specified share of value added in the free trade area in the final price of the product i s normally set at 50 percent. 111. REGULATORY REQUIREMENTS, STANDARDS AND EXPORTS FROM AZERBAIJAN TO MAJOR MARKETS. 39. The discussion so far has concentrated upon barriers at the border, specifically tariffs, which govern the access of the exports of Azerbaijan to its major overseasmarkets. However, for the majority of products effective market access i s also determined by a range of other factors which are not directly trade oriented but nevertheless affect the placing of products. Primary amongst these factors will tend to be regulations relating to health and safety and requirements regarding testing and certification to prove conformity to such regulations. Exportable products which cannot satisfy regulations applied in overseas markets will not be able to be placed on overseas markets. 40. Inaddition to the mandatory requirements specifiedby governments markets are also governed by voluntary standards set by standards organizations such as the International Organization for Standardization (ISO). Although voluntary in law, compliance with such standards can often be a prerequisite for accessing overseas markets. For example, many companies in western countries will insist that suppliers satisfy the I S 0 9000 group of standards which are concerned with quality control and management systems. According to the I S 0 only one firm in Azerbaijan had been certified as complying with I S 0 9000 standards at the end of 2001. This compares with 41 in Kazakhstan, 202 inLithuania, 260 in Georgia and 1026 in Slovenia. Lack of effective quality control and management systems maybe a significant constraint upon the participation of firms in Azerbaijan in western markets. 41. Inthis light, the standards regime of Azerbaijan and its implementation is of crucial importance in assessing access to overseas markets. The main body in charge of standards i s the State Agency on Standardization, Metrology, and Patents (SASMP). The SASMP introduces new standards into the state standard system by its Decision and it also accredits laboratories conducting testing and conformity assessment. New standards are introduced following the decision of the CIS Interstate Committee on Standards. Some new standards are developed in Azerbaijan. All international standards to be adopted have to be translated into local language, which can be a very slow process. Certificates of conformity and quality are issuedby the Certification Service within the SASMP. 42. Azerbaijan has been a corresponding member of the I S 0 since 1998. Nevertheless, 70percent of its state standards are still based on Soviet GOST system. The current Law on Standards adopted in 1996 allows for two types of standards -- mandatory and voluntary; the 66 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan recent Government ordinance gives the list of mandatory standards (about 300 positions), the rest are declared voluntary. Work on technical regulations, which will detail mandatory standards, along with applicable technologies and methods of testing, i s about to begin. This will be a difficult and intense work possibly requiring international technical assistance. The SASMP i s preparing to conduct certification of production facilities along the IS09000 certification system though there is no accredited unit to issue this certificate today. 43. All imports into Azerbaijan are required to have a certificate of conformity and a certificate of quality. The two certificate requirement seems excessive. A certificate of conformity alone would suffice. Also, these certificates are not accepted by the Customs Committee. Rather, the members of the SASMP and the Ministry of Agriculture (in the case of products of animal and plant origin) placed at the custom posts issue their own certificate for each shipment, which i s then accepted by the Customs. The standards officers at the customs posts take inconsideration the certificates of conformity and quality presentedby the importer but have the obligation to evaluate the quality characteristics of imported goods themselves. According to the SASMP, it can take anywhere from a few hours to ten days, depending on the product. 44. Another important multilateral agreement i s the CIS Agreement on Standards. According to the Agreement, the standards of the CIS members are harmonized, and the members honor one another's certificates of conformity and quality. This i s an important trade advantage for the CIS members since, despite their membership in the ISO, their national standards are not honored in the rest of the world. According to the Azerbaijani officials, the standards officers at the Customs posts routinely recognize the certificates of conformity issuedby each CIS member. 45. The Agreement established the Interstate Council on Standards, which develops and introduces new harmonized standards. At the outset of the market transition, the standards system of the CIS countries was based on the Soviet GOST system, which was not recognized in the rest of the world. The Council has been gradually introducing new standards in line with the I S 0 standards, which has been incorporated in the national standards systems of the individual members thus facilitating a movement of the bloc members towards the international system. All new standards introduced by the Council since its inception in 1992 were in line with international standards. This movement has been slow, however. At this time, roughly 30 percent positions in the standards nomenclature are conformant with the I S 0 system, while 70 percent are still based on GOST. The Council, however, does not determine which standards are mandatory and which are voluntary. This i s the responsibility of national standards organizations. Therefore, the list of mandatory standards differs by country. When trade occurs, the mandatory standards of the importing country have to be satisfied. 46. The Interstate Council on Standards can potentially act as a vehicle of integration of the CIS into the world trading system if the evolving CIS standards system i s built in accordance with the I S 0 guidelines and WTO agreements. This means not only developing new standards but bringing the system of standards in line with international practices. For instance, the current, overwhelmingly mandatory, system of standards should be broken down into mandatory standards (in WTO terms, technical regulations) and into voluntary standards, defined by industry bodies rather than the government. 67 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan 47. As mentioned above, the certificates of conformity and quality issued by Azerbaijan are honored in all CIS countries. The only countries outside the CIS that honors Azerbaijani standards are Turkey, Slovakia, Estonia, Latvia and Lithuania. Bulgaria and Iran have signed memoranda on mutual recognition of standards but they have yet to be ratified. Inall other instances, exports from Azerbaijan are subject to testing for conformity to the standards of the destination country. 48. Thus, the challenge for Azerbaijan, and the rest of the CIS countries, is to upgrade the system of standards and conformity assessment to facilitate trade with the west without undermining mutual recognition of standards in CIS countries. Coordination at the CIS level will continue to be important particularly if Russia and other European CIS countries move towards adopting EU standards to integrate into the wider European Economic Space that i s evolving. Of relevance here will be the intensification of the use of international standards on a voluntary basis. It is also important that Azerbaijan factors in the changes necessary for compliance with WTO rules on technical regulations and sanitary and phytosanitary standards into the broader reform of the standards and conformity assessment infrastructure that i s necessary for companies inAzerbaijan to effectively compete on world markets. 68 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan ANNEX 4: I S ACCESSION TO THE WTO INTHE ECONOMIC INTEREST OF AZERBAIJAN?* I. INTRODUCTION 1. The idea underlying the WTO i s liberalization of market access in the multilateral trading system. Its membership requirements have been designed to repress trade policy- induced negative externalities imposed by one country on other WTO members. The objective of foreign trade policy should be to minimize the domestic welfare cost by removing distortions to patterns of production and consumption. Yet, the two objectives, though not identical, do overlap, as the implementation of all the rules and principles of the WTO contribute significantly to the reduction of distortions in incentives of the trade policy regime. Furthermore, membership in the WTO guarantees the same access to WTO member countries' markets as that enjoyed by any other WTO member thanks to Most Favored Nationprinciple and offers access to the WTO dispute settlement mechanism. 2. Hence, accession to the WTO yields welfare gains. But membership also involves administrative costs andimpliesgiving up some sovereignty over the conduct of foreign trade policy by subjecting it to multilateral disciplines. Although Azerbaijan has already applied for WTO membership, it still faces an important policy choice: should it devote more effort andresources to speed up the process? 3. The pace of the accession depends not only on other WTO members but also on the speed of adjustment in foreign trade policy and institutions made by a government seeking accession. The process is not fully controlled by the government, but it can speed it up by implementing WTO-compatible reforms and active participation and cooperation with the WTO Working Party. This note addresses the question whether a more intensive effort to close the gap between Azerbaijan policies and WTO requirements would be beneficial to Azerbaijan's economy. 4. While it seems that benefits outweigh the administrative costs of enforcing WTO rules, the final answer hinges critically on decisions made prior to accession. Tariff setting provides a salient illustration of this point. New members are expected to bindall tariffs. At what levels will they be bound? If they were bound at very high levels, this would be-even if acceptable to WTO members-detrimental to economic welfare of Azerbaijan. Similar comment applies to lower but highly dispersedbindings.The generalpoint i s that one should go beyond WTO requirements in tariff setting. Azerbaijan's tariff schedule does not seem to be `worse or better' than that of most other WTO members. But it has a number of weaknesses whose elimination would reduce the extent to which it currently distorts incentives, entails inefficiencies andcreates opportunities for rent seeking. * Preparedby Bartek Kaminski (MNSED). Special thanks to Ulviya Ibrahimova for superb research assistance and Evgeny Polyakov. 69 INOTIS-Integrated Non-Oil Tradeand InvesttnentStrategyfor Azerbaijan 5. The remainder of this note is organized as follows. Section 2 briefly reviews forces driving the evolution of Azerbaijan's foreign trade regime and argues that it has become more and more compatible with the WTO disciplines. Section 3 compares benefits with the cost of membership-while no attempt i s made to provide a quantitative assessment, it argues that Azerbaijan with its relatively well developed administrative capacity and many WTO- compatible institutions inplace will not incur significant cost. Section 4 points to weaknesses inthe structureof currently appliedMFNtariffs. Section5 concludes. 11. AZERBAIJAN'SFOREIGN TRADEREGIME INCREASINGLY INLINEWITH WTO RULES 6. Over the last seven years Azerbaijan's foreign trade regime has been evolving towards the WTO. It has moved from state micromanagement of both exports and imports to a largely market-based regime. While the full compatibility i s yet to be achieved, a significant progress has been already achieved. 7. Effort at liberalization of foreign trade in Azerbaijan began in 1995 with the introduction of a radical stabilization cum transformation program. Untilthen the dismantling of the state monopoly over foreign trade was piecemeal and the scope of various administrative controls remained broad. Trade policies were the exact opposite of trade policies in market economies, restricting exports and encouraging imports, often through subsidies. Export controls were the residue of centralized trade, with its system of cross- subsidization and ad hoc state intervention to raise extra budgetary revenue. The central planning system included state monopolies on trading and export controls and lacked both convertibility for current accounts in domestic currency and a foreign exchange surrender requirement. 8. The internal logic of liberalization of other spheres of economic institutions and policies has led to the emergence of a market-based foreign trade regime in Azerbaijan in defiance of grad~alism.~~The IMF-supported program to establish macroeconomic stability drastically curtailed central controls over prices, introduced convertibility on current account and thereby removed the rationale for quantitative restrictions on both export and import activities. Previous barriers to trade were not in line with the growing liberalization of other spheres of the economy. For instance, with domestic prices converging towards world prices, export controls lost their relevance. So did other measures includingthose designed to extract foreign exchange earnings from exporters at rates below market-clearing levels, once the domestic currency became convertible. They were all successively dismantled. In consequence, like in any market-based economy, exchange rate, tariffs, non-tariff barriers (NTBs) as well as the behind-the-border regulatory measures has begun shaping developments inAzerbaijan's foreign trade. 36 For instance, despite the end of the state monopoly on foreign trade, the right to conduct foreign trade operations was limited to around 2,000 firms. State-owned enterprises clearly dominated this group until 1997. The picture was different for imports and exports, as it was in many other transition economies during the initial stages of reform. On the import side access to foreign currency and licenses (issued by the Ministry of Foreign Economic Relations) was not a major impediment, and a large number of importers entered the market. The share of private firms in total imports mirrored that of SOEs on the export side: private enterprises accounted for more than 50 percent of imports. 70 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan 9. AlthoughAzerbaijan's foreign trade regime remains relatively-that is, incomparison to countries at a similar level of GDP per capita-liberal and open, the level of tariff protection has been on the increase since 1997 and border practices remain a barrier to trade. The maximum tariff rate of 60 percent in 1996 was slashed to 15 percent in 1997. However, a two-band tariff structure introduced in 1997 with rates of 15 per cent and 5 per cent was subsequently expanded to four bands, albeit with the same maximum rate, and then to a six- band tariff schedule with the maximum rate of 25 percent, albeith the latter levied on one nine-digit CN item. Step Description Dates WTO documents 1 Application Received 30 June WTIACClAZEIl 1997 2 Working Party Established 16 July WT/GC/M/2 1 I Chairperson:H.E.Mr.W. Lewalter 1997 (Germany) 3 Memorandum 9 April WT/ACC/AZE/2 1999 12April IWT/ACC/AZW2/Ad 1999 d.1 4 Questions and Replies 14July WTlACClAZW4 2000 5 Meetingsof the Working Party 10. The increase in tariff protection coincided with Azerbaijan request to accede to the WTO, which-needless to add-should not suggest the causative link between the two, although considerations of increasing bargaining position in future negotiations concerning tariffs might have played a role. Azerbaijan applied to the WTO inJune 1997 and submitted Memorandum of Accession @e., Memorandum on the Foreign Trade Regime) in 1999 (for details, see Table 4.1 above). The progress towards accession was relatively slow and the negotiation stage has not been reached as yet. The first meeting of a Working Party took place only in June 2002, i.e., three years after the Working Party was established. In the meantime, the government received a number of questions from WTO members concerning 71 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan information contained in the Memorandum on the Foreign Trade Regime.37 The main technical issues raised by member countries have related to transparency of foreign trade regulations, bilateral free trade agreements, the application of the VAT scheme, customs valuation approach, protection of intellectual property rights, and standards implementation. 11. The WTO-accession raises two important questions. Should Azerbaijan make an effort to accelerate accession to the WTO?What other measures should it take to assure that foreign trade regime enhance microeconomic efficiency and growth performance? Answers to these two questions largely overlap, albeit not completely. WTO measures are designed to assure market access not economic efficiency per se. Full consistency with WTO requirements i s neither necessary nor sufficient condition to avoid the capture of the trade policy process by rent seeking lobbies.38As will be argued later, this outcome may be avoided by liberal commitments made duringaccession. 12. Considering Azerbaijan's progress in establishing a market-based foreign trade regime as well as the administrative capacities that are in place (which seem to be much stronger than in countries at a similar level of GDP per capita), one i s tempted to argue that benefits of membership outweigh costs. Since Azerbaijan has made significant progress in establishing a market-based economy, its foreign trade regime i s already largely compatible with principles underlying multilateral trading regime, especially so, in terms of border measures. Hence, for instance, + There i s no state monopoly over foreign trade, as foreign trade activity i s open to all actors with usual caveats (some products-namely alcohol and tobacco require licensing), and no firms have exclusive trading rights. + Quantitative restrictions and import licensing requirements are not used to control imports. + Except for exempted products (some agricultural inputs, capital equipment, some pharmaceuticals), tariffs apply on non-discrimination basis to all products no matter their origin. + Tariffs are published, relatively stable over time and information about them i s available to importers. + There i s no discrimination against imports in terms of taxation, as the same tax (excise and sales) rates apply to both domestic and imported products. Except for the development of infrastructure and energy, the state i s not directly involved in the pursuitof industrial policy. Exports are not subsidized. 13. For the purpose of classification of products, Azerbaijan-like most WTO members-uses the Harmonized Commodity Description and Coding System, developed by the Customs Cooperation Council inBrussels. 37See WTO documents-W/ACC/AZE/4 (14July 2000) and W/ACC/AZE/S (4 December2001). 38 See Bemard Hoekman, 1995. "Trade Laws and Institutions. Good Practices and the World Trade Organization," WorldBank Discussion Papers 282, The World Bank, Washington, D.C., p. xiii. 72 INOTIS-IntegratedNon-Oil Tradeand Investment Strategyfor Azerbaijan 14. It would seem, therefore, that had Azerbaijan already been a WTO member, its policies would not have drawn particular attention from other members even taking into account behind-the-border measures. As will be argued below, technical standards are not used as a policy tool of protectionism and there i s institutional infrastructure, admittedly very rudimentary, for protecting intellectual property rights. 15. Furthermore, the accession process has already triggered some changes bringing institutions and policies more in line with the WTO `behind-the-border' rules. Examples include efforts, which are discussed in Section 3, to implement rules of the WTO TBT (Technical Barriers to Trade) and TRIPS (Trade-related Intellectual Property Rights) Agreements. In both areas, accession has provided impetus to develop detailed plans of action for achieving their full implementation. 16. But more is expected from countries seeking accession in the post-Uruguay environment. They have to meet more stringent requirements than many current members meet and these requirements have considerably increased because of the Uruguay Round Agreements and members willingness to exploit their power to encourage accedin governments to adopt more market-oriented approaches in their economic policies.35 Azerbaijan's economic regime has still to undergo significant changes to achieve full compatibility with various WTO agreements. Leaving aside the administrative capacities indispensable to meet such institutionalrequirements of WTO membership as participation in a Trade Policy Review Mechanism (requiring the existence of a body responsible for keeping informationand monitoring trade policy), notification requirements, establishment of enquiry points providing information on technical regulations and conformity assessment procedures and sanitary and phytosanitary measures, there are several areas that constitute a major barrier. These are mainly issues related to widespread perception of limited transparency in foreign trade policy making and implementation, ad hoc executed customs procedures, customs valuation and regulatory environment unfriendly towards private sector development. While often Azerbaijan often has right regulations in place, they are often incomplete and their implementation leaves much to be desired.40 By the same token, meeting WTO requirements does not call for the establishment of new institutional structures but their redesigning andchange inpolicies. 111. COSTS AND BENEFITS OFMEETING THEWTO RULES 17. The government has to decide whether it wants to move fast to close the gaps. The decision should weigh costs and benefits of membership. Costs may be substantial, as the Uruguay Round (UR) Agreements require that WTO members not only lower trade barriers but also implement reforms intrade procedures (e.g., customs valuation and import-licensing 39 Inconsequence, there is a tendency among WTO members to seek commitments from acceding governments going beyond the letter of WTO laws. For instance, "... a number of transition economies have been asked to make commitments and report progress on privatization of state-ownedenterprises-matters on which the WTO i s silent." (Bernard Hoekman and Michael Kostecki. 2001. ThePolitical Economy ofthe World Trading System, Oxford University Press, New York, p. 67). 40 This i s the conclusion one can draw from questions (often accompaniedby extensive comments) submitted to the government by WTO members. See for instance Question 53 addressing the compatibility of Azerbaijan's laws on customs valuation with the WTO Customs Valuation Agreement (WTO, WTIACCIAZEIS, 4 December 2001). 73 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan procedures) and business environment (Le., technical standards, sanitary and phytosanitary standards, and intellectual property rights). As a country will have to purchase equipment, train personnel, and establish systems of checks and balances, the implementation costs money. This in turn begs an answer to " the question of whether money spent to implement WTO rules (...) would bemoney productively 18. The answer hinges critically not only on the existing institutional infrastructure that would support implementation of the WTO Agreements but also on the assessment of likely benefits as well as modalities of implementation. While without a detailed analysis it would be impossible to assess whether benefits to Azerbaijan would be higher than implementation costs, there are reasons to believe that the former would exceed the latter provided that, as will be discussedbelow, the government i s credibly committed to liberalization. 1II.a. Benefits 19. Considering that 144 countries are already members of the WTO and another 28 countries are engaged in accession negotiations, the question about benefits of membership may be superfluous. Yet, these need to be spelled out. Accession to the WTO i s in Azerbaijan's economic interest, as it will contribute to improved national economic policies and, consequently, economic growth and performance, provided that the government stay the "second-generation'' reform course. It will do so through four major channels. The first two are domestic in nature and the remaining two are external: a. Accession usually provides an economically sound framework for structuring trade policy and helps lock the country into liberal reforms. Regulatory requirements on trade policy institutions including technical standards, customs valuation, intellectual property rights, transparency of regulations, etc. are in Azerbaijan's national economic interest. b. Membership in the WTO reduces the potential for capture of some foreign trade decisions by narrow interest groups. WTO membership provides a government with a basis to resist domestic protectionist pressures. Taming the rent-seekers i s the greatest challenge in designing the process of foreign trade policy making. Azerbaijan does not face various constraints by virtue of its membership in the WTO. It has freedom of action to raise tariff^.^' It i s not bound by the GATT disciplines on areas of domestic regulatory regimes that involve trade, that is, intellectual property rights, food and animal safety, industrial product standards, import licensing, customs procedures, investment measures. Neither i s Azerbaijan required to liberalize trade in services. While protectionists may regard this freedom of action as advantageous, this is clearly not so. Although many WTO-related reforms are regulation-intensive requiring implementation of the practices that already exist in highly developed countries (e.g., intellectual property rights) and require expending significant res0urces,4~ the international experience suggests huge benefits in terms of efficiency and growth performance from locking-in a liberal and transparent foreign trade regime. 41J. Michael Finger and PhilipSchuler, "Implementation of WTO Commitments. The Development Challenge," in B. Hoekman, A. Mattoo, and P. English, eds., Development, Trade, and the WTO.A Handbook,The World Bank, Washington, D.C., 2002, p. 493. 42For some, this may be a cost, but to economists this is a benefit, as WTO membership reduces the freedom to engage inharmfulprotectionist, self-defeating, trade policies. 43For an extensive discussion of these costs to a developing country, see J.M.Finger andP. Schuler, op. cit. 74 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan c. Membership in the WTO will offer automatically at least an MFN (Most Favored Nation) status among all WTO members. It may open new markets to products and services offered by Azerbaijan firms. In terms of its position in international markets, Azerbaijan i s a small country with too weak a bargaining power to negotiate trade concessions effectively on a bilateral basis. While market access may be now of secondary importance, as Azerbaijan exports (i) mainly either to countries granting it a Generalized System of Preferences status (e.g., EU) or WTO non-members (Russia and almost all other CIS countries); and (ii)oil accounts for the dominant share of its exports (usually subject to zero tariff rates), it may become a barrier once exports are more diversified interms of their comp~sition.~~ d. Membership in the WTO would offer protection to Azerbaijan exporters against undertakings by other countries to restrain access to their markets. It will give Azerbaijan access to the WTO dispute settlements procedures, which as a rule tend to shield the weak. This in turn reduces the costs associated with other WTO member country undertakingactions adversely affecting other member's exports. 20. The first two `domestic' channels have the potential of generating significant gains in terms of the quality of institutions and policies. Preparations designed to bring Azerbaijan's institutions and policies in line with WTO requirements have already provided an extra guidance to `second-generation' economic reforms. The challenge now i s to use it as a catalyst for external sector reforms that comply with the Uruguay Round agreements. WTO accession offers the government a window of opportunity to influence not only foreign trade policies but also the broader framework for economic policymaking. 21. Benefits from the WTO membership depend on the mode ofjoining the organization, i.e., on national tariff and service opening commitments and other regulations determining contestability of domestic markets. In other words, they depend on the changes a country makes in order to join-that is, on the tariff structure and regulations that determine market access. But the WTO accession alone does not guarantee an efficiency-enhancing foreign trade regime. It creates, however, possibilities for a prospective member to overcome political opposition to adopting unilateral liberal policies and institutional design aimed at increasing national welfare. 22. But whether these possibilities become realities depends entirely on the reforms undertaken before accession. What guarantees such a regime are the kinds and extent of the unilateral commitments made during the accession process. Some recommend increasing tariffs prior to accession negotiations, binding tariffs at high rates, developing and enacting comprehensive antidumping legislation, and negotiate longtransitional periods. According to this view these measures improve a country's bargaining power during accession negotiations. But this approach carries with it the danger that a country will lock itself into a 44Azerbaijan is a member of CIS that was established in 1992 to ease, among other goals, the economic impact of the demise of the Soviet Union on Newly IndependentStates. Its statute contained the provision to establish a Free Trade Area. Since, however, multilateral free trade agreements have not been so far ratifiedby parliaments of all CIS countries, a network of bilateral FTAs was put inplace instead. Untilthe late 2000, imports from CIS countries into Azerbaijan were not subject to preferential treatment. Neither were Azerbaijan's exports to CIS countries. Azerbaijan has signed free trade agreements with Georgia, Kazakhstan, Russia and Ukraine, and its provisions have been implemented. For details, see Evgeny Polyakov. 2002. Azerbaijan Trade Diagnostic Study: Regional TradingArrangements and Market Access Conditions. World Bank, mimeo, December. 75 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan bad policy framework for a long time and actually reduce its chances for rapid accession to the WTO. The government should work hard to prevent this outcome. 1II.b. Costs 23. The ability to conform to WTO requirements i s usually inversely correlated with the level of economic development. Countries at a lower level of the economic ladder face much more demanding task calling for extensive changes in institutional arrangements, legislation and its enforcement as well as in policies than highly developed countries. This i s so simply because the latter have already had them in place even before they became the WTO disciplines. While Azerbaijan i s a least developed country in terms of its GDP per capita, its administrative capacities to implement the WTO rules appear to be more developed than in countries at a similar level of economic de~elopment.~~Four areas seem to be of particular importance in assessing the magnitude of problems faced: transparency and information availability, customs valuation, standards, and intellectual property rights. Each will be discussed in turn. Transparency and information disclosure 24. Assuring transparency and disclosure of information on conditions of conducting foreign trade operations does not require significant resources. Setting up a unit responsible for keeping information and monitoring trade policy and in charge of future WTO notification requirements i s not a major barrier in Azerbaijan, though this may require training and bureaucratic reshuffling. Neither would the establishment of enquiry points providing information on technical regulations and conformity assessment procedures and sanitary and phytosanitary measures seem to be the barrier. This i s often more a question of the government commitment than of expending administrative resources. Customsvaluation 25. The rules of the WTO Customs Valuation Agreement require that members levy customs duties on an imported good's transaction value rather than on some reference price constructed by the g~vernment.~~Azerbaijan's customs rules have not been in full concordance with that Agreement as revealed in comments and questions of the WTO Working Party (see e.g., the WTO document WT/ACC/AZE/5). The major issues raised concerned additions to transaction value, methods of applying deductive value, valuation using reasonable means, currency conversion, confidential information, the right of appeal, and definitions of some terms. The discrepancies identified are relatively easy to address and some of them have already beenremedied. 45 With some caveats, this commentary applies to many transition economies, especially former Soviet republics. Following the collapse of central planning, these countries experienced huge fall in output triggered by the shock of the dissolution o f the Soviet state exacerbated by, among others, disregard of communist industrialization for competitiveness and comparative advantage. Inconsequence, their administrative capacities as well as the quality of human capital appear to be more in line with a higher level o f economic development. 46The Agreement requires that the transaction value of a shipment together with add-ins be used as a primary basis for customs value. It also prescribes a hierarchy of methods for determining that value as well as contains provisions concerning the right of appeal, confidentiality of information, etc. 76 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan 26. A more relevant problem-though not explicitly raised in the questions of the Working Party-relates to weaknesses in Azerbaijan's administrative environment. These include, among others, the lack of an accurate and up-to-date computer database of prices or more broadly the lack of computerization and information management of customs, excessive bureaucratization multiplying forums for negotiations between traders and customs officials, discretionary applications of customs procedures varying across border points. Addressing those weaknesses would bring tangible benefits to both the government (higher customs revenue) and consumers (lower prices of imports). 27. However, modernization of customs to create administrative environment similar to that existing in highly developed countries i s both costly and time consuming. It i s estimated that the cost of computerization, training of management and staff, legislative reforms increasing transparency, refitting of customs buildings in order to allow for the use of computer software, supply of antismuggling equipment, etc., may run as high as U S $10 million.47 Yet, it seems that this may be an investment with highreturns considering the value of total Azerbaijan's imports of US$ 1.4billion in 2001 and the weighted average tariff rate of 7 percent. One expects that the introduction of these measures would lead to a significant increase in customs revenues. 28. On the other hand, however, not all these measures would have to be implemented to meet the requirements of membership. But, as we shall discuss in Section 4, simplification of procedures, greater uniformity in tariff rates, simpler tariff schedule would go a long way to improve customs administration. Technical, and sanitary andphytosanitary standards 29. Meeting the requirements of the GATT 1994 Agreement on Technical Barriers to Trade (TBT) or of its lex specialis Agreement on the Application of Sanitary and Phytosanitary Measures (SPS) does not strike one as particularly costly or difficult to implement in A~erbaijan.~'Neither does the TBT nor SPS Agreement require that a member have product standards. It merely calls for non-discrimination in applying standards, avoidance of writing trade-restrictive mandatory technical regulations, nondiscrimination in conformity assessment procedures, and the establishment of a national enquiry point.49It also requires that WTO members join and use international systems for conformity assessments, and it encourages members to negotiate mutual recognition agreements. 30. How does Azerbaijan score on TBT and SPS Agreements? First, it has refrainedfrom using technical standards as a measure to discriminate against imports and applies non- discrimination and national treatment to imported goods. Second, the list of 700 products subject to mandatory testing in effect since i s relatively short (see Annex Tables 3 and 4). Moreover, Azerbaijan recognizes FA0 standards for agricultural products. Third, Azerbaijan i s a member of the International Plant Protection Convention (IPPC) and the Office of 47 See Finger and Schuler, ibidem, p. 495. 48 For more details, see Evgeny Polyakov, Azerbaijan Trade Diagnostic Study: Regional Trading Arrangements and Market Access Conditions, mimeo, World Bank, December 2002. 49 In line with transparency requirements of Article X GATT, a national enquiry point should provide answers and documents related to (i) proposed or adopted technical regulations, (ii) proposed or adopted standards, and (iii) conformity assessmentprocedures, adoptedor proposed, applied by enforcing bodies. 77 INOTIS-Integrated Non-Oil Trade and Investment Strategy for Azerbaijan International Epizootic (OIE) but not yet a member of the Codex Alimentarius providing rules for SPS standards. Fourth, Azerbaijan has signed mutual recognition agreements with CIS countries, Bulgaria (not ratified as of January 2003), Turkey, Slovakia, Iran (not ratified as of January 2003) and the Baltic states-Estonia, Latvia and Lithuania. In terms of Azerbaijan's imports, these agreements cover well over half of its imports. As for the SPS Agreement, the Law "On the Sanitary and Epidemiological Welfare" bans the import of products that could trigger spreading of infections dangerous to people, animals, plants and food products and requires certificates confirming the quality and origin of goods to be presented at customs clearance. Hence, taking all these aspects into consideration, Azerbaijan-once it has established a national enquiry point-should have no fundamental problems of meeting the letter and spirit of SPS and TBT Agreements. 31. The importance of standards and technical regulations goes beyond accession to the WTO and observance its disciplines. Product standards are an essential component of any economy seeking integration into global markets. Consider that a large share of exports i s subject to health, safety, and related standard^.^' Countries may thus need enforcement capacity (i.e., conformity assessment procedures and market surveillance) not only to assure that imports meet prescribed standards but also for exports to countries with which they have mutual recognition agreements. Hence, any attempt to encourage exports should also include issues related to technical standards. 32. What implications does it have for Azerbaijan? First, the development of organizational capacities to encourage improvements in the quality of domestically produced goods through issuance local "quality markings," certificates of meeting international standards and organizing contests for the best manufactured products would be a good investment. There i s no accredited unit certified to issue certificates of meeting I S 0 9000 standards on quality or IS 14000series on the environment. 33. Second, as a small country, Azerbaijan should not invest too much effort in developing its own standards. The best policy option is to follow international practice and accept standards and certificates issued by recognized international and national bodies. In fact, harmonization of national with international standards is essential to participation in international supply chains cutting across national borders, as common standards reinforce linkages between component manufacturers, assembly operations, and distributors inthe final product markets. It generates the so-called network externalities. Even though Azerbaijan may not have mutual recognition agreements, it should accept certificates from highly developed countries (e.g., EU, US). Products safe for consumers in these countries are also safe for consumers in Azerbaijan. These products should not be subjected to mandatory testing. 34. Azerbaijan has made the first step towards establishing a modern, market-based, system of technical regulations, product standards and certification by organizationally splittingthe function of accreditation and certification and privatizing laboratories. The State Standardization and Metrology Agency, responsible for technical standards and accreditation lacks, however, resources indispensable for carrying out its mission. But, as argued above, it For instance, according to one estimate, over 60 percent of US exports i s subject to certification indestination markets. For 45 percent of US exports to the EU government-issued certificates were required, for 15 percent private, third-party certification was required, and for the rest manufacturers self-certification was sufficient. See J. Wilson. 1998. Standards and APEC: An Action Agenda, Institute for International Economics, Washington, D.C. 78 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan mission should not be designing technical regulations. Its main mission should be to provide information on international standards, raise awareness of the importance of quality management, to encourage the development of private-public cooperation in promoting international standards. Intellectualproperty rights 35. The WTO Agreement onTrade RelatedIntellectual Property Rights (TRIPS) has been particularly controversial from the point of view of benefits to developing countries. In contrast to WTO Agreements discussed above, its implementation involves significant adjustments and costs and does not offer quick returns, albeit good regime of IPRs (intellectual property rights) may be crucial for investment (domestic and foreign alike) in creative industries and industries intensive in research and development. Without IPRs regime, firms would not engage in costly R&D activities transforming inventions into innovations. 36. In contrast to many least developedWTO members, Azerbaijan has already in place some components of an infrastructure for protecting and enforcing IPRs. It does not have to start from scratch. For starters, it has a Patent Office as well as Copyright Agency. Since December 1995, Azerbaijan has been a member of the World Intellectual Property Organization (WIP0)-a Geneva-based UN organization administering international conventions upon which the TRIPs Agreement was built. These international agreements include the Bern Convention on copyrights, the Paris Convention on patents, the Rome Convention on sound recordings and music, and the Treaty on Intellectual Property in Respect of Integrated Circuits. Azerbaijan signed the Bern Convention in 1998 and the Paris Convention in 1995. 37. Yet, the process of buildingenforcement capabilities and bringingAzerbaijan's laws in full compliance does not seem to be over, as questions from the WTO Working appear to indicate. Both tasks will require considerable administrative effort. The big unknown, which should be explored, i s the magnitude of another category of costs, Le., the amounts of rents that would have to be transferred to foreign holders of IPRs over the present commitments madeby Azerbaijan whenjoining the international conventions on IPRs. Concludingcomment 38. In all, the costs of following the WTO rules appear to be neither prohibitive nor significant. Significant costs had already been expended and some "WTO-related investments" would generate significant returns. The rationalization of customs services would bring significant returns. So would improvements in country's systems of technical regulations, product standards and certification, provided that the government does not become involved in designing its own mandatory technical regulations. The gains from TRIPs may not be instantaneous, but over a longer period observance of IPRs would be beneficial to Azerbaijan's economic performance. 1II.c. What can be done to maximize benefits?--Pitfalls to be avoided 39. Benefits from the WTO membership depend on the mode ofjoining the organization, Le., on national tariff commitments and regulations determining market access. They depend on the changes a country makes in order to join-that is, on the tariff structure and regulations that determine market access. WTO accession does not guarantee an efficiency- 79 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan enhancing foreign trade regime. It creates, however, possibilities for aprospective member to overcome political opposition to adopting unilateral liberal policies and institutional design aimed at increasing national welfare. 40. But whether these possibilities become realities depends entirely on the reforms undertaken before accession. What guarantee an efficiency-enhancing regime are the kinds and the extent of unilateral commitments made during the accession process as well as complementary policies. Some recommend increasing tariffs prior to the accession negotiations, binding tariffs at high rates, developing and enacting comprehensive antidumping legislation, and negotiate long transitional periods. According to this view these measures improve a country's bargaining power during accession negotiations. This is a wrong-headed prescription for three reasons. First, the negotiations focus on `bound' (Le., maximum level that cannot be exceeded without triggering renegotiation of a tariff or providing compensation by slashing tariff rates on other products) rather than `applied' tariff rates. 41. suggests that ... the smaller the country and the more liberal its regime, the faster the Second, it reduces its chances for rapid accession to the WTO. The experience " accessionprocess.' ,'' 42. Last but not least, this approach carries with it the danger that a country will lock itself into a bad policy framework for a long time. Since the WTO provides a "cover" for good economic policies and shields against private interests lobbying for protection, the government should work hard to prevent this outcome. 43. Another issue that the government should try to prevent i s to implement rules that are WTO-compatible though not required by WTO Agreements. Contingent protection i s the case in point. Although antidumping i s a favorite protectionist weapon used by developed countries and more recently by developing countries as well, accessionto the WTO does not require adoption of an antidumping law. Antidumpingi s not a magic formula that will make ordinary protection legal under GA'ITNTO rules. It i s a bad idea from the viewpoint of accession since the emphasis on antidumping raises doubts about Government's commitment to trade liberalization. It is also a bad idea once Azerbaijan becomes a member, as private interests will lobby for its use, which has no viable economic justification. The alternative-a safeguard option-is the right approachto IV. TARIFF STRUCTURE: THEINCREASE INTHEPOTENTIALFORDISTORTIONS 44. Tariffs should be low and uniform. Tariffs are, however, important for revenue generation in Azerbaijan, as they account for a significant share of the government budget revenue. Their overall level should be such as to generate the revenue required. If the tariffs are high, they should show little dispersion, with only a small number of bands. The closer the tariffs are to uniformity, the lower is the loss in net welfare. Tariffs have undergone significant evolution since 1997. Although both the dispersion and their overall levels " C. Michalopoulos. 2002. "WTO Accession," in in B. Hoekman, A. Mattoo, and P. English, eds., Development, Trade, and the WTO. A Handbook, The World Bank, Washington, D.C., 2002, p. 68. 52Incase of serious injury caused by imports, GATT Article XIX allows for safeguard actions. Ifprotectionist measures are necessary to prevent injury to domestic producers, they should be price-based (Le., expressed in terms of tariffs), precisely defined, temporary, nondiscriminatory and introduced after appropriate procedures consistent with WTO rules are followed, and taking into account the costs to consumers and users. Thus, there is no needto resort to antidumping laws. c 80 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan increased, they remain low in comparison to other countries at a similar level of GDP per capita. While the overall level does not raise concerns, the increase in dispersion should be addressed, as this i s a source of serious distortions inproduction and consumption incentives. This section discusses briefly the evolution in tariff policy of Azerbaijan, discusses characteristics of the current tariff structure in comparative perspective, and then assesses geographical and factor content dimensions of Azerbaijan's tariffs. 1V.a. Increase intariff protection over 1997-2001 45. With the abolition of the state monopoly over foreign trade and liberalizationof prices in 1997, tariffs became a meaningful tool of foreign trade policy in Azerbaijan. A new two- band structure was introduced in 1997 with tariffs of 15 and 5 percent, some goods entering d~ty-free.'~The access to domestic markets improved as the maximum tariff rate fell from 60 percent in 1996 to 15 percent in 1997. The Decree No. 91 of the Cabinet of Ministers "On customs duties levied on import and export in the Republic of Azerbaijan" (22 April 1998) and the Decree No. 25 of the Cabinet of Ministers on the additions and changes to the above mentioned Decree (27 February 1999) expanded the number of bands to four-15 percent, 5 percent, 3 percent, and 0.5 percent. Simultaneously, the number of products subject to the maximum rate of 15 percent increased. So did the number of goods subject to specific duty rates.54 In consequence, the tariff protection has increased. The weighted average applied tariff rate rose from 4 percent in 1997 - 1998 to 7.4 percent in 2000.55 46. No further increases inthe overall level of tariff protection occurred in 2001. But the Decree No. 80 of the Cabinet of Ministers "On customs duties levied on imports into the Republic of Azerbaijan" (12 April 2001) moved from the previous four-band tariff schedule to the six-band schedule. In addition to previous four bands, two other bands-leaving newly introduced zero-tariff rates (1% of all tariff rates)-were added (lo%, and 20%). This aside has increased dispersion in the tariff schedule. The maximum tariff rate rose to 20 percent, albeit admittedly only for one nine-digit Harmonized System item. The average weighted tariff rate slightly fell to 6.7 percent or .7 percentage points. However, with a further increase inthe number of goods subject to specific duty rates, this declinemay be illusory. 1V.b. Characteristicsof 2002 tariff structure incomparative perspective 47. Tariff structure can be the source of two types of distortions: those related to dispersion in tariff rates and those caused by differences between MFN applied rates and preferential or zero rates on imports from FTA countries. As for the latter, Azerbaijan signed bilateral free trade agreements with seven CIS countries (Russian Federation (September 1992), Uzbekistan (May 1996), Ukraine (July 1995), Georgia (June 1996), Moldova (May 1995), Kazakhstan (June 1997) and Turkmenistan (March 1996). By the end of 2003, FTA with Kyrgyzstan should go into effect. These were not full-fledged FTAs but rather commitments to negotiate them. As of December 2001, they were in effect on imports from Georgia, Kazakhstanand Ukraine.56In2002 FTA with RussianFederation went into effect.57 53 Azerbaijan had then a similar structure of tariffs as Albania and Bosnia and Herzegovina have today with a maximum rateof 15 percent and threebands. 54The use of specific tariffs (defined as a fixed amount per unit of quantity or volume) has been increasing to control under-invoicing. 55EBRD, TransitionReport 2001,London 2001. The averagedoes not include specific tariffs. 56See WTO Accessionof Azerbaijan, WTlACClAZEl5, 4 December2001. 81 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan It appears that since Azerbaijan's imports from CIS countries tend to cover products subject to relatively low tariffs, its tariff schedule does not generate the second type of distortions on a significant scale. 48. Dispersion in tariff rates lead to prices frequently seriously distorting production and consumption patterns. As notedearlier, the uniform tariff rate minimizes the net welfare cost. The welfare loss increases as tariff structure becomes more di~ersified.~~Azerbaijan's tariffs-both MFW and preferential-are not uniform, although rates do not exceed 20% ad valorem. The higher the dispersion in tariff rates, as measured by the standard deviation (absolute dispersion between items), the larger are potential distortions-as the variance in tariff rates causes the variation inimportedproduct prices. 49. How does Azerbaijan compare to other countries? Table 4.2 providing information on MFNapplied tariffs in selected Central Europeancountries andthe European Union leads to the following observations. First, Azerbaijan's level of overall tariff protection does not strike one as excessive. To the contrary, the average simple MFNtariff rate of 8.7 percent i s lower than that in Hungary, Poland and Romania. It is, however, higher than inAlbania, Czech and Slovak Customs Union and a free trader, Estonia. There i s a caveat, however. Except for Albania, the level of competition from imports in terms of tariff protection i s significantly higher as their trade i s mostly duty-free. Table 4.2: Azerbaijan's tariff structure incomparative perspective Simple Standard Coefficient Simple Standard Coefficient Simple Standard Coefficienl Average Deviation of variatior Average Deviation of variation Average Deviation of variatior 8.7 6.6 0.75 12.7 5.2 0.16 7.9 6.5 0.82 7.2 4.8 0.67 n.a. n.a. n.a. n.a. n.a. n.a. 9.6 16.4 14.9 0.91 8.8 6.5 0.74 4.5 3.8 0.84 9.4 9.2 0.98 4.4 4.1 0.93 0 0 0.00 0 0 0.00 0 0 0.00 15.2 18.2 1.20 39.4 26.4 0.67 8.7 5.6 0.64 17.7 12.7 0.72 27.5 22.7 0.83 15.3 6.7 0.44 17.0 8.5 0.50 23.8 4.5 0.19 15.9 8.5 0.53 10.6 7.8 0.74 13.8 13.2 0.96 9.8 5.4 - 0.55 4.7 4.6 0.98 8.9 8.7 0.98 L 4.3 3.6 0.84 Source: xived from the World Trade Organization databaseand national sources. 5' For the list of products exempt from FTA in trade with Kazakhstan and Russia, see Evgeny Polyakov, "Azerbaijan Trade Diagnostic Study: Regional Trading Arrangements and Market Access Conditions," mimeo, World Bank, December2002. 58 A uniform nominal tax minimizes the net welfare cost insofar as two conditions are met: import demand elasticities are uniform across commodities; andcross-price effects are negligible. 82 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan 50. Second, neither does Azerbaijan score high in terms of dispersion (measured by standard deviation and coefficient of variation). The treatment afforded to various sectors of the economy is relatively uniform. At any rate, it i s more so than in Bulgaria, Czech and Slovak CustomsUnion, and Hungary. There are two caveats, however. As noted earlier, these countries levy no duties on more than half of their total imports, i.e., those from preferential partners, though this i s a source of other distortions (e.g., trade diversion). Furthermore, Azerbaijan resorts to tariff exemptions, which leads to higher dispersion and entails significant inefficiencies, and has a highpercentage of specific tariffs. 1V.c. Overall tarifflevel and differential treatment of industrialand non-industrial products 51. Revenues collected at the border are an important source of total budget revenues. Duties, VAT, excise taxes, and other border charges accounted for 20 percent of the total budget revenues in 2000 (Table 3). Revenue from duties as well as from excise taxes accounted for a surprisingly low share of revenues collected at the border. 52. Although the reliance of the state budget on revenue collected by customs might provide an argument against lowering tariff rate, this appears not to be the case. Neither does it does argument against bilateral regional liberalization, although in this case other considerations are more relevant, i.e., an assessment of their static and dynamic effects. As can be seen from the data tabulated in Table 4.3, the bulk of these revenues does not come from duties. Infact, duties were responsible for only 38 percent of the total revenue collected at borders by customs. The major revenue-raiser was VAT payments, and these are levied on imports no matter their origins. 0 Customs Revenue, InbillionofManats Inpercent of which: Duties 271 38 VAT 385 53 excise taxes 12 2 other charges 51 7 Total 720 100 Memorandum: as percentof total budget revenue 20 53. Which sectors are afforded high levels of tariff protection? Two observations can be derived from the data tabulated in Table 4.4. First, MFN tariff protection `discriminates' against industrial sectors of the economy and favors agricultural sector. The simple average tariff rate for agricultural products i s almost 5 percentage points higher than for industrial 83 INOTIS-Integrated Non-Oil Trade and InvestmentStrategyfor Azerbaijan products. The difference i s not huge, but it i s not clear how tarification of specific tariffs levied on 37 percent of all H S items in this group would affect the average. 84 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan , Table 4.4: Characteristicsof the structure of MFNapplied tariffs in2002 Simple Average 12.7 Standard Deviation 5.2 Dispersion (coefficient of variation) 0.4 Maximum tariff rate 20 Percent of tariffs above the level of a simple average 83.0 Percent of tariffs above twice the level of a simple average 0 Percent of specific tariffs 36.6 SimpleAverage 7.9 Standard Deviation 6.5 Dispersion (coefficient of variation) 0.8 Maximum tariff rate 15 Percent of tariffs above the level of a simple average 49.2 All Products (HS Chapters 0 through 97) D i s ersion (coefficient of variation) MaximumPercent of tariffstariff rateabove the level of a simple average Percent of tariffs above twice the level of a simple average Percent of specific tariffs 6.9 Source: The Decree No. 80 of the Cabinet of Ministers "On customs duties levied on imports into the Republic of Azerbaijan" (12 April 2001). 54. Second, treatment of various sectors within industrial products i s much more differentiated than within non-industrial products. The value of a coefficient of variation for tariffs on industrial products i s twice as highas that for agricultural products. 55. Hence, the tentative conclusion one could draw is that tariffs offer greater protection (or subsidy) to industrial products than to non-industrial products, though there appears to be significant differences in treatment of different industrial products. Before identifying the production lines that have been accorded `privileged' treatment, it i s important to assess the extent to which protection (or subsidy) offered to domestic producers i s neutral among products at various stages of processing. 1V.d. Differential treatment interms of processing 56. At a first glance, it would seem that Azerbaijan's tariff structure tends to "discriminate" against low processed products leading to tariff de-escalation, i.e., tariffs for fully processedproducts tend to be lower than for semi-processedproducts andraw materials. But this conclusion does not seem to be fully warranted, as the cascading effect is weakened by the pattern of protection on raw materials. As can be seen from data in Table 4.5,59 the simple average tariff rate on processed goods i s higher than on intermediate goods but both 59The classification of different stages o f productionwas calculated according to the WTO classification usedin Trade Policy Reviews. 85 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan are significantly lower than the simple average tariff on raw materials. This would suggest that the overall cascading effect of the tariff structure is relatively low, although it clearly `discriminates' against raw materials while simultaneously raising the cost of imports of raw materials for further processing.60 Simple Standard Weighted Percentof tariffs Maximum Average Deviation average twice the level of tariff rate average Raw materials 10.6 6.2 10.1 0 20 Intermediateproducts 7.8 6.8 3.6 0 15 Processedgoods 8.1 6.4 7.4 0 15 57. The review of data in Table 4.5 gives also support to another observation. Lower values of weighted average tariff rates than those of corresponding simple averages across all stages of production seem to indicate that either high tariffs prevent entry of some goods or they are misclassified by customs, or both. The difference is particularly high for intermediate products. 58. Exporters from CIS economies are least vulnerable to Azerbaijan's tariffs, simply because of the large share of intermediate products in their exports to Azerbaijan, which accounted for 55 percent of their total exports in 2001 (Table 4.6). They supplied42 percent of Azerbaijan's imports of raw materials and 57 percent of intermediate products in 2001. (Their share in imports of processedgoods was 15 percent). The average weighted tariff on CIS of 7 percent was significantly lower than on imports from the EU(12%) or from the rest of the world (13%). In EU and ROW (rest of the world) export baskets to Azerbaijan, processed goods dominated accounting for around 70 percent of their Azerbaijan-oriented exports. 6o Duty drawback resolves the anti-export bias inherent in high tariffs on raw materials but at the expense of administrative complexity and weakening support for trade liberalization, which is always the best policy option (see 0. Cadot, J. de Melo, and M. Olarreaga, "Can Duty Drawbacks Have a Protectionist Bias?," The World Bank, mimeo, Washington, D.C. 2000. 86 INOTIS-IntegratedNon-Oil Tradeand IiivestinentStrategyfor Azerbaijan Imports, Imports, Imports, Total EU CIS ROW'' Imports (intermsof percent) ~ Low processedgoods 7 20 18 16 Intermediategoods 19 55 21 32 Processedgoods 74 26 61 52 Shareintotal by direction 21 34 45 100 Memorandum: Weightedaveragetariff 7.1 3.8 8.6 6.6 rates by direction (inpercent) 59. Given the dominance of ROW in Azerbaijan's imports of processedgoods, it comes as no surprise that they face on average higher tariff rates. Suppliers from ROW were much more affected than those from the EUor CIS countries.61 1V.e. Informationtechnology products 60. How friendly or unfriendly i s Azerbaijan's tariff schedule towards IT (information technology) products? The importance of this question stems from the fact that they have been one of the driving forces of world trade over the last decade or so. Friendly business environment and disciplined workforce have attracted investments in this sector in the third tier of East Asian "economic success stories"-Malaysia and Thailand. The available data suggest that the IT sector inAzerbaijan is yet to take off. 61. In order to answer the question of this section, we follow the identification of IT products as specified in the WTO Information Technology Agreement (ITA).62With some exceptions (e.g., TV sets but not computer monitors), the ITA covers most IT products. Attachment A, Section 1 lists the Harmonized System headings or parts thereof to be covered, whereas Attachment A, Section 2 covers semiconductor manufacturing and testing equipment including parts. Data tabulatedinTable 4.7 distinguishbetween these two groups. As can be seen, the bulk of Azerbaijan's IT imports fell under Section 1of the ITA. Imports of IT products were quite significant in 2001 accounting for 7 percent of total imports into Azerbaijan. Since Azerbaijan has FTA with four CIS countries, including Russia-by far the most important trading "artnerITA among them-this proportion for imports from CIS may be even smaller. The is a tariff cutting mechanismthat emerged from the Singapore WTO Ministerial in 1996. 56 WTO members have signed this Agreement, which zeroes out tariff rates on all information technology (IT) products, components as well as final products. Most of them have a high R&D component, but not all of them. For instance, articles as ordinary as cash registers and water pressure gauges are also considered "information technology." For details, see httn://www.wto.orcr/encrlish/trator, e/inftec ehnftec e.htm. 87 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan Attachment A Attachment A Total Section 1 Section2 Imports(in thousandof 86,821 6,98 1 93,802 US$) Shareintotal 6.1% 0.5% 6.6% Average MFNrate 8.3 3.5 6.8 Standarddeviation 5.5 4.4 5.6 Maximumtariff rate 15 15 15 Minimum tariff rate 0.5 0.5 0.5 Weighted averagerate 6.1 6.2 6.1 62. ITproducts are subject to slightly lower tariff protection than other products imported into Azerbaijan. A simple average tariff rate of 6.8 percent is lower than an average simple rate on imports of industrial products (8%). The weighted average rate of 6.1 percent i s lower than both the weighted average rate of Azerbaijan's total imports of 6.5 percent and imports of processed goods of 7.4 percent. Again the reasons behind the relatively high tariff protection on IT products are not clear, as most of these products, usually with a high R&D content thus contributing to transfer of technology, are not domestically produced. 1V.t Tariff schedule: opportunitiesfor corrupt behaviour 63. Azerbaijan's tariff policy expands opportunities for corruption of Customs in three distinct ways: through variability in tariff rates for relatively similar items, practice of granting tariff and VAT exemptions on discretionary basis and free trade agreements. The importance of customs valuation WTO rules stems from the fact that discretion in assessing the value of imports would render irrelevant tariff concessionsnegotiatedby WTO members. While this consideration may be of little importance to countries that are not WTO members, the possibility of significant losses in customs revenues i s usually of great concern. Tariff schedule characterized by high dispersion combined with tariff exemptions creates environment conducive to customs fraud. On the other hand, a one-band tariff schedule (one uniform tariff rate) reduces corruption related to customs clearing and lowers the administrative costs of trading.63 64. While Azerbaijan's tariff schedule is not characterized by high dispersion, the potential for fraud is much larger than the value of the average coefficient of variation might indicate for one major reason. Products differing only in the national specification in Harmonized System, which are subject to varying tariff rates offer significant opportunities to custom officers incharge of clearance to misclassify products. Note that the H S international specification covers first six digits, whereas the remaining 2-3 digits can be defined by national a~thorities.~~The differences in characteristics among products falling into the same 63For an in-depth discussion of advantages of a uniform tariff, see D. Tarr. 2002. "Arguments for and against Uniform Tariffs," in B. Hoekman, A. Mattoo, and P. English, eds., Development, Trade, and the WTO. A Handbook,The World Bank, Washington, D.C., 2002, p. 493. 64 Azerbaijan uses the first six digits in accordance with HS, the next two digits in accordance with the combinedusedinthe Council of Europe, andthe last digit takes into account Azerbaijan's preferences. 88 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan six-digit group are usually minor. Hence, customs have significant discretion in classifying products within the same six-digit groups. 65. There are about 40 six-digit H S groups with differences intariff rates of 14.5 percent. These are both agricultural and industrial products. Classifying a shipment of products worth US$ 100,000 as subject to 0.5 percent ad valorem tariff rate rather than 15 percent would reduce duty revenue from U S $15,000 to US $500 and revenue from VAT-assuming the rate of 18 percent-from US$ 20,700 to US$ 18,900, or by US$ 1,800. The total loss to the treasury would then amount to US$ 16,300, or 16.3 percent of the value of misclassified shipment. The bottom line i s that this provides apowerfulincentive to misclassify goods. 66. The practice of tariff and VAT exemptions also offers opportunities to misclassify goods at customs clearance, albeit-it seems-on a much smaller scale. Not all products belonging to two-digit H S groups (84, 85, 86, 87, 88, 89) are exempt from VAT. 67. Last but not least, the entry into force of several free trade agreements create extra opportunity to fraudulent behavior related to `misreading' of the origin of a shipment, Le., classifying as one coming from apreferential, free-tradepartner. 1V.g. Concluding observations 68. There has been a reversal, albeit not a large one in tariff liberalization in Azerbaijan since 1996. While between 2000 and 2002 the overall level of tariff has slightly decreased, the dispersion in tariff rates appears to have increased.By the same token, the extent to which tariffs distort consumption and production pattern and entail inefficiencies has also expanded. The reasons behind this change in the increase of tariff bands are not clear. No industrial policy considerations seem to explain it, as the new pattern of protection does not seem to follow any clear standard. Beefing-up the bargainingposition during the WTO accessionmay explain it, but this would be a self-defeating approach in terms of economic policy consideration and prospects for a quicker accession. Fiscal considerations may provide an explanation, but again they are methods inflicting much smaller economic damage to accomplish this objective. 69. Whatever the reasons were behindthe change inAzerbaijan's applied tariff rates, the shift towards a uniform tariff rate even slightly exceeding the current weighted average tariff rate would be a better policy. If the revenue considerations drove the decision to increasethe overall level of tariffs, introducing a uniform tariff rate (even below the current weighted average tariff rate) would expand `tariff base' and increase customs revenue. I t would also push private interests to focus on productive activities rather than lobbying the government, remove incentive to misclassify products, and reduce smuggling, which result in lower budget revenuesand business-unfriendly environment. Furthermore, it could contribute to the acceleration inthe WTO accessionprocess. v. CONCLUSIONS AND POLICY RECOMMENDATIONS 70. An answer to the leading question of this note, Le., whether WTO accession is in Azerbaijan's economic interest i s clearly affirmative. The costs of conforming to the WTO rules seem to be considerably lower than in the case of country at a similar level of GDPper capita. Azerbaijan has already made significant progress in establishing a market-based, WTO-compatible foreign trade regime and does not have to buildadministrative capacities to implement WTO rules from scratch. In areas where these capacities remain weak, their upgrading, although often costly, would bring significant returns independently of accession 89 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan to the WTO. (An example i s modernization of customs or improvement in transparency and information disclosure.) More problematic returns may be from `investments' in IPRs or technical standards, although-since many ingredients of both regimes are already there- costs may not be prohibitive. 71. Benefits should not be assessed through the lenses of the current export basket dominated by oil products. To the contrary, accession to the WTO increases chances for export diversification, although this i s only a necessary condition (with many caveats pending on the mode of accession) and not a sufficient one. These prospects for supply response increase, as the international experience indicates, if the government uses accession a mechanism to lock-in foreign trade liberalization. Foreign trade liberalization alone will not produce supply response without complementary policies improving investment climate and business environment. Inother words, WTO accession should be viewed as a component of second-generation economic reforms. 72. The government faces the choice of either pursuing the current course of `benign neglect' or adopting a more aggressive "maximum liberalization" approach. The latter would speed up the accession process. This would call for two sets of measures. First, as noted above, WTO-related liberalization (including a neutral tariff policy) should be made an integral part of second generation reforms and Azerbaijan poverty reduction strategy. Second, administrative resources allotted to accession-related issues should be increased and the government should submit a single `take-it-or-leave-it' legal package to the parliament insteadof piecemeal changes invarious acts. 73. The "maximum liberalization" approach seems to be in economic interest of Azerbaijan. This i s the only way to use trade as an engine for poverty-reducing growth and exploiting opportunities offered the global integration process. 0 90 INOTIS-Integrated Non-Oil Tradeand InvestmentStrategyfor Azerbaijan STATISTICAL APPENDIX Appendix Table 1: The listof products subject to mandatorycertification(introduced onJanuary 1,1994) 1. Meat, preparations of meat, milk and dairy products 2. Fishand preparations of fish 3. Bird's meat, chicken eggs 4. Grain, flour cereals 5. Bread-roll and macaroni preparations 6. Coffee, tea, mint and spices 7. Natural honey 8. Fruits, vegetables and products made from them 9. Animal andplant oil 10.Animal or vegetable fats 11.Margarine 12. Sugar, sweetens and other sugar confectionery 13. Beer, non-alcoholic drinks, vinegar 14.Foodsalt 15. Tobacco and tobacco products 16. Perambulator 17. Children toys on whiles such as three while bicycle, children's automobiles, carriages for toys 18. Human toys 19. Other children toys, small size models, puzzles 20. Children soothers, footwarmers 21. Rubber masks for swimming, flippers 22. Maximum 44 size children underwear, night-shirtspajamas 23. Maximum44 size combinations, underwear skirts and shorts 24. Shirts, sweaters and similar tied wares with sizes up to 44 25. Underwear for just bornchildren andfor children under school age. 26. Maximum44 size swimming suits and trunks for young kids 27. Maximum22 size socks and tights for children 28. Maximum24 size children shoes 29. Washing, bleaching and cleaning manufactories 30. Rubber gloves and gloves used for medical purposes 31. Not more than 1kilowatt strong transformers except measures not considered for private aviation 32. Usedelectro-mechanicalmachines made out of electrical motors 33. Accumulated and non-inertial electrical water heaters, electrical boilers, electrical carpet heaters, apartment heaters, electrical hands drying machine, electrical irons, other socially usedheating equipment. 34. Electrical telephone sets 0 91 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan 35. Not more than 1000 V strong equipment for connection, to open safety-locks or to connect in the electrical lines (knife-switch, transformers, relays, vibration switcher, plugs and wall outlets, lamp-sockets for electrical lamps, connecting boxes etc.). 36. Hooks and half-hooks, other not moveable by itself transport means and their parts 37. Instruments and means used in medicine, surgery, dentist and veterinary practice, other electrical medicine devices, equipment aimed to identify the sight 38. Socially usedcleaning machines 39. Electricalmotors and generators except ones aimed for private aviation 40. Socially usedwelding machines 41. Audio players and other audio recordingequipment 42. Gas and electric incandescent lamps 43. Insulated wires, cables and electric conductors with and without connecting parts 44. Radiotelevision equipment 45. Automobile and special types 46. Pneumatic rubber tiers 47. Wood-sawdust wicks and similar wood wicks hewed or not hewedfrom the soot 48. Heating furnaces, heating cookers, kitchen stoves and ovens (including central heaters made of small boilers), ovens, heaters for food and socially used similar electrical equipment not made of black metal. 49. Refrigerators and other refrigerating and freezing equipment or other types, heating pumps 50. Ammonium sulfate 51.Exposed and identifiedcinema tapes 52. Insecticides, rodenticides, herbicides, disinfecting medicine and their analogues effecting germination and growth of plans 53. Clothes dryers 54. Dishwashing machines 55. Machines automatically analyzing information and their block parts 56. First elements and batteries 57. Soling equipment 58. Distance telephone, radiogram, sets receiving and broadcasting radio and television channels 59. Melting safety-locks andmelting connectors 60. Motorcycles (including mopeds) and bicycles with fixed support engines 61. Two wheels and other types of unengagedbicycles 62. Baby-carriages and their parts 63. Yachts and other sport, relaxation sailing equipment, boats with oars and canoe 64. Breathing sets, gas masks (except protecting masks) 65. Orthopedic corrections 66. Meter 67. Electricalmusic instruments 68. Single-barreled small caliber sport and huntingrifles 69. Rivet instruments and bullets for painless animal killing or deafening guns 70. Video games 71. Motorcycle helmets 72. Steal bottles heatedup to 1,6 mPa pressure 73. Instruments with diamond 74. Fluidsubstance pumps used under 36 V electrical transformer 75. Utilizedfor social purposes air and vacuum pumps, air and gas compressors 76. Clothes washing machines 92 INOTIS-Integrated Non-Oil Tradeand InvestmentStrategyfor Azerbaijan 77. Wood processing machines 78. Drossels for luminous bulbs 79. Electrical accumulators 80. Different types of screws 81. Socially usedroundsaw 82. Socially usedpolishing devices working at 36V and higher 83. Haircut and shaving electrical instrumentsworking at 36 V and higher 84. Equipment aimed to transfer electrical vibrations to the sound and not recording the sound working at 36 V and higher 85. Oscilloscopes, network meters and other equipment and sets constructed to measure and control the voltage (except meters). 86. Equipment and sets constructed to identify cosmic and other ion beams alpha-, beta-, gamma- and roentgen. 87. Two-barreled sport andhunting rifles 88. Small caliber guns 89. Bullets for small shot guns 90. Lighting equipment 91. Games working on coins or counters except machines usedinautomatic bowling bars. 93 INOTIS-Integrated Non-Oil Tradeand Investment Strategy for Azerbaijan Appendix Table 2: The list of goods subject to mandatory certification (introduced on July 1,1994) 1. Cognac, Champaign, alcohol-wine beverages and wine products 2. Tins for childfood 3. Milk mixtures for childfood 4. Dishes made from aluminum, cast-iron steal, copper-brass, enamelled, matted and from nickel 5. Oil-clothes and other types of products made of polyethylene 6. Artificial leather and goods made from it 7. Plastic goods 8. Mineral fertilizers 9. Varnish andpaint products, ticks and putties 10.Socially usedelectrical devices 11.Audio-video technology 12.Air-conditions 13. Electricalpumpsand compressors 14.Socially useddevices and electrical sets 15. Agricultural machines, techniques andcomponents 16. Roadbuildingmachines 17.Equipment for oil wells 18. Glasses for windows and car windows 19. Non-ferrous and ferrous metals, their alloys 20. Furniture 21.Gas equipment 22. Sanitary techniques 23. Facingmaterials 24. Linoleum 25. Oil refining goods 26. Cotton-fiber 27. Stockinet underwear 28. Goods made of leather and leather substitutes 29. Leather-fur goods 30. Shoes 31.Incubators 32. Naturaland compressed gas 94 INOTIS-Integrated Noli-Oil Trade and Investiiient Strategyfor Azerbaijan ANNEX 5: BUSINESSENVIRONMENT AND COMPETITIVENESS* I. INTRODUCTION -THE COMPETITIVE CHALLENGE 1. This report evaluates the competitiveness of the business environment in Azerbaijan for non-oil activities. It identifies the major factors constraining development of the private sector, particularly foreign investors, and outlines reform proposals. It draws on a number of recent evaluations of Azerbaijan's business environment, which have been conducted from different perspective^.^^ One of the most recent of these i s a study conducted by the Foreign Investment Advisory Service (FIAS) that conducted a diagnosis of the investment climate from a foreign investor's point of view. This analysis attempts to extend that work to the Figure 5.1-Qualitative Assessmentof the BusinessEnvironmentin 1999 and 2002-Substantial Improvement Access to Financing Quality of Judiciary Regulations 1-1999 -2002 1 See EBKDand World Bank, Busmess Environment and EnterpnsePerlormanceSurvey, 2002. Note: The combined measureof qualitative assessmentsof the business environment is calculated as an unweightedaverage acrossseven dimensions. The values range from 1to 4, with 1 indicatingno obstaclesto businessgrowth and operation, and 4 indicating major obstacles. The extremity of each axis representsa scoreof 4, indicatinga less favourable business environment. * This Annex was preparedby Kishore Rao and Sheri Pitigala (Consultants) These studies include Foreign Investment Advisory Service, "Azerbaijan: Joining the Race for Non-Oil Investment, a Diagnostic Review of the Environment for FDI." (FIAS, May 2002); Halcrow Group Limited. "Trade Facilitation in the Caucasus-Defining the Mechanisms of Change - Azerbaijan." (Report to the World Bank, June 2002); Transborder. "Azerbaijan Investment Policy Review. (Report to the Department of International Development, UK, June 2001); EuropeanBank for Reconstructionand Development. "Strategy for Azerbaijan." (EBRD, 2001) 95 INOTIS-Integrated Non-Oil Trade arid InvestmentStrategyfor Azerbaijan micro-economic environment affecting firm-level competitiveness. It incorporates the findings of two additional analyses conducted for the overall study." 2. Overall, Azerbaijan has made considerable progress in transitioning its economy from a command-based model, to an open, market-driven one. Over the past decade, privatization and related programs have contributed substantially to private sector development. In 1990, Azerbaijan's private sector accounted for a mere 10percent of GDP, growing to more than 70 percent by the end of 2001. Today, the private sector accounts for more than two-thirds of all employment, with the small and medium enterprise (SME) sector growing rapidly. The S M E sector grew more than 30 percent between 2000 and 2002, alone, in terms of the number of enterprises. Employment inthe sector grew by more than 40 percent over the same period. 3. Much of Azerbaijan's economic progress to date can be attributed to the Government's economic reform program. The creation of the Ministry for Economic Development in 2001, bringing together five ministries and state committees into the one body i s a major administrative step towards the achievement of a coherent and integrated economic strategy. Legal and institutional development has spanned the full spectrum of economic policy areas, including commercial law, trade and investment law, banking and finance, privatization, and tax and customs. - Figure5.2-Reform PatternsinTransitionCountries. 2002 Second Phase Reforms FR Yugoslavia Initial Phase Reforms 1.o 1.5 2 .o 2.5 3.O 3.5 4.0 Source: EBRD, BusinessEnvironment andEnterpriseSurvey, 2002. Note: The chart reports the average score for each country in two broad dimensions of reform. "Initial phase reforms" include price liberalization, foreign exchange and trade liberalization, and small-scale privatization. "Second phase reforms" include large-scale privatization, governance and enterprise restructuring, competition 3 policy, infrastructure reforms, banking and interest rate liberalization, and non-bank financial institutional development.Scores rangefrom 1 to 4, with 4 representingthe greatest degree of liberalization. 65 These are an analysis of the Azeri fruit and vegetable processing cluster and a study of administrative bamers to inward investment. 96 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan 4. Azerbaijan's progress to date has been measured, together with 25 other transition countries, in the EBRD's Business Environment and Enterprise Performance Survey (BEEPS), which was conducted in cooperation with the World Bank. The BEEPS, first conducted in 1999 and again in 2002, illustrates the substantial progress that Azerbaijan has made in transitioning toward a market-based economy (Figure 5.1). Major achievements include successful privatization of small-scale enterprises and farms, price liberalization, and a relatively liberal trade and investment regime. The Government's reform program contributed substantially to the development of the private sector. By 2001, the private sector share of GDP grew to 71percent, up from a meager 24 percent in 1994. 5. Despite these impressive achievements, it i s also true that these favorable overall statistics mask the fact that the Azeri non-oil private sector remains a laggard, even from the perspective of other transition economies. Azerbaijan's progress i s typical among the transition economies - quick successes in initial reform efforts that are easiest to implement, but slower progress in more complex, institutional reforms. Azerbaijan, however, has fallen behind many other transition countries, particularly the Central and East European Countries (CEEC), as well as other CIS countries, including Armenia, Ukraine, Georgia, Kazakhstan, and Russia (Figure 5.2). 6. While initial reforms have introduced key elements for the establishment of a market- based, private sector driven economy, barriers remain that hinder private sector development and the expansion of trade, both interms of the legal and regulatory framework itself, as well as the administrative systems that are charged with implementing them. 7. The legal framework remains complex, with significant inconsistencies and gaps. Moreover, information on decisions implementing laws and regulations i s often difficult to obtain. While laws and decrees are usually published in one of the country's official newspapers, implementation i s often delayed while regulations are developed. Those regulations often are not published or distributed. Many investors doing business in Azerbaijan complain that bureaucratic procedures contribute to long delays in gaining necessary permits and licenses. Inconsistent laws and regulations, gaps in legislation, cumbersome procedures, a general lack of transparency and clarity, and resulting corruption and predatory practices pervade the business environment in Azerbaijan. These factors impose high costs on firms, in terms of both money and time spent, as well as indirect costs resulting from operating in an environment of uncertainty. 8. The emerging private sector in Azerbaijan remains largely small-scale, inwardly oriented, and largely operating in the informal economy. The extent of the informal economy-larger than most other transition economies-is indicative of the pervasiveness of existing barriers to private sector development and the costs that they are perceived to impose on the private sector. The net effect of the current investment environment is to discourage entry of enterprises inthe formal economy. 9. The hardest hit are the Small, Medium and Micro Enterprises (SMMEs) who do not have the resources to navigate labyrinthine requirements and procedures. Such barriers impose high costs on firms, in terms of both money and time spent, as well as indirect costs resulting from operating in an environment of uncertainty. This negatively impacts their growth as scarce resources are diverted to dealing with administrative requirements. Others prefer or have been forced to operate outside the formal sector-in 2002, it was estimated 97 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan that the size of the informal economy in Azerbaijan is equivalent to more than 60 percent of GDP, significantly higher than the average 38 percent in other transition economies and the low average 17 percent in OECD countries.66The GOA'Sestimates are lower, but still point to the existence of a large informal economy. The emerging private sector in Azerbaijan remains largely small-scale, inwardly oriented, and largely operating in the informal economy. The net effect of the current investment environment i s to discourage entry of enterprisesinthe formal economy. 10. To address these issues, the Government has enacted a number of actions. The most recent wave of initiatives in the latter half of 2002 have included both legal and administrative improvements in the area of commercial law, as well as other aspects of the business environment. These new initiatives, which largely came in the form of Presidential Decrees, were designed to enhance the effectiveness of existing legislation andor the development of new programs and initiatives to support private sector development. These new measures should provide ongoing momentum to regulatory and administrative reforms and the development of programs to encourageprivate sector development inAzerbaijan. 11. Building a competitive business environment will be a key factor in boosting private sector development in the non-oil sector, diversifying trade, and achieving sustainable growth. This paper examines the effect of Azerbaijan's businessenvironment on firms in the traded goods sector and, inparticular, foreign trade. Given Azerbaijan's large share of foreign trade relative to GDP (foreign trade was equivalent to approximately 64 percent of GDP, as of June 2002),67in many cases the factors that impact firms engaged in foreign trade are the same as those that affect the private sector more generally. The following assessment focuses on two types of firms that are expected to play a key role in expanding and diversifying Azerbaijan's export base, namely foreign investors and SMMEs. The majority of foreign investors in the traded goods sector are expected to use Azerbaijan as an export base, given the relatively small size of the Azeri market. SMMEs are also expected to play a key role in export development, as evidence worldwide suggests that such firms tend to account for the majority of trade growth, both in developed and developing markets. Wherever possible, specific reference is made to the impact of the business environment on these two key segments. 12. The paper also utilizes an industry cluster-basedapproach to identify and understand the impact of factors in the micro-economic economic environment. While macro-economic characterizations are useful, they do not really provide a sense of the constraints that are felt by individual firms. Ultimately, as has been pointed out before, it i s individual firms rather than nations that compete inthe global marketplace. The identificationof issues that make or break competitive advantage requires a more focused, in depth analysis at the micro-level. Competitive advantage is increasingly being defined by the cluster approach, rather than traditional sector-based analysis. The cluster approach, which provides a holistic framework for understanding how firms interact to build a competitive advantage, provides a market- based perspective for the development of appropriate government policies and programs to complement macro-level reforms and support competitiveness. 66Friedrich Schneider, "Unofficial Activities in Transition Countries: Ten Years of Experience." (Working Paper, October 2002). 67National Bank of Azerbaijan Republic, Monthly Bulletin, November 2002. 98 INOTIS-IntegratedNon-Oil Trade and Investment Strategyfor Azerbaijan 13. A pilot initiative in the fruit- and vegetable-processing cluster is utilized to highlight the advantage of such an approach and to provide an indication of the types of policies and initiatives that will be requiredto support increased competitiveness. 11. BUSINESS ENTRY REGULATION AND 1I.a. Investment Regime 14. One of the key aspects of the business environment i s the quality of the legal and regulatory framework governing inward investment, business entry and operation. Azerbaijan's regime for direct investment i s relatively liberal and open. Direct investment in Azerbaijan is governed by two separate, but related laws: the Law on Investment Activity (Investment Law) and the Law on Protection of Foreign Investments (FDI Law). These are supplemented by bilateral investment treaties that provide for mutual protection of investment.68 Relatively few sectors are either restricted or prohibited from private investment. Prohibited activities currently include those relating to national security and defense. Investment in other key sectors, including energy, banking, and telecommunications, are subject to restrictions, which apply to domestic and foreign investors alike. The Investment Law governs both portfolio and direct investment. The FDI law provides equal treatment to foreign investors, while granting them a number of extra protection^.^^ 15. While these two laws generally provide a solid framework for investment, the MED has drafted a single, unified investment law providing a single policy regime for both foreign and domestic investors. While this i s an important and commendable step forward, there three main weaknesses inthe proposedlaw, as currently drafted:70 0 Ambiguity regarding investment policy. Many parts of the law appear to suggest Government control rather than liberalization of investment. Examples include provisions requiring Government's approval being apparently required for all foreign investments into the country; application of discretionary criteria for the granting of incentives for certain types of projects; and unclear and discretionary screening and approval process. 0 Regulatory rather than promotional emphasisof the new IPA. Parts of the law are unclear whether the new Investment Promotion Authority i s an approval rather than a promotion agency. Neither the IPA nor the "Executing Agency" are clearly defined in terms of structure and responsibilities; specifically, whether these Agencies are Bilateral investment treaties have been signed with France, Georgia, Germany, Great Britain, Iran, Italy, Kazakhstan, Kyrgyz Republic, Lebanon, Moldova, Pakistan, Poland, Ukraine, Turkey, the United States, and Uzbekistan. 69The law provides for the standard range of guarantees, including repatriation of profits, provisions regarding due compensation in the event of expropriation or nationalization, and mechanisms of dispute resolution (including international arbitration). Furthermore, the FDILaw places a ten-year moratorium on the application of certain subsequent legislation that worsens the investment environment. However, this does not include any legislation pertaining to taxation or finance and credit-two key areas of the investment environment-as well as defense and national security, natureprotection, and moral and public health. 'OThis is a summary of points made by FIAS in their comprehensive review of the draft investment law. For detailed points, please see "Republic of Azerbaijan-Desk Review of the Draft Investment Law," Mimeo, April 2003. 99 INOTIS-Integrated Noii-Oil Tradeand Investment Strategyfor Azerbaijan intended to promote investments, manage and grant incentives to investments, or both. 0 Unclear and discretionary screening process for provision of incentives. The law does not specify transparentprocesses for the award of incentives, and leaves open the possibility that these may be grantedon a case-by-casebasis. International experience suggests the use of "performance-based" incentives that are automatically gained, rather than a discretionary process. 16. The Investment Law also needs to be revised to improve the investment regime for both foreign and local investment. The Investment Law governs both portfolio and direct investment. These activities are substantially different and should be treated separately. The Investment Law should govern direct investments only; separate laws and regulations on the stock market should deal with portfolio investments. The law should also be strengthenedin terms of state guaranteesof investments. 17. A related area of legislation is company law, which governs company formation. In Azerbaijan, company formation i s governed by a number of inter-related laws- the Civil Code (effective SeptemberZOOO), the Law onEnterprises (July 1994), the Law on Joint Stock Companies (July 1994), and the Law on Limited Liability Companies (December 1998). The provisions o f each of these laws are, in general, compatible with best practice, but are in many ways incomplete, particularly in terms of corporate governance and the protection of shareholder rights.The State SecuritiesCommittee has already drafted a revisedLaw on Joint Stock Companies that addresses some outstanding issues. While a substantial improvement, the draft law needs to be further strengthened in a number of areas in order to ensure an adequatedegree of business flexibility and shareholder protection. 1I.b. BusinessRegistrationand Licensing 18. It is widely acceptedthat complex regulations andcumbersome proceduresgoverning businessentry are a major deterrent to inward investment, contribute to pervasive corruption, and provide incentives for firms to remain ~nofficial.~'Business registration and licensing form the core of business start-up procedures and, as such, provide an important indicator to investors of the ease of doing business in a given location. Lengthy and/or cumbersome registration and licensing procedures can impose high costs on entrepreneurs and deter business development. Unnecessarydelays in registration and licensing can increase start-up and other costs of companies, particularly smaller enterprises, by delaying their ability to do business, tying up resources, and hindering the ability of a company to respond to a changing market, and consequently causing them to lose potential revenues or even market share. If a company sees an opportunity and needs a new license to pursue it, the opportunity may be lost or compromised by the time the license i s granted. 19. The business registration and licensing regime in Azerbaijan i s governed by a wide array of legislation. While some recent attempts to introduce reforms will improve the process-most notably the September 2002 Presidential Decree "On Improvement of Regulations of Granting Special Permissions(Licenses) for Some Types of Activities", which substantially reduced the number of types of activities requiring licensing-the overall regime is reportedly one of the most cumbersome and time-consuming aspects of business '' "Countries with a heavier regulation of (business) entry have higher corruption and larger unofficial economies, but not better quality of public or private goods." Simeon Djankov, Rafael La Porta, Florencio Lopez de Siames, and Andrei Shleifer, "The Regulation of Entry," World Bank, June 2001. 100 INOTIS-Integrated Noiz-Oil Tradeand bivestineiit Strategyfor Azerbaijan start-up in Azerbaijan. In the assessment of administrative barriers conducted for this study, for example, registering a business took an average of 8-10 weeks; business licensing entailed an additional 2-3 weeks.72 While larger investors can absorb the costs associated with bureaucratic delays, smaller entrepreneurs can be discouraged from entering the formal sector. The registration process in responsible, at least in part, for the large number of entrepreneurs operating in the informal sector. 20. All enterprises operating in Azerbaijan are required to register with the Ministry of Justice. According to the Civil Code, the Law on Enterprises, and the Law on State Registration of Legal Entities (February 1996), private companies may take any of the following forms, which must be registered with the LegalEntities Registration Department at the Ministry of Justice: e State Enterprises; e Individual (Family) Enterprises e Joint Stock Companies 0 General Partnerships e LimitedPartnerships a LimitedLiability Companies; and 0 Additional Liability Companies. 21. All these forms are open to foreign-owned and domestic-owned (or joint venture) enterprises alike. Foreign enterprises may also form branches and/or representative offices, which are not considered legal entities but must be registered with the Ministry of Justice, as well. Although the Ministry has decentralized and opened district offices, companies must continue to submit their registration documentationto the Ministry's central office inBaku. 22. While the business registration procedures are relatively straightforward, interviews with the private sector indicate that, inpractice, business registration tends to be overly time- consuming and subject to arbitrary decision-making. Registry officials have discretion to review almost every detail of a company registration. This stems from the tradition that registration of a company signifies compliance with all legal requirements. It requires or at least invites officials to examine the contents Table 5.1-Average Lengthof Time to and form of all filed documents, to review and pass on the work, and to reject a registrationthat the official feels i s deficient. While the Law on I United States I -4 1 State Registration sets a limit of ten days for I United Kingdom I 5 I processing registration applications, interviews Ukraine with the private sector suggest that actual processing times can take several months. Russian Federation 20 Delays due to insufficient information or documentation are reportedly common, as are requests for additional documentation, beyond those required by law. When seeking help on I Belarus 69 documentation and/or procedures, some observers suggest that staff members are generally not well informed or helpful. While large investors can afford to hire lawyers andor l2See Annex Fof Volume IIfor analysis and further details. 101 INOTIS-Integrated Non-Oil Tradeand InvestmentStrategyfor Azerbaijan other facilitators to guide them through the business registration process, SMMEs typically cannot afford to hire facilitators and are, therefore, often faced with long delays andor requests for informal payments to pave the way, or, alternatively may discouraged from entering the formal sector. 23. Table 5.1 provides a comparative picture of the averageqength of time to register a business in Azerbaijan and neighboring countries, as well as some selected other countries. As can been from the table, Azerbaijan lags behind many of its neighbors. Business registration takes more than three times as long as in Georgia, the Kyrgyz Republic, and the Russian Federation, where registration averages 18 to 20 days. In the United States and the United Kingdom, where business registration is a simple public notification process, it takes only a fraction of the time to formally establisha businesspresence. 24. While such delays can impose additional costs on entrepreneurs, in its most severe form non-transparent registration procedures can act as a screening process that effectively blocks business development.Although requiredby law only to determine that documents of enterprises seeking registration are in order, the Ministry reportedly operates in a non- transparent and sometimes arbitrary way. According to the most recent Country commercial Guide (2003) published by the U.S. Foreign Commercial Service in Baku, credible reports indicate that Ministry officials make extra-legal determinations of whether individual investments, particularly those with foreign participation, are of an appropriate nature before making decisions about registration. 25. Inaddition to company registration, some investors may be required to obtain sector licenses, depending on the type(s) of activity. Licensing is carried out by the relevant ministry, and one company may require separate licenses from more than one ministry, depending on the nature of their activities. Like the company registration process, the licensing process can be both time-consuming and i s often used as an unofficial screening tool by public officials, which limits private sector development. In the past, documentation and technical requirementsare often unclear or unavailable. 26. The September 2002 Decree, which ratifies the Regulation "On Granting Special Permissions (Licenses) for Some Types of Activities," seeks to improve the licensing regime inanumber of ways: 0 It substantially reducesthe number of types of activities requiring licenses(from more than 240 to 30 categories) 0 It prohibits implementing agencies from demanding documents that are not envisaged intheregulation 0 It grants the MED the authority to act as plenipotentiary in the field of licensing to provide control and administration over licensing procedures, including the preparation of directions and draft legislation, the supervision of implementation by other public organs, and the maintenance of a unifiedregister 27. The reduction in the number of activities requiring licenses is now limited to only those activities that require some degree of oversight to protect consumers and the public interest (such as the production and distribution of alcohol and tobacco, banking, professional services, and the like). Following on the Presidential Decree, in November 2002 the Cabinet Ministers issued a Resolution "On Additional Conditions for Issuing Licenses due to the 102 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan Specificity o f Licensed Activities." The Resolution specifies the application documents requiredfor each types of activity subject to licensing, including any certifications regarding standards and/or other technical requirements. While it i s too soon to assess the impact of these new reforms on investors, it i s expected that the substantial reduction of licensing requirements and the introduction of clear documentation requirements and criteria will increase transparency and reduce the opportunities for undue discretion on the part of public officials. Recommendations 28. While the Investment and FDI laws generally provide a solid framework for investment, each can be strengthenedin a number of ways that would improve the framework for direct investment: 0 Improving the Investment Law. The Investment Law governs both portfolio and direct investment. These activities are substantially different and should be treated separately. The Investment Law should govern direct investments only; separate laws and regulations on the stock market should deal with portfolio investments. The law should also be strengthenedinterms of state guarantees of investments. 0 Improving the FDI Law. The FDI Law, while generally liberal, i s vague and imprecise in a number of areas. The FDI Law also comprises many superfluous provisions and repeats the content of other specific laws. The MED i s working on a new draft FDI Law to address some of these issues and FIAS has provided recommendations on improvements in the above-stated areas. These recommendations should be adopted to ensure that the newly amended law i s reflective of best practices. 0 Improving Company Law. The provisions of Azerbaijan company law is, in general, compatible with best practice, but i s in many ways incomplete, particularly in terms of corporate governance and the protection of shareholder rights. The State Securities Committee has already drafted a revised Law on Joint Stock Companies that addresses some outstanding issues. While a substantial improvement, this draft law needs to be further strengthened in a number of areas in order to ensure an adequate degree of businessflexibility and shareholder protection. 0 Simplify business registration. Box 5.1 illustrates guidelines that a recent EU commission has issued for the reform of company registration procedures in member states.These guidelines comprise best practice andtheir adoption inAzerbaijan would greatly reduce the scope for undue administrative discretion and bureaucratic delays. The submission of the application should be reduced to a mere formality and in case closer evaluation reveals faults or omissions in the application, these findings should be specified to the applicant in writing. Legal standards for the maximum acceptable delays for the final registration and the issue of the official certificate should be introduced to reduce the potential for corruption. The registration procedure should be simplifiedby replacing the submission of an identification code of the State Statistical Committee with inter-agency communication between the Ministry of Justice and the State Statistical Committee, thereby also reducing the potential for informal payments. The same holds for the final registration with the State Statistical Committee, Ministry of Taxes and other mandatory registrations after the business entity has been registered with the Ministry of Justice (see next section). Overall, the 103 INOTIS-Integrated Non-Oil Trade and InvestmentStrategyfor Azerbaijan workflow and efficiency of the registration system should be closely monitored to identify bottlenecks and to measureimprovements. Shifting from a system of control to one of notification, as in the United States or the United Kingdom, could further minimize the administrative burden and scope for discretion. 0 Provide clear guidelines. Whatever system i s ultimately in place, the provision of clear written guidelines, for use by both the private sector and officials responsible for registration and licensing, would provide increased transparency and ensure that the streamlined procedures that are laid down inthe law are put into practice. 0 Provide training. Additional training should be providedfor staff at the Registration Department on the overall process of starting up a company. This training should focus on general customer service skills as well as the steps, requirements, and dependenciesthat exist inthe company registration process. 0 Move to computer-based system. The business registration system in Azerbaijan i s currently a paper-based, manual system. In the medium-term, if the process could be computerized, even partially, it could be made faster and more efficient and reduce opportunities for rent-seeking behavior by government officials. An increasing number of countries have introduced web-based systems that allow investors to download and, in some cases, file all the necessary forms, obtain information on registration requirements, and perform company name searches. The Registrar of Companies in Ireland, for example, offers these services on its website. A similar fee- basedsystemhas beenintroduced inLatvia. 1I.c. Access to Landand Site Development Land Acauisition 29. Among the transition economies, Azerbaijan has one of the most liberal land laws in the region. Legislation regulating land rights in Azerbaijan consists of the Civil Code, the LandCode (June 1999),the Law on LandReform dated (July 1996), the Law on LandLease 104 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan (March 1999), and the Law on Land Market (May 1999). All Azerbaijani citizens and all legal entities, including foreign-owned legal entities, may own, buy, sell, or lease land and other property in Azerbaijan. Non-legal entities (such as branches and representativeoffices) and foreign individuals may only leaseproperty, though long-term leases (up to 99 years) are available. Compared to many countries in the region, the relative ease of access to land, particularly for foreign-owned enterprises, i s laudable. 30. A competitive business environment requires that investors have access to the resources they require, including land, at market prices and that procedures for obtaining land are streamlined and efficient. In Azerbaijan, land acquisition has been characterized by the private sector as often difficult and time-consuming due to both an underdeveloped market and land allocation policies that are currently in practice. According to the administrative barrier analysis background study, acquisition of site development and buildingconstruction permits typically requires aperiod of 50-120 weeks. 31. The real estate market remains relatively underdeveloped in Azerbaijan and a multi- purpose, unified landcadastre has yet to be established, making the identification of land and other property and their ownership rights time-consuming, particularly for foreign investors who are less familiar with the territory. Informationon privately owned landi s difficult come by-some websites and other advertising are available, but are often out of date. 32. Moreover, land allocation continues to be a politically sensitive issue in many transition economies, and Azerbaijan is no exception. Acquiring ownership or land use rights to publicly owned land tends to be even more difficult, as it typically requires multiple reviews and approvals by the public authority to which the property has been vested, as well as, in some cases, the State Committee of Land and Cartography or the MED. A large proportion of publicly held land has been vested with local authorities. In many municipalities, including Baku, much of the land i s still under the ownership of the relevant municipalauthority. FIASfindings indicate that BakuMunicipality, for example, i s perceived to be less than cooperative with investors seeking to obtain property within the city.73Most transfers of land from public to private hands are realized through auctions or other competition methods. However, in cases where more than one individual or entity has expressedinterest in obtaining ownership of the same property, preference is given to those who already work andor live on the site in question, or to shekhid families (Karabakh war victims' families), war veterans, or other similar special interest groups. Such pre-emptive conditions, though designed to alleviate sensitivities toward land allocation, can hamper private sector development and can result in the inefficient allocation of resourcesand reduce the overall gains to the Azerbaijani economy. 33. Once property has been identified and the terms established, all real estate transactions are subject to registration with the State Committee of Land and Cartography. Transactions relating to state owned land parcels and rights to use of such parcels must also be registered in the Register of State Owned Property kept by the MED. The registration process i s presently inefficient and non-transparent.It can reportedly take several weeks, and sometimes several months, to complete the registration process-a procedure that, ideally, should be an automatic filing process and take no more than one day once all documentation has been submitted. As in other areas where application procedures are unclear or unduly time-consuming, interviews with the private sector reveal that the payment of informal fees i s often relied upon to accelerate the process. The development of a unifiedland and real estate l3FIAS, p.A-5. 105 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan registration system andcadastre i s to be developedwith assistancefrom TACIS. The required legislation has already been drafted-this legislation provides for the register to be administered by the Ministry of Justice and will significantly reduce the time required to register a property transaction. While this will be an important step in streamlining the land acquisition process and improvingaccess to information on property resources, the reluctance in some jurisdictions to privatize publicly owned lands and other property remains an impedimentto private sector development. Site Development 34. Once land has been acquired, the site development process is often perceived as a long and complicated process. While such procedures can be time-consuming and frustrating in many countries, developing and developed alike, the process appears to be particularly arbitrary and unduly long in Azerbaijan. Building regulations and standards date back to the Soviet era and are not readily available to investors. Construction permitting, once all project plans have been submitted to the relevant a~thorities,~~typically takes one to two months. Obtaining environmental clearances are complicated by the lack of adequate resources at the Ministry of Environment. According to the recent FIAS procedures for obtaining utility connections are unpredictable and often problematic. 35. The occupancy permittingprocess tends to be even more time consuming. Redundant reviews are carried out by a Working Commission to be adjourned by the investor and a State Trial Boardappointed by the relevant authorities, which must be done sequentially, implying a minimum two-month delay before a newly constructed property may be occupied. Throughout the site development process, in the absence of clear guidelines and procedures, investors are often subject to illegal rent extractions by public officials in order to accelerate the process. 36. The problems faced by investors in the site development process are indicative of the problems faced throughout the administrative system-unclear rules and lack of access to information, bureaucratic delays, public sector interference into private sector development beyond the scope of law, and illegal rent extraction. Given the wide range of difficulties associated with the site development process, it i s not surprising that, according to FIAS' Investment Climate and Administrative Cost Survey, many in the private sector rated site development as a major obstacleto doing businessinA~erbaijan.~~ 37. The availability of industrial land and ready-to-occupy facilities i s one of the most important contributing factors to an investor's location decision. Typically, governments play a key role in facilitating investment start-up when they actively encourage private industrial park development and enter into partnerships to develop the legal and physical infrastructure for industrial and commercial location. The availability of such facilities can substantially reduce the burden of company start-up by simplifying and/or reducing procedures for construction and occupancy permitting and by providing easy access to utilities and other infrastructure. Inthis respect, the regime for acquiring landinAzerbaijan falls short. 74For constructionprojects in large cities, the local Direction of Architecture and Town Planning; and for other regions, the State Committee for Construction andArchitecture l5FIAS, p. A-6. 76FIAS, p. 53. 3 106 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan 38. The establishment of a Special Economic Zone (SEZ), currently under consideration by the Government, offers the potential to improve trade efficiencies, promote processing activities, and facilitate regional trade. The zone could have an important "demonstration effect" by de-regulating and de-monopolizing telecommunications services, expedite the implementation of IT systems (such as a computerized customs system), and be a model of good governance. It can assist enterprises to use Azerbaijan as hub to serve markets in the Caspian region more cost-effectively. It also permits access by smaller enterprises who generally cannot afford the costs of operating a bonded warehouse. However, it i s important that SEZ framework reflect the decades of international experience with SEZs and avoid mistakes made elsewhere (see Box 5.2). 39. Inthis context, itisimportant that the draft SEZlaw berevisedto address anumber of weaknesses, which undermine an otherwise competitive framework. Among the most critical of these are to: 0 Remove all special tax incentives (income tax holidays, turnover taxes, social payments) for zone enterprises, to ensure that unwantedtax distortions do not occur. 0 Enhancecriteria for designation of SEZs so that only bona fide projects are supported.77 0 Enhance the institutional status of the Management Board by increasing its decision- making andregulatory autonomy, andpower to act as a "one stop shop" for investors. 40. The key elements of a world-class zone should include: simplified and automated business procedures, de-monopolization and deregulation of telecommunications and other services; development and operation of the zone by a private development group; a public- private partnership for provision of offsite infrastructure; WTO-compatible duty and tax policies; and a lean, efficient and private sector-oriented zone regulatory authority (for regulation and administration of the zone regime, not physical development). 41. The draft Special Economic Zone Law falls short in number of areas, particularly in the terms of providing an overall regulatory framework and simplified operating environment. The key elements of a world-class zone should include: simplified and automated business procedures, de-monopolization and deregulation of telecommunications and other services; development and operation of the zone by a private development group; a public-private partnership for provision of offsite infrastructure; WTO-compatible duty and tax policies; and a lean, efficient and private sector-oriented zone regulatory authority (for regulation andadministration of the zone regime, not physical development). "Implementingregulationstodefinerelevantdesignationandperformancecriteriato minimizegovernment expenditures and that existing enterprisedfactories cannot be designated as SEZs. 107 INOTIS-IntegratedNon-Oil Tradeand Investnzent Strategyfor Azerbaijan Utilities and Telecommunications 42. Lastly, access to utilities and telecommunications can also be problematic. The utilities sector, in its present state, i s unable to meet the needs of Azerbaijan's economic development goals. Though significant investmentshave already beenmade inupgrading and expanding infrastructure, service remains unreliable and capacity i s insufficient, particularly electricity. Implicit subsidies to SOCAR (inthe form of unpaid tax liabilities), which account for approximately 25 percent of GDP, and below-market tariffs have allowed consumers to over-consume as there is little incentive to economize. It will be impossible to enhance economic efficiency, in both the oil andnon-oil sectors, without addressingthe shortcomings of the utilities sector, a sector that underlies economy-wide efficiency and competitiveness. The electricity sector appears to be particularly troublesome for investors. 43. Significant energy utilities' sector reform was not initiated by the Government until 2001. The Government has now committed to significant reforms to increase financial discipline to improve the performance of the energy utilities sector and encourage the provision of quality services. However, reforms in the telecommunications sector are less well advanced, and the current environment i s characterizedby limitedcompetition and poses and important impediment to growth. At present, limited competition has been allowed in the telecommunications market-there are two cellular telephony providers (one a joint venture with the Ministry of Communications); the national telecommunications operator, Aztelecom has a monopoly over fixed line telephony (voice and data), as well as a broad range of telecommunications services. Internet service providers are under a number of restrictions that limit the potential for web hosting services. The basic laws governing communications and broadcasting have a number of problems including content controls. The Ministry of Communications i s both the regulator and an operator. Privatization of Aztelecom i s proceeding very slowly. Figure5.3-Number ofDays LostfromUtility Outages Recommendations 44. Azerbaijan offers investors a relatively liberal land regime in terms of ownership rights. Domestic and foreign- owned legal entities are free to own land and other property. Long-term leases (up to 99 years) are also available. However, land can be politically sensitive and needs to be handled accordingly. The difficulties encountered by investors in accessing land need to be addressed, if the country i s to be successful in attracting private investment. Only by opening up more landfor investment can a greater level of investment be realized Source: EBRD andWorld Bank, Business Environment and inthe comingyears. EnterprisePerformance Survey, 2002. Development of unified cadastre. The real estate market remains relatively underdeveloped in Azerbaijan and a multi- purpose, unified land cadastre has yet to be established, making the identification of land and other property and their ownership rights time-consuming. Information on privately owned land i s difficult come by. Efforts are now underway to establish a unified cadastre 108 INOTIS-Integrated Noiz-Oil Trade and Investment Strategyfor Azerbaijan under newly drafted legislation. This work should be completed in as timely a manner as possible in order to ensure that the most up-to-date and comprehensive information i s available. Simplify transfer of state owned property. Acquiring ownership or land use rights to publicly owned land tends to be difficult, as it typically requires multiple reviews and approvals and, in some cases, preferential policies, though designed to alleviate sensitivities toward land allocation, can hamper private sector development and result in the inefficient allocation of resources, reducing the overall gains of privatization to the Azerbaijani economy. While land can be politically sensitive and needs to be handled accordingly, the difficulties encountered by investors in accessing land need to be addressed, if the country i s to be successful in attracting private investment. Only by opening up more land for investment can a greater level of investment be realized in the coming years. Streamline title transfer. The registration process i s presently inefficient and non- transparent. It can reportedly take several weeks, and sometimes several months, to complete the registrationprocess-a procedure that, ideally, should be an automatic filing process and take no more than one day once all documentation has been submitted. The procedures for registering land and other property should be streamlined and made available to the public. Simplify site development requirements. The site development process is often perceived as a long and complicated process. There i s no formal zoning framework in place. Building regulations and standards date back to the Soviet era and are not readily available to investors. Construction permitting, once all project plans have been submitted to the relevant authorities, typically takes one to two months. Obtaining environmental clearances are complicated by the lack of adequate resources at the Ministry of Environment. Procedures for obtaining utility connections are unpredictable and often problematic. It will be important to streamline procedures and establish clear guidelines and timeframes for approvals. The regime for occupancy permitting should be reviewed andre-engineered to eliminate unnecessary duplication of efforts and long delays. Promote establishment of private industrial estates. The establishment of privately owned and managed industrial estates could alleviate infrastructure constraints by providing factory shells, serviced facilities and dedicated utility services to companies. The Government can promote the development of these facilities by developing an land use and zoning exercise; identify prospective sites for industrial estate development; develop a regulatory framework for the establishment and operation of private industrial parks; and develop a public-private partnership approaches to stimulate such a ~ t i v i t i e s . ~ ~ Improve access to and quality of utilities and telecommunications. Future reform efforts should focus directly on improving access to and quality of utility and telecommunications services through increased public investment in infrastructure and private sector participation. Other supply-side issues needto be addressed, as well. Future reforms should include the elimination of indirect subsidies to utility providers through further improvements in financial discipline and gradual adjustments in tariffs to cover 78 Typically, the government provides all infrastructure facilities and service connections to the industrial estate site (off-site or external infrastructure), and the private investor provides all infrastructure and facilities within the bounds of the industrial estate. 109 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan the true economic costs of providing these services. While it i s clear that, given the size of the subsidies, any reform program must be long-term in nature, short- and medium-term goals must be set across the board in order to ensure movement toward full financial discipline. Improving performance in the telecommunications sector will require substantial restructuring and further liberalization, including the privatization and eventual de-monopolization of Aztelcom, the establishment of an independent regulator, tariff rebalancing to stimulate efficiencies in domestic services, the loosening of restrictions on web hosting to facilitate the expansion of value-added ISP services, relaxation of content controls, and a fundamental restructuring of the Ministry of Communications to separate regulatory, operationsand commercial activities. 111. LABOR POLICIESAND RELATIONS 45. The transition process has engendered the need for a substantial structural shift in Azerbaijan's labor market. Azerbaijan offers a relatively highly educated, low cost workforce for a country with its income level. According to the 1999 population census, up to one-fifth of working age population in Azerbaijan have completed specialized secondary education, and a similar share of the population has completed or was enrolled in higher education. At present, however, Azerbaijan has been struggling to sustain previously achieved education outcomes due to decreasing fiscal resources and increasing competition for limited funds, while reorienting its education system to the needs of a market economy and an independent country. At the same time, Azerbaijan's working age population i s growing rapidly, increasing 20 percent between 1990 and 2000. In order to reduce poverty, new economic opportunities must be createdto generatea sufficient number of new jobs. 46. Much of the Azeri workforce is quickly losing its skills and the existing skills are becoming obsolete, as reflected in the unemployment statistics. The lack of formal employment opportunities for some groups of population means that an increasing share of workers with higher education is either unemployed, or self-employed in low-skilled, small- scale, informal activities and agriculture. In 2000, more than 60 percent of the unemployed hadhigher or secondary special education. 47. Labor relations are regulated by the new Labor Code that entered into effect in 1999. The Labor Code establishes the necessary provisions for a contractual agreement between legal entities and employees, whether the employee is local or an expatriate. Hiring provisions are relatively liberal, with no quantitative constraints on the employment of expatriate workers. More important, however, are the relatively strict provisions for dismissal and generous statutory benefits that especially impact SMMEs. Written employment contracts are compulsory and are usually valid for an unlimited period. Fixed-term contracts, either for five years or less, or for the duration of a project, are possible under certain conditions. Dismissals for economic reasons are restricted. Dismissals without notice are limited to cases of drunkenness, theft, and "immoral activity." Dismissal for other reasons, such as incompetence, must be precededby a history of under-performance. The Labor Code also imposes European Union-style restrictions on working hours and large minimum requirements to paid holidays, maternity leave, and other statutory benefits. Such provisions can substantially increase the operating costs, which can weigh particularly heavy on SMMEs. Consequently, in practice, many small and medium enterprises do not formalize labor relations unless compelled by circumstances (an upcoming inspection by tax or social fundauthorities). 110 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan 48. While relations vis-&-vis expatriate employees are governed by the Labor Code, the procedures for hiring such workers is governed by the Law of Labor Migration (2000). Although there are no quantitative restrictions on hiring expatriate labor, the procedures for bringing in expatriate labor to Azerbaijan i s relatively cumbersome. It is a two-step process, requiring first a general license for the company wishing to hire expatriate labor and then work permits for each individualforeign worker. 49. Each company wishing to hire expatriate workers must obtain a general license from the Ministry of Foreign Affairs. The term of the license is one year (renewable), duringwhich time the employer is permitted to "invite and use" foreign employees (subject to the issuance of work permits for the individuals in question). Approval typically takes two to four weeks. Although no substantialguidance exists within the Rules as to what constitutes the "invitation and use" of foreign employees, it would appear that a license i s required only inthe case of a foreign employees concluding a labor contract with an entity operating in Azerbaijan. While investors have indicated that the procedure itself i s not particularly difficult or time- consuming, it i s not clear what purpose this licensing procedure serves or what criteria are usedby the Ministry of Foreign Affairs to license employers. The lack of transparent criteria provides the public officials with an undue degree of discretion and increases the unpredictable nature of the investment environment. This also appears to be an additional layer that, while not cumbersome on its own, increases the overall administrative burdenon investors while servingno clear purposeto the authorities. 50. Once the employer i s licensed, work permits must be requested for each foreign worker. Applications for work permits must be submitted to the Migration Department of the Chief Employment Directorate of the Ministry of Labor and Social Protection. Standard criteria for approval include proof of qualifications, as well as evidence from the employer that the required personnel cannot be found locally. While processing times are reasonable (30 days), the terms are relatively short (one year), requiring employers to repeat the process on an annual basisfor each foreign employee. 51. Written employment contracts are compulsory for both local and expatriate workers and are usually valid for an unlimitedperiod. Fixed-term contracts, either for five years or less, or for the duration of a project, are possible under certain conditions. Dismissals for economic reasons are restricted. Dismissals without notice are limited to cases of drunkenness, theft, and "immoral activity." Dismissal for other reasons, such as incompetence, must be preceded by a history of under-performance. The Labor Code also imposes European Union-style restrictions on working hours and large minimum requirements to paid holidays, maternity leave, and other statutory benefits. Such provisions can substantially increase the operating costs, which can weigh particularly heavy on SMMEs. Recommendations 52. The encouragementof the non-oil sector will require the re-alignment of labor policy to meet the demands of a more diversified, growing economy: 0 Match education and skills training to private sector demands. Many workers find that their skills have become obsolete in the new market economy. This confirms that there i s a significant skills mismatch-the skills obtained and possessedby new graduates differ significantly from the skills in demand. Developing training programs that meet private sector needs will be essential. 111 INOTIS-IntegratedNon-Oil Trade and Investment Strategyfor Azerbaijan 0 Relax restrictive dismissal provisions. While hiring provisions are relatively liberal, overly cumbersome procedures for hiring expatriate workers-which include licensing firms to hire foreign workers can deter some foreign investors that rely on expatriate technical and/or managerial expertise. More important, however, are the relatively strict provisions for dismissal and generous statutory benefits that especially impact SMMEs. More flexible labor provisions, together with investments to assist unemployed persons- such as skills training and an adequate social safety net-are generally more helpful in achieving the increased efficiencies that ultimately determine competitiveness and promote sustainable economic growth and reduced poverty. Eliminating unnecessary application procedures can reduce the red tape without compromising Azerbaijan's interests inlimiting expatriateemployment. w. TAXATIONAND INCENTIVES 53. Taxation is often cited as one of the top issues concerning the private sector in developing countries and Azerbaijan i s no exception. Evidence from the first decade of transition across the region shows that the most dynamic parts of transition economies are new or restructured enterprises that employ fifty or fewer workers. Interviews with the private sector in Azerbaijan suggest that taxation i s among the most prominent of the difficuIties in the investment climate facing such firms. Unduly high rates of taxation, combined with a complex tax code, can lead companies to either purposefully or inadvertently underestimate their income and/or tax liabilities. It i s therefore extremely important that tax policy and its associatedadministrative requirementsbe simplifiedinorder to improve the investment climate. Improved policies and administration can also reduce the incidence of non-compliance or under-reporting, which is a result of the complex and non- transparent rules and procedures, and boost government revenues through improved collection rates. 54. All Azerbaijani enterprises, representativeoffices, branches andforeign entities which conduct business activity in Azerbaijan through a "permanent establishment" must register with the Ministry of Taxes without regard to whether their activities are taxable in Azerbaijan. In order to reduce the incidence of tax evasion, registration i s now automatic, as the necessary information is forwarded to the Ministry of Taxes from the Ministry of Justice at the conclusion of the businessregistration process. 55. There are presently three separate and distinct tax regimes that are applicable in Azerbaijan: the statutory regime, the oil consortia regime, and the Main Export Pipeline regime. The Main Export Pipeline regime applies to enterprises working on the Baku-Tbilisi- Ceyhan oil export pipeline. The oil consortia regime i s governed by the PSAs that have been ratified by the Milli Majlis. The statutory tax regime is applicable to all other entities operating in Azerbaijan. All legal entities that are tax bearers are required to submit annual tax reports to the Ministry of Taxes. 56. Recentpolicy reforms inAzerbaijan include a substantialoverhaul of the statutory tax regime, including the introduction of a new Tax Code, the first codified digest of Azerbaijani tax law which came into effect in January 2001. In the past, tax rules were scattered across numerous laws and other legislation, which created an overly complex and non-transparent regime. In addition to the consolidation of tax law into a single unified code, the new Tax Code provides for revised ratesand new procedures for filing and auditing. Over the past few months, further actions have been implemented to improve tax policy and administration, including: 112 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan 0 Restructuring of the Ministry of Taxes (MOT) including establishment of a Large Taxpayers Unit to simplify administration of taxes for large enterprises, and reduction of 40 percent of MOT staff andthe number of offices 0 Preparation of draft amendments to the Tax Code to address inconsistencies with other laws and incorporate provisions contained within other laws 0 processes for receipt of tax returns; standardization of audit practice^?^ and establishment Improvements in tax administration practices including introduction of new work of taxpayer audit divisions at local tax offices 57. The following provides a brief overview of the main types of taxes assessed under the statutory tax regime: 0 Corporate profit tax i s levied on all legal entities in Azerbaijan, both Azerbaijani and foreign. Legal entities, including those entities with foreign investment, are taxable on worldwide gross annual income, less allowable deductions. Branches and taxable representative offices of foreign enterprises are taxed only on profits from activities performed in Azerbaijan. The corporate tax rate i s presently 27 percent on worldwide income. Deductions are limited to wages, doubtful debts related to the sale of goods and services, and depreciation. Deductions for travel, advertising, and other business expenses are minimal. Taxes must be paid on a quarterly basis and all records must comply with local accounting standards. Corporate tax rates inAzerbaijan are considerably higher than most others in the region. Corporate tax rates are 20 percent (on net income) in Armenia and Georgia, 20 to 24 percent in Russia. Furthermore, Azerbaijan imposes corporate taxes on worldwide, rather than territorial, income, which can effectively increase the tax burden for investors from countries without tax treaties. For example, no treaties are in effect with the United States, Canada, Japan, France, and Italy. 0 Value added tax i s levied at a rate of 18 percent and must be declared and paid by all legal entities operating in Azerbaijan on a monthly basis. Exports are zero-rated and limited exemptions exist for certain goods and services, including leasing, currency or securities transactions, goods and services purchased under international loans agreements, equipment imported under financial leasing agreements, publications, fruits and live animals, certain chemicals and metals, and energy. 0 Excise tax i s levied on the production or import of certain products, including tobacco products, alcohol, diesel fuels, fuel, and oil. Tax rates range from 26 to 65 percent. Excise taxes must also be declared and paid on a monthly basis. 0 Property tax is assessed at the rate of 1.0 percent of the average annual value of fixed assets, except for vehicles and aircraft, which are subject to tax at rates that depend on engine capacity. Enterprises must make advanced payments on a quarterly basis. 0 Land tax i s levied as a fixed payment on all land plots, irrespective of the financial results of the economic activity of owners or users of the land. Tax rates depend on 79 To ensure compliance with the Presidential Decree "On Prevention of Inspections that Impede the Development of Entrepreneurship" of September 28, 2002, the MOT developed formats to be used in taxpayer audits, standardized procedures and improved supervision of audits. According to the MOT, these actions have resultedin a significant decline inthe number of on-site audits and an increase intheir quality and efficiency. 113 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan quality scores assignedto each parcel of land basedon the quality, location, and level of water supply. Both individuals and legal entities are required to pay their land tax in two equal installments. 58. The collection of each of the above taxes i s administered and controlled by the Ministry of Taxes and its divisions. Incertain cases, such as VAT due on imports, tax control i s also exercised by the customs authorities. While the procedures for the submission of each of the relevant tax reports are simple, interviews with the private sector point to numerous obstacles and illegal rent extractions. The forms are deemed to be relatively complex, particularly for small entrepreneurs that do not have the resources to retain the services of a facilitator. Interviewed firms indicated that report submissions are often met with requestsfor informal payments. 59. Tax control by the Ministry of Taxes is carried out through audits. Routine, paper- basedaudits are carried out each time a taxpayer files a return. Comprehensive, onsite audits may also be carried out, based on a substantiated decision of the tax authority. Onsite tax audits may be conducted once per year, over a maximum 30-day period (which can be extendedto three months by the decision of a higher tax body). Extraordinary tax audits may be carried out in special circumstances, including when there i s a determination of deliberate misrepresentation of information or repeated failures to file and pay taxes. In case the inspected legal entity disagrees with the results of tax audit, a second audit (by a different team of officials) may be requested. A large taxpayers unit has been established in Baku to facilitate the processingand auditing of large-scale taxpayers. 60. Interviews with the private sector indicate that auditing procedures tend to be highly problematic and are a regular source of illegal rent extraction by government auditors. Informal payments are often solicited by government auditors to overlook small, unintentional infringements resulting from the complexities of the Tax Code, as well as larger, intentional infractions. The abuse of audits has also been perceived as a source of harassment and interference with private enterprises. In light of this growing problem, the September 2000 Presidential Decree "On Prevention of Interferences Impeding the Development of Entrepreneurship" included explicit proscriptions on the auditing activities of the Ministry of Taxes, including a prohibition on audits that last longer than envisagedby the legislation and that go beyond the limits of their authorities; a reduction on the number of on-site audits and the prevention of repetitive, unjustified audits; and the dismissal of 40 percent of the structural divisions of the Ministry engagedinauditing andrelated functions. 61. While Azerbaijan's new Tax Code has made substantialprogress towards introducing standards and concepts common in international practice, several issues remain to be addressed: 0 The tax system undergoes amendment on a frequent basis and remains one of the more complex aspects of the Azerbaijan business environment. The absence of clear, readily available printed materials explaining the tax code inlayman's terms makes it difficult for investors to keep pace with changes, particularly small entrepreneurs that cannot afford the services of facilitators. 0 The new Tax Code, while it has provided a substantial improvement in terms of clarity over the previous range of legislation, still falls short in specific areas, where contradictions with other laws and regulations are evident or definitions remain ambiguous andor contradictory. 114 INOTIS-Integrated Non-Oil Trade and InvestmentStrategyfor Azerbaijan Presently, there are no special tax incentives offered to stimulate foreign investment. While a single, flat tax rate i s generally considered less distortionary and easier to administer than tax holidays and/or differentiated tax rates, the effective tax rate in Azerbaijan i s relatively high due to the limited range of deductions and the absence of double tax treaties (beyond a small group of countries) that would lower the overall tax burden in light of the worldwide tax jurisdiction that i s presently imposed. While the large taxpayers unit that has been set up in Baku will greatly facilitate compliance by multinational and other large taxpayers, the required use of local accounting standards i s seen as problematic. Azeri Accounting Standards (AAS) differ in many ways from International Accounting Standards (IAS). Such taxpayers must keep two separate set of accounts, one in compliance with AAS and one in compliance with IAS for their headquarters abroad, which increases the burden of compliance. Recommendations 62. Specific actions that can further improve the tax system include: Further strengthen Tax Code. While draft amendments to the Tax Code have been proposed at various times, it i s critical that the Tax Code be comprehensively amended and stabilized. Among the various issued to addressedinclude: - Gaps andinconsistencies with other laws-For example, while the Insurance Law classifies insurance brokerage services as insurance activities, the Tax Code does not, precluding such services from the more beneficial tax treatment accorded to income derived from insurance and financial services activities. - Tax regulations-Currently, tax regulations are dispersed and are not harmonized with the new Code, adding a further layer of confusion. - Provisions regarding tax administration-Currently, a number of administration related issues are contained in other legislation and need to be incorporated into the new Tax Code inorder to create a truly unified set of legislation. - Allowable deductions for business expenses-The provisions for allowable deductions are unclear and lead to discretionary interpretation by both the public and tax officials. Moreover, the limited range of deductions leads to a relatively higheffective tax rate inAzerbaijan.80 - Disputesettlement-Dispute settlement mechanisms are insufficient to address the concerns of taxpayers. An impartial appeals mechanism should be established to protect taxpayers and increase confidence in the system. - International Accounting Standards-Currently, local accounting standards must be used. Azeri Accounting Standards (AAS) differ in many ways from International Accounting Standards (IAS). Multinational taxpayers must keep two The MOT claims that the determination of deductible expenses i s consistent with IMFrecommendations and international norms. 115 [NOTIS-Integrated Noiz-Oil Tradeand Investment Strategyfor Azerbaijan separate set of accounts, one incompliance with AAS and one incompliance with IAS for their headquartersabroad, which increasesthe burden of compliance." Further streamline tax reporting. The MOT has improved tax reporting practices by revising procedures for receiving tax returns and permitting taxpayers to submit returns personally, through an authorized representativeor by mail. However, interviews with the private sector point to other issues that need to be addressed. The forms are deemedto be relatively complex, particularly for small entrepreneurs. Simplifying tax forms and increased use of no-contact filing mechanisms-including, eventually, electronic meanss2-would reduce the burden on investors, particularly SMMEs. Improve transparency of auditing practices. Auditing procedures also tend to be highly problematic and have been a regular source of illegal rent extraction by government auditors. The introduction of a risk-based system, whereby audits are targeted at non- compliant businesses, would further ensure that audits are no longer a source of administrative abuse. Increase public awareness. The tax system undergoes amendment on a frequent basis and remains one of the more complex aspects of the Azerbaijan business environment. The absenceof clear, readily available printed materials and training programs explaining the Tax Code in layman's terms makes it difficult for investors to keep pace with changes, particularly small entrepreneurs that cannot afford the services of facilitators. Foremost among these i s the provision of clear and well-defined procedures and rules for calculating and submitting tax returns to increase the understanding of the private sector and reduce the discretionary powers of the tax authorities in interpreting tax law. Better access to consolidated, simplified written materials is essential to increasing transparency and simplifying the system. Negotiate double taxation treaties. Azerbaijan has enteredinto bilateral tax treaties with 13 other c~untries,'~including several CIS partners, as well as Great Britain, Norway, Germany and Poland. No such treaties have been concluded with a number of other potential sources of foreign investment, including the United States, Canada, Japan, France, and Italy, among others. Tax Treaties play an important role in curbing fiscal evasion and encouraging foreign investment through the prevention of double taxation- Azerbaijan should actively seek to conclude tax treaties with the most promising sources of foreign investment. v. ACCESSTO FINANCE CREDIT AND 63. The banking sector has been a key component of the Government's structural reform strategy. In coordination with the IMF and World Bank, substantial reforms have been undertaken to strengthen the sector and expand credit opportunities to private enterprise, including the restructuring and privatization of state-owned banks; the consolidation and rationalization of private banks through increased capital requirements; improvedregulatory capacity and powers for the National Bank of Azerbaijan (NBA); and improvedinstitutional and technical infrastructure to support the banking sector. "ThisisbeingachievedthroughtheDraftAccountingLaw,whichiscurrentlybeingfinalized. A draft law ondigital signatures and electronic documentationi s under review. 83 Double tax treaties are in force with Great Britain, Germany, Austria, Norway, Turkey, Poland, Russia, Moldova, Ukraine, Georgia, Kazakhstan,Uzbekistan, andPakistan. 116 INOTIS-IntegratedNon-Oil Tradeand Investment Strategyfor Azerbaijan 64. While recent reforms have improved the sector's performance, the banking sector remains small and weak, playing a minimal role in an economy which functions primarily on cash. Access to financing ranks among one of the key factors constraining the development of private enterprise, particularly the SMME sector, inAzerbaijan. While short-term bankmg credit i s more readily available, many of SMMEs have no access to affordable long-term credit given collateral requirements and short payment terms. Long-term financing in the US$l50,000 to US$1.5 million range i s virtually unavailable at present. Interest rates, including those attached to loans through SME-directed credit lines, are normally in the 25% to 45% range (in US dollar terms), and collateral up to two to three times the loan amount i s required for all but the smallest loans. Assets acceptable for collateral are very limited, and doe not include land.s4This i s exacerbated by an undevelopedcapital market and inadequate confidence inthe Manat-some 80 percent of the borrowing base i s inforeign exchange. 65. The non-bank sector provides limited support to SMMEs. Several microfinance projects, set up by donors and NGOs, are providing a limited supply of financing. However, loan sizes are small, averaging US$200-insufficient to meet the development needs of SMMEs. A new Micro-Finance Bank (MFBA) has recently been set up with funding from the EBRD (25 percent), IFC (35 percent), Black Sea Trade and Development Bank (35 per cent), and LFS Financial Systems (5 percent). The MFBA focuses on loan operations for small companies and entrepreneurs, providing loans ranging from US$400 to US$10,000, with low collateral requirements (1.5 times loan size). The credits carry an annual interest rate of 36 percent, much lower than the usurious 15 percent per month being chargedSMMEs by informal lenders. Since beginning operations in October 2002, the bank has provided over 1,000 microcredits worth over US$1 million. Over 90 percent of clients are new to the banking system. 66. The Government has also initiated efforts to provide much-needed financial support to SMMEs. A National Fund for Entrepreneurship Development i s to be set up under the MEDto provide financing and other fundingsupport to SMMEs. Inaddition, under the State Program on Small and Medium Entrepreneurship Development, approved by presidential decree inAugust 2002, other financing support mechanisms will be developed, including new microfinance schemes; assistance to credit unions; new mechanisms for investment support for industrial modernization of SMMEs; new mechanisms for venture capital and other technology development support; and the extension of cooperation with foreign financial and credit structures. According to MED officials, more than 300 enterprises have been financed through the Fundas of June 2003. 67. While these new programs, and other donor-backed financing facilities that are in place, will certainly contribute to SMME development, they are unable to fill the vast gap that exists between supply and demand. Recommendations 68. Measures to improve SMME access to finance will be critical to supporting the development of the non-oil sector: ~~ 84 There are a few private equity funds operating in Azerbaijan (AIG Silk Road Fund and the Soros Fund) but minimum investment size requirements are well above US$2 million. "Risk Capital Finance for SMEs in Azerbaijan," IFC, October 2002. 117 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan Banking sector reform and restructuring. Further banking sector refodrestructuring will be required to develop a sustainable local banking sector that can meet the project and trade financing needs of the private sector in Azerbaijan. Necessary reforms include the restructuring and privatization of remaining state-owned banks, measures to further increase consolidation, further liberalization of foreign participation, improvements in the regulatory framework, and further development of banking infrastructure. Development of leasing mechanisms. Leasing can serve as a significant source of finance for small firms wanting to invest inequipment. Unlike banks, which rely on credit history, assets, or capital base to assess credit-worthiness, leasing companies evaluate the lessee's ability to generate cash flow to service lease payments. SMMEs, without a long history of financial statements, can benefit from such arrangements. Currently, there are very few leasing companies operatinginAzerbaijan. Leasing inAzerbaijan i s currently in its infancy. Weaknesses in the current legislation can hinder its development. For example, the current legislation does not appear to permit a lessor to transfer the lease to the third party. To encourage the development of the leasing sector, the relevant legislation must be improved to increase the protection of lessors' rights. Development of equity and/or venture capital funds. There i s presently only one equity fund operating in Azerbaijan, the Soros Investment Capital Fund. The Soros Fund operates throughout the CIS and Central Europe, providing equity and other financing for large-scale projects. Currently there are no venture capital funds in Azerbaijan that provide financing to new entrepreneurs. Venture capital and other equity funds can be an important resource for SMME development. Experience from other developing and transition economies demonstrates private investment in the establishment of venture capital markets can be promoted through various mechanisms, includingthe development of an appropriate enabling framework, tax and other fiscal incentives, and the provision of matching funds. Designing an appropriate framework for Azerbaijan must be tailored to its development context, including the current culture for entrepreneurship and risk- taking.85 Improving the framework for secured transactions. A related issue is the legal and institutional framework for secured transactions. The existing framework for secured transactions i s insufficient to meet the needs of the private sector, particularly in the case of movable property. The legislative and institutional framework governing collateral in Azerbaijan i s fragmented and incomplete. The Civil Code and Law on Mortgages, both of which cover different aspects of collateral, are inconsistent. Moreover, Azerbaijan does not presently have a regime that effectively allows the pledging of movable property collateral. Several registries are maintained by different governmental bodies for various types of collateral and not all types of collateral are covered, such as equipment, inventory, and accounts receivable. The establishment of a comprehensive collateral registry system i s a necessary institution to support the extension of securedcredit. Improving financial management in private sector. While increasing the supply of financing options for SMMEs will be critical for their development, equally important i s the development of their own financial management skills. Many SMh4Es in Azerbaijan lack the tools necessary to develop relevant financial documentation, such as accounting This recommendation i s intended to promote private investment inthe establishment of venture capital funds, and does not advocate the establishment of such a fund by the Government or any related entity, such as the Oil Fund. 118 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan standards (particularly International Accounting Standards), business plans, cash flow statements, budget, and income forecasts. 0 Introductionof new payment schemes for non-cashtransactions. Azerbaijan is still a predominantly cash-based economy. Salaries, pensions, and day-to-day transactions are generally carried out in cash. Similar countries have developed innovative payment mechanisms to reduce dependence on cash transactions. For example, smart card technologies provide a cheap and easy mechanism for enabling cashless transactions. In Azerbaijan, the extensive network of postal offices could be leveraged to provide smart card terminals that would allow cashless transactions for a wide variety of services, from pension payments to utility bills. VI. COMPETITION POLICY 69. The development of Azerbaijan's export sector i s contingent upon the development of a competitive, market-based economy at home. The establishment of an effective legal and institutional framework for promoting competition and curbing monopolistic behavior i s particularly important for Azerbaijan and other transition economies, given the highly monopolized nature of the centrally planned Soviet economy. 70. Azerbaijan has already come a significant distance in developing a legal and institutional framework for competition policy. An Anti-Monopoly Law was introduced in 1993 and amendedin 1997, which defines several different kmds of monopoly and abuse of dominant position in the marketplace. The law restricts both horizontal and vertical agreements that take advantage of a dominant position to gain monopoly powers, as well as unfair competition. In accordance with international principles, Azerbaijan's anti-monopoly legislation does not deal negatively with the dominant position of market power per se-only the abuse of a dominant position i s prohibited by the law. 71. In 2001, the Department of Anti-Monopoly Policy was establishedwithin the MED. As the executing agency, the Department has the power to impose a range of measures against monopolistic behavior, including the ultimate power to terminate a company's activities. 72. As in other policy areas in Azerbaijan, while the framework is in place, effective implementation has been more difficult to achieve. While the Department has initiated the development of a public register as a database for the analysis of price movements and other indicators, the lack of methodological guidelines and adequate data collection impede the Department from effectively detecting and counteracting monopolistic behavior. 73. An issue related to competition policy is the extent of state participation in the economy. Unfair competition from state-ownedcontinues to be a concern to investors. Inthe FIAS Investment Climate Survey, the private sector rated unfair competition from state entities as a serious impedimentto doing business in Azerbaijan. The pace and direction of Azerbaijan's privatization program will have a direct impact on both the actual and perceived degree of competition inthe marketplace. 74. Azerbaijan initiated its program of privatization in 1996. The first wave of privatization, which ended in 1998, resulted in the transfer of approximately 26,000 SMEs and farms to private hands, but little was achieved in the way of privatizing the larger state- owned enterprises. The second wave of privatization began in 2000, following the 119 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan development of a new legal and institutional framework. The Privatization Law was updated and more extensive powers were granted to the privatization body, the Department of Privatization of State Property, which i s seated within the MED. A presidential decree in August 2000 provided for case-by-case sales of some of Azerbaijan's largest state-owned enterprises, and in March 2001, the president issued decrees identifying approximately 450 enterprises that were to be privatized. However, implementation of this second phase has been slow as attempts to privatize some of the large state enterprises have failed due to the lack of qualified bidders. One reasonfor such failures is the Government's attempt to sell off loss-making enterprises,rather than liquidating assets. Recommendations 75. Efforts to improve the competitive environment in Azerbaijan should include: Effective enforcement of competition policy. As in many other policy areas in Azerbaijan, while the legal and institutional framework i s in place, effective implementation has been more difficult to achieve. The Department has little authority or capacity to carry out its mandate under the law. To date, its role has been primarily advisory innature. If the law i s to have any impact, the role of the department mustbe re- oriented toward monitoring and enforcement and the Department must be armed with the tools, funding and other resources necessary to back up its mandate. While the Department has initiated the development of a public register as a database for the analysis of price movements and other indicators, the Department needs to develop methodological guidelines and improve data collection to enable the Department to effectively carry out its monitoringandenforcementfunctions. Increase SMME participation in government procurement. An issue related to competition policy i s the set of rules pertaining to government procurement. As in many developing and transition countries, the government i s one of the largest domestic consumers of goods and services and can therefore play an important role in encouraging the development of local industry. Complex or unfair procurement rules can effectively rule out participation by SMMEs, limiting their ability to attain scale economies and compete in the global marketplace. A new procurement law in Azerbaijan appears to provide non-discriminatory rules. However, in practice, it will be important to monitor and promote the participation of SMMEs inpublic procurement. Accelerate privatization of large enterprises. In order to accelerate the privatization program and increaseinvestor confidence that the Government i s committedto ensuring a competitive marketplace, it will be important to accelerate and shift privatization efforts in the right direction. Accelerating the privatization of the remaining large-scale enterprises,particularly those that are viewed as assets, mustbe part of future plans. VII. CONTRACTENFORCEMENT DISPUTE AND RESOLUTION 76. The wide range of gaps and ambiguities that are prevalent throughout the legal and administrative system, as well as the extensive corruption, can make contract enforcement and dispute resolution challenging inAzerbaijan. The need for a fair and reliable mechanism for dispute resolution i s paramount to building confidence in the business environment. In many developing countries this need i s met, at least in part, through a private arbitration system, which is generally regardedto be faster andless expensive than litigation through the traditional court system. It is also deemed to be fairer in countries where the judiciary i s not 120 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan well established or i s distrusted. The private sector in Azerbaijan has indicated a lack of confidence inthe judicial system and its ability to enforce contracts andor judgments. 77. The Government has made important strides over recent years to bring its commercial law framework into line with international best practices and its commitments under international law: 0 The 1992 Law on the Protection of Foreign Investment provides for access to local courts andor international arbitration in the case of dispute settlement. 0 InFebruary 2000, a Law onInternationalArbitration came into force that provides for the possibility of localarbitration ininternational commercial matters. 0 In May 2000, the parliament ratified Azerbaijan's accession to the 1958 New York Figure 5.4-Private Sector's Perception of Court System Able to enforce Honest - -Best Case \' J -Azerbaijan \ - - -CIS-7 Source: EBRD andWorld Bank, BusinessEnvironment and EnterprisePerformance Survey, 2002. Convention on the Recognition and Enforcement of Foreign Arbitral Awards. The Convention provides for binding international arbitration of investment disputes between foreign investors and the State. As the New York Convention i s not self- enforcing, a new Civil Procedure Code enacted in 2000 provides that foreign arbitral awards may be enforced inAzerbaijan so long as they do not contravene legislation or public policy, and if reciprocity exists. The new Civil Procedure Code also simplifies all court procedures. 0 A number of bilateral investment treaties, including the one signed with the United States, provide foreign investors with recourse to the International Center for the Settlement of Investment Disputes. 0 Azerbaijan i s a party to the World Bank Convention on the Settlement of Investment Disputes between States andNationals of Other States. 121 INOTIS-Integrated Nan-Oil Tradeand InvestmeiitStrategyfor Azerbaijan 78. Despite these important legal provisions, enforcement of these laws continues to be a concern to investors. According to the FIAS survey, investors are still distrustful-less than one-third has any confidence that the legal system would uphold contractual obligations and property rights. The Economic Court, which has jurisdiction over commercial disputes, is, according to most accounts, weak and inefficient and has itself been subject to charges of corruption.86 There i s presently no independent arbitration service in Azerbaijan that can provide an alternative to the localjudiciary. 79. In the recent Presidential Decree "On Prevention of Interferences Impeding the Development of Entrepreneurship" (September 2002) acknowledged these persistent weaknesses, particularly in the area of corruption, and recommended that the courts provide timely and consistent judgments. In addition, in order to further protect the rights of investors, it i s requested that the Supreme Court examine and discipline judges for any unfair and/or "distorting" judgments. As in other areas, the real impact of this decree on reigning in corruption and improving contract enforcement remains to be seen. Recommendations Figure 5.5-Firm Growth Rates, by Size (1999-2002) 80. The wide range of gaps and ambiguities that are prevalent throughout the legal and administrative system, as well as the extensive corruption, can make contract enforcement and dispute resolution challenging in Azerbaijan. The need for a fair and reliable mechanism for dispute resolution is paramount to building confidence in the business environment. Improving the quality and reliability, as well E l Small Medium til Large as confidence in, dispute Source:EBRDandWorld Bank BusinessEnvironmentandEnterprise Perfonnance resolution must be a priority: 0 Strengthen the judiciary. While the Government has already taken steps to strengthen and build confidence in the judiciary-for example, through new testing-additional measures that should be taken to strengthen the judiciary include more training of judges in commercial law, improvements in enforcement, better case management systems, and an improved mechanism for judicial oversight. 0 Establish an independent alternative dispute resolution mechanism. While strengthening the judiciary is an important component-and will ultimately be a medium- to long-term effort before public confidence i s increased-also important i s the role of independent alternative dispute resolution (ADR), i.e. arbitration. A recent Eurasia Foundation funded initiative to establish such a service should be actively pursued, 86 See U.S. Foreign Commercial Service and Department of State, "Azerbaijan Country Commercial Guide," (2003); and EuropeanBankfor ReconstructionandDevelopment, Azerbaijan Investment Profile, (2001). 122 INOTIS-Iiitegrated Noli-Oil Trade and Investment Strategyfor Azerbaijari including the development of training and credentialing mechanisms, as well as increased public awareness of the value of ADR. VIII. SMME DEVELOPMENT 81. SMMEs account for more than 80 percent of registered enterprises in Azerbaijan. Duringthe last five years, the share of SMMEs inGDP grew from under 25 percent to almost 43 percent. However, as in many of the CIS countries, interms of sales, small enterprises are growing much slower than their larger counterparts in Azerbaijan (see Figure 5). While most of the recommendationsin the preceding sections will contribute, directly or indirectly, to the development of small enterprises and entrepreneurship, supporting sustainable SMME development will require additional, targeted measures. A recent Presidential Decree established an Entrepreneurs' Council that will advise on SMME development-this new public-private dialogue should be actively supported. Recommendations 82. Future efforts to stimulate entrepreneurship and SMME development should focus on: 0 Implementation of State Program for S M M E Development. A new State Program on Small and Medium Entrepreneurship Development envisages a comprehensive and ambitious program to support SMMEs, including financial support, technology transfer, human resource development, regional diversification, and protection of entrepreneurs' rights. More than 60 specific, actionable measures have been identified to encourage entrepreneurship. These initiatives-all worthy and practicable-need to be carefully prioritizedto ensure that maximum efforts are exerted on those activities that will provide the most results. IX. PUBLICSECTOR GOVERNANCE 83. The business environment in Azerbaijan offers investors a number of important advantages, including a liberal foreign investment law, an educated and skilled workforce, a wealth of natural resources, and a relatively high degree of economic stability. These factors provide an important foundation for private sector development. However, as the foregoing analysis indicates, there are a number of areas in which the investment environment can be improved to enhance the business environment. Ambiguous and/or conflicting legislation, the lack of transparent and consistently applied rules, overly discretionary powers granted to public officials, and low-level corruption all combine to create a challenging business environment. 84. Ambiguous and/or conflicting legislation, the lack of transparent and consistently applied rules, and overly discretionary powers granted to public officials can all combine to create a challenging business environment and can give rise to state capture and administrative corruption. Recognizing this growing issue and its negative impact on economic development, the Government of Azerbaijan has already taken the first steps towards rooting out corruption. A presidential decree "On the Intensification of the Fight against Corruption" was issued in June 2000, instructing the Prime Minister and the head of the Presidential Administration to prepare a draft anti-corruption law and a state anti- corruption program. To date, the draft law has passed the first hearing in the Parliament. 123 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan 85. While corruption remains an important issue, some progress has already been achieved in reducing the incidence and extent of corruption. The 2002 Business Environment and Enterprise Performance Survey revealed a substantial decline in the extent to which business are subjected to bribes and other forms of corruption. The number of firms reporting that they have made bribes has fallen substantially, from 59.5% in 1999 to 27.5% in 2002. Associated with this decline i s the reduction in the average "bribe tax", as measured as a percentage of firm revenues, which declined from 3.7% to 2.7% over the same period. Nevertheless, among other transition economies, Azerbaijan still rates relatively high on the corruption scale. The impact has been positive, with a substantial decline in complaints about corruption (see figure 5.6). 7igure 5.6-Decline inAdministrative Corruption o0.6 .a 0.4 0.2 0 -0.2 -0.4 -0.6 -0 .a -1 -1.2 I Change in average score 1999-2002 Source: EBRDand World Bank, Business Environment and EnterprisePerformance Survev. 2002. 86. Several other decrees have been issued that attempt to tackle various types of corruption. Most recently, the September 2002 decree "On Prevention of Interferences Impeding the Development of Entrepreneurship" aims to reduce public sector abuses of power, including prohibiting the law enforcement agencies and state authorities from interfering with business activities of private entities. While these efforts may have some positive impact on reducing corruption, progress can be better achieved through the elimination of the legal, regulatory, and administrative barriers that have created the opportunities for corruption. Recommendations 87. Nevertheless, some other specific actions can be taken to reduce corruption and state capture inAzerbaijan: 0 Develop legaland institutional framework. Passing the anti-corruption law and, equally important, setting up an effective institutional framework to monitor and enforce the law will be essential to ensuring that the Government's continued success in combating administrative corruption. 0 Develop private-public dialogue. State capture, another form of corruption, must also be addressed. The most effective means of combating state capture is the development of 124 INOTIS-Integrated Non-Oil Trade and Investment Strategy for Azerbaijan transparent mechanisms for public-private dialogue on economic policies. The ability of the private sector, particularly SMMEs, to promote its interests needs to be strengthened. One of the most effective means of promoting private sector interests i s through business and trade associations-improving their skills in policy analysis, advocacy and public outreach can play an important role in reducing state capture and promoting economic policies that provide broad-based benefits to the Azeri population. X. MICROECONOMIC COMPETITIVENESS 88. To deepen and complement the preceding assessment of the Azeri macro business environment, this study conducted an evaluation of the "microeconomic business environment" facing a selected industry-fruit and vegetable processing. Rather than the standard sectoral or industry assessmenttypically used, the study employs an industry cluster perspective to the evaluation of competitiveness, as detailed further below. The adoption of this cluster-competitiveness perspective provides a much richer understanding of the complexity of inter-dependencies among seemingly unconnected activities. This i s completely missing from traditional definitions of industries captured in typical national statistics. Clusters and Competitiveness 89. There i s increasing acceptance of the proposition that the nation's competitiveness i s ultimately determined at the micro-economic level. There i s growing evidence that improvements in the macro-business environment are a necessary but insufficient condition to ensure a nation's competitiveness.87 As articulated by several competitiveness theorists, a nation's prosperity is based upon the competitiveness of its firms or industries, which i s determined in large part by the quality of the "micro business environment" within which firms compete. This i s typically understood to be the result of four interrelated areas: the quality of factor (input) conditions; context for firm strategy and rivalry; quality of local demand conditions; and the presence of related and supporting products and industries. This i s commonly referred to as the "Competitiveness Diamond." 90. The industry cluster concept i s at the core of the effort to enhance national competitiveness, particularly at the micro economic level. Clusters are "geographically proximate groups of interconnected companies, suppliers, service providers, and associated institutions in a particular field, linked by commonalities and complementarities." A cluster differs from a sector in that it focuses on entities that are in some fashion similar or interdependent. That interdependency may by a final product but it also may be a core competency, technology, process, horizontal and vertical linkages, supply and market chains, common inputs, common skills, common customers, and/or common technologies. A cluster, unlike a sector, also has defined (although porous) geographic boundaries. By locating close to one another, businesses are able to acquire information, communicate, collaborate and 87 "Iti s well understoodthat sound fiscal and monetary policies, a trusted and efficient legal context, a stable set of democratic institutions, and progress on social conditions contribute greatly to a healthy economy. However, these broader conditions are necessary but not sufficient, providing the opportunity to create wealth but not by themselves wealth creating. Wealth is actually createdinthe microeconomic level of the economy.. .""Building the Microeconomic Foundations of Prosperity: Findings from the Microeconomic Competitiveness Index." MichaelPorter. 2002. 125 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan share inputs in such a way as to add to a "collective" advantage that could not otherwise be achievedalone. 91. Competitiveness theory says that a firm inside a cluster i s more likely to be competitive than a firm outside. In part, this i s due to externalities created by clusters, including better access to technologies, markets and networks, as well as to better skills, specialized services, greater variety and lower cost supplies and components, etc. B y improving innovation, entrepreneurialism, competition, formal and informal networks, and specialized skills and services, clusters enhance the productivity and competitiveness of firms. 92. The rational for the application of this approach to Azerbaijan in the context of the present Study i s to determine whether the cluster-competitiveness methodology i s an effective tool to identify prospective non-oil clusters based upon competitive advantages; encourage the establishment of cluster working groups comprised of private sector firms, government, support services firms, academia and other cluster participants; devise integrated and holistic strategies and actions to enhance the competitiveness of clusters; and identify mechanisms to sustain public-private collaboration in this area. The analysis also was undertaken to demonstrate how improvements to the microeconomic environment of clusters, can be complementary (and not distort) actions needed to improve the macro business environment. Ultimately, the analysis illustrates an approach to that can be replicated in other parts of the economy that have the scale or potential to achieve scale. Pilot Initiative: Fruit and VegetableProcessinn Cluster 93. Earlier investigations suggested that there was potential for the development of clusters in a number of industries-oil and gas; ago-processing; garmentdtextiles; tourism; ICT; and others. But it was evident that the most significant near-term potential for focusing initial efforts was in agro-processing, particularly of fruits and vegetables, as well as in deepening linkages of the oil and gas industry. Further discussions with a range of stakeholders in Azerbaijan pointed to the fruit and vegetable processing industry as the focus of the analysis for a number of reasons. While the industry has declined from its prominence inthe Soviet era, the potential remains. Agricultural output has beengrowing inrecent years, and the strong export orientation persists. The industry also has significant potential for poverty alleviation, given its domination by small-medium enterprises (SMEs); impact on rural employment through the relatedfarming sector; and extension into regions well beyond Baku. 94. While the analysis conducted cannot be considered to be a rigorous cluster smdy- which are generally much larger and more extensive-the methodology encompasses their main components: background study and assessment of market potential; cluster mapping and benchmarking against other regions; strategic planning sessions with various stakeholder organizations; and strategy and action plan development. Azeri Fruit and VegetableProcessinn Cluster Mar, 95. One of the key steps in the analysis was to "map" the fruit and vegetable processing cluster inorder to depict its systemic relationships. A cluster map i s nothing more than a flow chart of the cluster showing the major connections among firms and the direction of the flows of goods, capital, and knowledge. The map depicted below describes the fruit and vegetable processing industry in Azerbaijan, which i s organized around growers and initial processors. 126 INOTIS-IntegratedNon-Oil Tradeand Investment Strategyfor Azerbaijan The diagram shows, for example, that the processors are at the center and adding the most value to the country's basic output, but that they and the growers and farmers depend on each other. Each also needs other inputs, from the seeds and fertilizers through containers and packaging materials. These do not have to be purchased from Azeri firms but they do suggest opportunities for new local companies that can work more closely with Azeri companies to fill gaps in supply chains. Further, both processors and growers need equipment, technical assistance, capital, and social infrastructure that make it easier for them to associate, network, and learn. 96. The Azeri fruit and vegetable processing cluster i s concentrated in the regions near growing areas. Each mini-cluster specializes in a specific type of food in the regions. For example, apples and apple juice concentrate are in Quba, tomatoes and tomato paste in Lenkaran, and pomegranates and eggplants in Ganja and Goycay. Among the main findings from the survey of 20 leading processors that underlay the mapping process included the following: 0 Processing companies inthe cluster are relatively small, with 55 percent having 50 or fewer employees. The cluster i s mainly comprised of micro-enterprises; some ten firms dominate the cluster in terms of output and exports. Most firms are privately owned. The government has a minority share in some enterprises. Foreign investment Figure 5.7-Map of the Azeri Fruit and Vegetable Processing Cluster Fresh Markets (Inc. Retail Outlets, Exporters ~~ (Inc. Exports) inthe cluster is very limited; only one enterprise is majority foreign-owned. 0 Processing within the fruit and vegetable cluster declined significantly between 1995 and 2000-from 18,900 tons of canned fruit to 12,600 tons and from 13,800 tons of cannedvegetables to 4,200 tons. Fruit, however, i s on the rebound, doubling its output 127 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan from its low in 1997. The majority of the survey respondents (70 percent) think that the industry has done well over the last 2-5 years. There i s also some agreement on the products that are most (or least) profitable. While tomato paste, juices, and concentrates are frequently mentioned as profitable, jams are seen as least profitable at this point. 0 Most of the larger processors are export-oriented, with 65 percent exporting at least some and 45 percentexporting all products. Italy is the customer for more than half of the nation's total exports, and Israel is a distant second with seven percent. The U.S., Russia, and Turkey are the major importers. But the situation i s different for food. Russia and Turkey purchased half of the exports of fresh vegetables and Russia purchased40 percent of fresh fruit. 0 Most inputs and equipment are imported. There is a lack of local suppliers of equipment and related services. The local supply for packaging materials is also limited; only four companies purchase such supplies within Azerbaijan. Iran i s a major provider of glass containers for the industry. 0 Supply and other relationships among the various parts of the cluster are weak. The closest relationships are betweenprocessors and their suppliers, a legacy of the Soviet era model of vertical integration. Many processorsalso report close relationships with their customers-these tend to be processors with intermediate products whose customers are firms doing value-addedprocessingor distribution-to limit the scope for cheating. There is virtually no collaboration amongprocessors. 0 Access to information on markets and technologies i s extremely limited. The flow of information appears to be mostly informal and unstructured. Many of the managers rely on personal relationships, friends, customers, as well as the media and the Internet to obtain information about markets and technologies. Information about technologies i s accessed informally, through equipmentsuppliers, customers, or local consultants. 97. Overall, the fruit and vegetable processing cluster can best be characterized as emerging, with limited vertical and horizontal supply, marketing and other linkages, and even more limited "soft" collaborations, in terms of skills development, knowledge, innovation and related areas. Several parts of the cluster are missing compared to similar clusters elsewhere. The legacy of strong vertical integration of industries, for example, has stifled the development of specialized transportation, trade and financial services. The limited collaboration and extensive competition among processors has limited the scope for the development of local sources of knowledge, innovation and skills. Competitivenessof the Azeri Fruit and VegetableProcessing Cluster 98. Competitiveness theory suggests that a firm's or cluster's competitiveness i s derived by the strength and interrelationships of four sets of attributes: factor conditions; business strategy, structure and competition; demand conditions and related and support industries. These four attributes and their interaction explain why clusters of companies located in particular areas innovate and remain competitive. These elements are visually presentedin a competitivenessdiamond diagram (Figure5.8). 128 INOTIS-IntegratedNon-Oil Tradeand Investment Strategyfor Azerbaijan Figure 5.8-Azeri FruitandVegetable ProcessingCluster Competitiveness Diamond I Azeri Fruit and Vegetable Processing Cluster Competitiveness Diamond \ I i + Increasingagmculturaloutput. multipleharvests. bmven~ty,organicproduck + lncreasinaavslabil~b'of traln.ngand technical -Poorinfrastructure,unreliableem I 99. This framework was applied to the Azeri fruit and vegetable processing cluster. The main findings are summarized inthe competitiveness diamond diagram below. 100. Factor Conditions.Competitiveness analysis stresses the competitive advantages of a nation or region in a particular cluster, rather than comparative advantages emphasized by classical economic theory. The difference between the two i s that the latter consists of factor endowments that are largely innate or inherited; competitive advantages derive from specialized factors that are created, unique, and hard to replicate by competitors.88 101. The current picture regarding factor conditions in Azerbaijan i s mixed and often in flux. For instance, a key factor condition for fruit and vegetable processing i s a reliable supply of produce that enables efficient plant operation. The diversity of climates in Azerbaijan supports a variety of fruits and vegetables, and mild temperatures support two outdoor harvests in most areas - three if greenhouses are used. But agricultural production is far stronger in potential than in reality. The capacity to produce large quantities of high A classicalexampleis the Dutchdominance of the world cut flower industry. Holland accountsfor two-thirds of fresh flower exports while lacking in most of the basic endowments critical to this activity: land scarcity, short production season, unsuitableclimate, and expensive labor. Through extensive innovation, the Dutch have beenable to create unique competitive advantages. 129 INOTIS-liitegrated Non-Oil Tradeand InvestmentStrategyfor Azerbaijan quality produce has been weakened by a decade of neglect, and land reform that has greatly reducedthe size of farms." 102. Despite the recent trend toward improvement in size and quality of harvests, Azeri processingf i r m s face supply shortages. Firms attribute this to cost differentials, their inability to match the current market prices for fresh fruits and vegetables. The underlying issues here are the scale of the harvest and the relationships between growers and processors, an element of "firm structure." An even more complex issue is the reduced scale of the farms following landreform. Growers selling to the processing industry are usually the large operations, while those selling from roadside stands and infresh markets are more often the small farms.9o 103. Another issue i s the relatively high cost of production. This i s derived from a variety of factors including inadequate access to capital; dependence on higher cost equipment and other imported inputs; and the lack of scale economies at most factories, who operate at a fraction of capacity and suffer obsolete technologies. 104. The availability and quality of the workforce i s another major issue. Schools focus more on general and abstract education than on practical skills needed by industry. The local workforce lacks management and technical skills Please provide description of skills that are required, as well as any available data on number of graduates, current employment by skills level, etc.-as a result many companies hire foreign employees for these jobs. Recently, however, management training and technical assistance have become increasingly available to Azeri businesses through NGOs and donor-sponsored programs. 105. A final issue is the impact of widespread infrastructure inadequacies, especially in rural areas. Roads are under-maintained, and the country lacks an adequate rural and farm-to- market road network. Despite relatively abundant and low cost oil and natural gas supplies, Azerbaijan has a poor distribution network, and many areas have an inadequate natural gas supply. Electrical power supply i s so erratic that the larger processors have their own generators. Lack of investment in the irrigation sector has led to many problems in terms of water supply. 106. Demand Conditions. Another important determinant of competitiveness i s the nature of local demand, in terms of composition, sophistication, growth trends, etc. Markets that are demanding provide an incentive for firms to innovate. Learning to compete effectively in local markets i s an important part of competing in global markets, particularly if local markets have mechanisms by which localpreferences are transmitted to foreign markets. 107. Local demand for processed foods and vegetable products i s not sophisticated and i s largely satisfied through legal and illegal imports from lower cost producers such as Turkey. However, international oil companies in Azerbaijan offer the potential to act in the role of a sophisticated local customer who pressures firms to improve their products. BP and associated companies are looking to increase food purchases from local firms. The scale of the food product purchases from local firms has the potential to increase the capabilities of local suppliers. 89The horticulture sector i s made up largely by small holders. These farms have low economies of scale and low yields, typically 1/3 of those found in similar crops grown in the West. "Competitive Analysis of Selected Agricultural Products in Azerbaijan," LandO'Lakes, September 2000. A related problem i s that processors have to compete with retailers for access to fresh fruit and vegetable supplies, as there is no differentiation between produce destined to processors and that produced for retail markets. Traders frequently offer higher prices to farmers at harvest time to divert produce to retail markets. 130 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan 108. There i s increasing demand for processed fruit and vegetable products and better market access in export markets, but Azeri producers are under pressure to meet high safety, quality, packaging and price requirements. Quality and safety concerns are exacerbated by the absence of identifiable labels or quality standards for much of the output from small firms, as well as a weak food safety certification program. Another export niche market potential is for organic foods, given the low use of agricultural chemicals in Azerbaijan in post-Soviet times. Translating this into actual sales will require not only branding but also certification. 109. Related and Supporting Industries. The absence of strong related and supporting industries undermines the competitiveness of the Azeri fruit and vegetable processing industry. The break-up of the Soviet Union and resulting independence for Azerbaijan created a situation where many of the related and supporting activities for fruit and vegetable processors are now in another country or so altered by political and economic transitions that they no longer function effectively. 110. There are several weak or missinglinks inthe supply andmarket chains. International partners, equipment manufacturers, and donor-sponsored programs have been addressing some of these gaps, but serious deficiencies remain. In interviews, firm managers often described inadequacies inthis arena-particularly packaging and containers-as their biggest problem. A major glass factory i s plannedbutfew seem aware of this. 111. Competitiveness theory and cluster perspectives favor out-sourcing over vertical integration, because it encourages competition among suppliers, and stimulates the development of specialized business services. An internal supply source has more bureaucratic obstacles and a captive market and thus has less incentive to innovate and improve. Out-sourcing also provides greater opportunity for flexible specialization among firms. However, in Azerbaijan, the Soviet model i s the most familiar, and producers still exhibit a preferencefor vertical integrationthat stifles development of supporting industries. 112. Lack of trust incommercial contracts andrule of law is another issue. Some managers cited bad experiences to explain their reluctance to contract for services. One told of a transport company that loaded up their products and then disappeared. Gradually, however, specialization i s slowly emerging; for example, firms that have invested in packaging equipment are now packing multiple products or making juices from purchased concentrate rather than processing only raw materials. 113. Firm Stratew, Structure and Rivalry. One of the key aspects to enhancing competitiveness i s to create a business environment that forces firms to continuously innovate and improve. At the macro level, an important element i s to maximize competition by facilitating competing imports, while at the same time, ensuring an even playingfield through effective competition andcorporate governance policies. 114. Currently, the impact of firm strategy, structure, and rivalry upon the competitiveness of the Azeri fruit and vegetable processing industry i s mixed. The business environment- especially for small and medium enterprises-does not encourage the investment, upgrading, and innovation that would enhance competitiveness. Serious problems derive from corrupt practices by government officials imposing unofficial taxation and by unregistered firms paying no taxes at all. SMEs appear to believe that survival depends upon remaining invisible to the government and subject to the predatory actions o f well-connected individuals and interest groups. This i s exacerbated by weak enforcement of competition and trade policies to 131 INOTIS-Integrated Non-Oil Tradeand InvestmentStrategyfor Azerbaijan enhance competition in the marketplace and create an even playing field. Furthermore, the government i s not approving licenses necessary for the formation of business associations, which could provide a channel for training and technical assistance, branding and quality control, and other efforts to strengthen the competitiveness their members. 115. On the positive side, interviews found that emerging cooperation among firms was a source of strength. Most this stems from relationships between firms, an area where donor organizations have been active: Land O'Lakes in Hazelnuts and dairy products; IFDC with fertilizer dealers; ACDWOCA with fruit and vegetable processing in the war-affected areas. However, the survey results indicate that collaboration among companies i s still fairly limited. 116. Some Conclusions. The Azeri fruit and vegetable processing i s clearly at an early stage of development, with several systemic weaknesses. Our analysis suggests that many of these are shared by industry clusters in other transition economies: Center of the cluster i s further down the supply chain, with weak links to end markets and customers Firmsare small, resource-poor Access to information on markets and competitors i s weak Technology i s obsolete, and firms have poor access to new technologies and knowledge support services Legacy of vertical integration has stifled the emergence of specialized business services There i s limited collaboration among cluster participants; competition i s primarily price-based which inhibitscooperation Basic infrastructure i s inadequate Capital i s expensive and difficult to access takes years; the Azeri fruit and vegetable cluster has a number of important- advantages that At the same time, it should be noted that the development of a strong industry cluster can be built upon to enhance competitiveness. Among the most important of these i s significant scope for increased collaboration among processors and other cluster participants in terms of workforce development, development of specialized business services, joint marketing, policy advocacy, etc. Another unique aspect that can be exploited i s the on-going efforts of a sophisticated local customer (a demand condition) to improve Azeri firms' business and management skills (a factor condition). This can be used to help firms improve their capabilities andpromote further innovation. Recommendations 118. The following actions will be required to improve the competitiveness of the fruit and vegetable processing cluster inAzerbaijan: Promote Inter-firm Cooperation. The benefits of a cluster occur when the private firms and other components of the cluster develop and build relationships. Synergy between firms helps create competitive advantage for the cluster. There i s scope for increased collaboration among processors and other cluster participants in terms of workforce development, development of specialized business services, joint marketing, policy advocacy, and the like. This can be used to help firms improve their 132 INOTIS-IntegratedNon-Oil Tradeand Investment Strategyfor Azerbaijan capabilities and promote further innovation. Some mechanisms for strengthening inter-firmcooperationinclude: - Create an industry committee of firm representatives to begin cluster organization. Currently it i s very difficult to get the necessary government approval for formation of an industry association. The cluster approach and an informal cluster organization offer a framework for effective inter-firm cooperation. This group will be involved in cluster development planning and serve as a framework to identify needs for information and technical assistance and opportunities for cooperation among firms. Box 5.3-Information and Technology Establish a cluster-based information Extension Services system. Participation of both the Azeri NGOs and the firms would be strengthened Many nations have establishedoffices to help small and mid-sized companiesfind by providing them with information, solutions to problems, learn about new especially specific examples, about methods, and locate and filter counterpart clusters and competitiveness. information. Inthe US., the government Information about markets and other critical established an agricultural extension needs-such as sources of capital, training, service in 1914 and a manufacturing extension service in 1990, each with and technology-are priorities. A good local offices to assist small firms. In model framework is the U.S.'s cooperative Denmark, the Technological Institute extension or manufacturing extension established a Technology Information partnership where individuals are widely Center in each county. In Baden- dispersed among localcommunities. Wurttemburg, Germany, the Steinbeis Foundation established more than 200 technology offices throughout the Provide technical assistance to firms in lander, and in the Valencia region, Spain a cluster setting. Several of the international createdTechnology Institutes for each of donors and NGOs are financing programs its key clusters. that provide management and technical assistanceto Azerbaijan firms in a group setting. GTZ convenes meetings of fruit and vegetable processors, and USAID funded efforts created associations of hazelnut growers and dairy farmers. By defining and planning interventions according to the collective needs of a cluster and not only of individual firms, the government, companies, and donors can achieve economies of scale and have greater impact. 0 Promote Innovation, Quality, and Specialization. Exposure to the cluster approach surfaced support for collaboration among firms but did not modify participants' priorities, and promoting innovation, quality, and vertical and/or value-added specialization i s not a current priority. However, developing institutions for these functions i s likely to become a priority once improvements related to vertical relationships and market orientation have been made. The absence of an ability to promote innovation, quality, and specialization will constrain cluster development. Specific actions include: - Promotefarming technologies that increase harvests. Assuring a supply of raw materials for processing must be given high priority. The importance of supply issues means that farmers and growers will have to play a large role in the strengthening of the Azeri fruit and vegetable-processing cluster. Plans should recognize that increased harvests, more effective and sustainable agricultural 133 INOTIS-IntegratedNon-Oil Tradeand lnvestmeizt Strategy for Azerbaijan practices, and in some cases, a change to more appropriate varieties of fruits and vegetables are all fundamental to development of a strong cluster. Activities to promote greater harvestsshould parallel efforts to develop the processingindustry cluster. - Establish a demonstration/teaching farm for farmers and growers. The demonstration farm was the precursor to America's cooperativeextension system, a place where farmers could go to observe and try out new methods and technologies in a neutral environment without vendor bias. The site would be an open working farm that uses the latest technologies and growing methods where farmers can observe, learn about, and learn to use the most appropriate new techniques to improve productivity. - Establish a national laboratoryfor quality certijkations. The highest priority for establishment of supporting institutions should be a testing and certification laboratory that will enable Azeri producers to export to EU and other western markets. If Azeri products are going to enter increasingly demanding higher end markets, they will need to be certified. If, for example, the cluster chooses to move toward higher end "green" and organic products, the product must meet specific standards.Within the EUand in many other places, testing labs that serve all of the firms in a particular cluster are becoming more common. For example, CERMET i s a testing lab for metalworking firms in Emilia-Romagna (Italy), and the Hosiery Technology Center tests socks for all companies in central North Carolina inthe U.S. The testing of food products i s even more important because o f health and other dietary, includingreligious, implications. - Expand value-addedforms of production basedon locally grown products. Some crop-basedmini-clusters have formed within the regions. For example, apples and apple juice concentrate are common in Quba, tomatoes and tomato paste in Lenkaran, and pomegranates and eggplants in Ganja and Goycay. Each region has a major packaging firm. However, a cluster could conceivably include numerous primary processors whose output is purchased by a single large packager and/or numerous small and medium-sized processors that contract for packaging services. Large packagers and value-added processors could benefit from development of numerous small firms and workshops that perform initial processing of fruit and vegetable products, many of which will require packaging or be inputsfor further processing. - Support developmentof a wholesale capacity. The regional mini-clusters look to the hub in Baku for warehousing and distribution, where some firms are locating their headquarters. For reasons ranging from habit to distrust, firms tend to be reluctant to contract for warehousing and distribution services, preferring to create neededcapacities in-house. To promote the specialization that creates efficiencies and promotes innovation in a cluster, donor organizations should seek opportunities to support development of firms that provide these specialized services. - Develop a better dialogue and a clear policy in the relationship between producers and processing firms. The importance of supply issues means that farmers and growers will have to play a large role in the strengthening of the 134 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan Azeri fruit and vegetable-processing cluster. The first step should be to establish relationships on contract basis. 135 INOTIS-IntegratedNon-Oil Trade and InvestmentStrategyfor Azerbaijan ANNEX 6: AZERBAIJAN ADMINISTRATIVE BARRIERS ANALYSIS* I. INTRODUCTION 1. Cumbersome administrative procedures and the prevalence of corruption have increasingly come to be regarded as key obstacles to private sector growth in transition countries. Such administrative barriers to doing business often have an important fixed cost component and are therefore of particular concern for small and medium sized enterprises (SMMEs). Also, they deter foreign investors since the setup costs and perceived risks for outsiders to operate in an unpredictable and informal regulatory framework are particularly high. 2. Several recent analyses have pointed to the prevalence and negative impact of administrative barriers to inward investment in Azerbaijan. The Business Environment and Figure 6.1-Ease of Administrative Procedures inAzerbaijan, 2002 Tax rates administration Customs - - - - Worst Case -Azerbaijan Source: EBKL)and World Bank, Business Environment and Enterpnse PeriormanceSurvey, 2002. Note: 'Ihe values range trom 1to 4, with 1indicatingno obstaclesto businessgrowth andoperation, and4 indicatingmajorobstacles. The extremity of each axis representsa score of 4, indicating a less favourable business environment. Enterprise Performance Survey (BEEPS) survey of the World Bank and EBRD conducted among more than 20 transition economies in 1999 and 2002 showed that while Azerbaijan made significant improvements in its business climate, administrative barriers remained an * Preparedby Kishore Rao and Sheri Pitigala based upon a draft report authored by an Azeri consultant, Agha KerimEmam-Zade.The report reflects the situation as of November 2002. For this study, 93 Representativesof the Authorities of Azerbaijan were interviewed, including officials from: Ministry of Foreign Affairs, Presidents' Executive office, Ministry of Internal Affairs, Ministry of Labor and Social Security, State Committee for Land and Cartography, Ministry of Economic Development, State Committee of Construction and Architecture, Department of Technical Inventory and Registration of Property Right, State Auditor Chamber, State CustomsCommittee, Ministry of Ecology. 136 INOTIS-Integrated Non-Oil Tradeand InvestmentStrategyfor Azerbaijan important impediment. A comprehensive diagnostic o f Box6.1-Core Set Administrative the investment environment undertaken by FIAS further i !i Procedures underlined the need for Azerbaijan to simplify regulatory procedures and remove other administrative constraints to . EntryApprovals registration facilitate foreign and local investment. That analysis Investment code regisvation showed that Azerbaijan was less competitive in this Initidbankdeposit respect than many other transition countries in the region. Residence and work permit Tax office registration Foreigninvestmcnt licensing 3. The Government of Azerbaijan has recognized the Business and trading p e h t importance of administrative constraints and has Statistical office registration implemented a number o f actions to deregulate and Existence, conformity, opening, simplify the investment environment. Among the most . reporting He,& care and pension plans significant of these were the presidential decrees sharply Social security registration reducing the number of economic activities subject to business licensing, and significantly limiting the scope o f Land, SiteDevelopment, Utilities government agencies to inspect enterprises on an ad hoc Access to (stae) land Townplahngcefiificate and unneeded basis. Site inspections & general approvals Buildingpermits 4. This study is a brief assessment of the main Electricity and power connection ~e~ep~onean~~ntemetconnections administrative constraints to inward investment in Water and sewerage Azerbaijan. I t evaluates these regulatory and procedural Post, box and privatebag barriers and makes recommendations for reform to enhance the overall business climate and aid the Operational Requirements . intention andpermils Government in its deregulation efforts. What are hnport-export clearance process administrative barriers? Administrative barriers can be FOEi@ exchange controls expressed in terms of the amount of time and money . Fiscal situation certificat (quitus) (official fees and unofficial payments) that i t takes to . Healthandsafetyinspections ~ ~ b ~inspections ~ k i ~ ~ ~ d complete all the processes required for a new investor to Social welfare plan payments establish, locate and operate his business. FIAS has identified a core Set o f 26 procedures required to set up swrcs:,aques Morriset andOlivier tumenga Neso,FlAS,May2002. and operate a business in most countries (Box 6.1). 5. This study covers a small set of these core procedures, including: P Establishinga business-including business registration, tax registration, and licensing P Locating a business-including land acquisition, site development, construction and occupancy P EntryandEmploying-including entry visas, workpermits, andemployment P Operating a business-including filing corporate tax returns, and import and export procedures The study was based upon detailed interviews with representatives of the Government92and private entrepreneurs. 6. It is hoped that this analysis will contribute toward making administrative procedures in Azerbaijan more transparent, rule based, and predictable so as to reduce entry and operational barriers and the scope for corruption. In addition, administrative procedures will need to be reviewed on a regular basis to assure that they stay realistic, in the sense that they can actually be enforced given the current administrative capacity, and that they are efficient, 137 INOTIS-Integrated Non-Oil Tradeand InvestmentStrategyfor Azerbaijan in the sense that they concentrate of those areas that actually need to be regulated and that they do not impose any unnecessary burden on businesses. 11. OVERVIEW 7. Table 6.1 provides an overview o f the main administrative procedures for inward investment in Azerbaijan, the main state agencies involved, and the typical length of time associated with each. In general, the procedures required to establish, locate and operate a business in Azerbaijan are lengthy, time-consuming, and frequently unclear. Based upon our analysis, most investors routinely resort to illegal payments to facilitate processing and compliance. At the same time, it should be noted that in many (but not all) cases, administrative barriers in Azerbaijan are about the same, and at times better, than most other transition economies. The most cumbersome and lengthy procedures are those that are associated with the process of land acquisition and building construction. Our analysis also suggests that there are enormous opportunities to simplify and streamline procedures to reduce the impact of these factors as barriers to inward investment. ,dministrative Procedures Establishinga Business Registering the business 0 Ministryof Justice 8-10 weeks (Company, Statistics, Tax and 0 State Statistical Committee Social Security) Ministryof Taxes 0 State Fundfor Social Security Obtaining a sector license for 0 Ministry of Economic Development 2-3 weeks selectedcommercial activities Other ministries depending on activity Ministry of Taxes Locating a site and verifying 0 Region, Municipal or City authorities Varies ownership rights Obtaining approvals of land Chief Department of Fire Safety, Ministry of Varies allocation for saleor lease Internal Affairs Department of Sanitation and Epidemiology, Ministry of Health Ministryof Ecology andNatural Resources 0 Municipal authorities 0 State Committee of Land and Cartography Concluding land purchase or 0 Localmunicipalities Varies lease contract 0 Executive authorities State Committee of Land and Cartography Registering transaction and Ministry of Justice 2-3 weeks obtaining landrights State Committee of Land and Cartography 0 Ministry of Economic Development Preparing and obtaining Regionalkity departments o f construction 20-60 weeks approval of construction plans and architecture and buildingpermit 0 Chief Department of Fire Safety of Ministry of Internal Affairs 0 Department of Sanitation and Epidemiology, Ministryof Health Ministryof Ecology andNaturalResources 0 Ministryof Labor and Social Security 138 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan State Construction and Architecture Committee 0 Utility companies Obtaining certificate of use and Regional/city departments of construction 30-60 weeks registering ownership right and architecture Chief Department of Fire Safety of Ministry of Intemal Affairs Department of Sanitation and Epidemiology, Ministry of Health 0 Ministry of Ecology and Natural Resources Ministry of Labor and Social Security 0 StateConstruction and Architecture Committee 0 Bureau of Inventory of Property of the Department of Privatization of State Property of the Ministry of Economic Development (inthe case of privatizedproperty) or Regional/ City departmentsof Technical Inventory and Registration of OwnershiD Riehts " c Entry and Employing Obtaining a business visa to 0 Ministry of ForeignAffairs 2-5 weeks enter the country 0 Azeri diplomatic missions overseas Ministryof Intemal Affairs Obtaining permission to work in ImmigrationDepartment of the Chief 1-2 weeks the country Employment Department of the Ministry of Labor and Social Protection Visa andPermission Department of the Filing corporate income tax 0 Ministry of Taxes 1day returns State Fundfor Social Security Audit and inspectionof Ministry of Taxes 15-60 weeks corporate income tax returns StateFundfor Social Security State Audit Chamber Customs clearance 0 StateCustoms Committee 3-5 weeks State Veterinary Committee Ministry of Health 111. ESTABLISHINGA BUSINESS 8. This discussion summarizes the main processes, procedures and enabling laws and regulations associated with establishing a new business in Azerbaijan, including registration of a business entity with the Ministry of Justice; registration of a businessentity with the tax department and other state agencies; and business licensing. Procedures for obtaining entrance visas for foreign investors are discussedinchapter V. 139 INOTIS-Integrated Non-Oil Tradeand InvestmentStrategyfor Azerbaijan 1II.a. Company Registration 9. It is widely acceptedthat complex regulations and cumbersomeproceduresgoverning business entry are a major deterrent to inwardinvestment, contribute to pervasive corruption, and provide incentives for firms to remain unofficial.93 Business registration and licensing form the core of business start-up procedures and, as such, provide an important indicator to investors of the ease of doing business in a given location. Lengthy andlor cumbersome registration and licensing procedures can impose high costs on entrepreneurs and deter business development. Unnecessarydelays in registration and licensing can increase start-up and other costs of companies, particularly smaller enterprises, by delaying their ability to do business, tying up resources, and hinderingthe ability of a company to respondto a changing market, and consequently causing them to lose potential revenues or even market share. If a company sees an opportunity and needs a new license to pursue it, the opportunity may be lost or compromised by the time the license i s granted. The following sections present an overview of the company registration process in Azerbaijan and recommendations for improving the relevant procedures. 10. The legal basis for private entities in the Republic of Azerbaijan i s regulated by the Civil Code (effective September 2000), the Law on Enterprises (July 1, 1994), the Law on Joint-stock Companies (July 12, 1994), the Law on State Registration of Legal Entities (February 6, 1996), and the regulations of the Council of the Ministers on Joint-stock Companies and LimitedLiability Companies (July 9, 1990), still effective with respect to limitedliability companiesto the extent it does not contradict the Law onEnterprises. 11. A foreign investor may choose either a limited presence, in the form of a representativeoffice or a branch, or a full presenceina number of other forms, including: 9 Individual "Family" Enterprise (E)-A legal entity owned by an individual (sole proprietorship) or by members of a family. Owners are personally liable to the full extent of their property. 9 General Partnership(GP)-A legal entity that is established by two or more physical or legal persons. The owners have unlimitedliability. 9 Limited Partnership (LP)-A legal entity that is established by two or more physical or legal persons, with at least one member bearing unlimitedliability. 9 Limited liability company (LLC)-A legal entity that is established by two or more physical or legal persons. The legal fund i s dividedinto authorized shares per its charter. The shareholdershave liability up to the value of their shares. 9 Additional liability company (ALC)-A legal entity that i s established by two or more physical or legal persons. The legal fund i s dividedinto authorized shares per its charter. The shareholders have liability inexcess of the value of their shares. 9 Joint-stock company (JSC)-A legal entity that i s established by three or more physical or legal persons, with a minimumcapital established by law. An "open" JSC may offers its shares to investors, while a "closed" JSC may only redistribute shares among the founder shareholders. 9 State Enterprise (SE)-A legal entity created by a state agency to manage state-owned assets (either wholly state-owned or a JSC in which the state i s the controlling shareholder). The state i s not liable for the company's obligations. ~~ 93 "Countries with a heavier regulation of (business) entry have higher corruption and larger unofficial economies, but not better quality of public or private goods." Simeon Djankov, Rafael La Porta, Florencio Lopez de Siames, and Andrei Shleifer, "The Regulation o f Entry," World Bank, June 2001. 140 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan 12. The following discussion focuses on the legal requirements for limited liability companies (LLCs), joint stock companies (JSCs), and additional liability companies (ALCs), which are the most popular forms of incorporation usedby foreign investors inAzerbaijan. 13. The Law does not set limitations on the domicile of partners. A partner in a legal enterprise can be a citizen or resident of any country. Foreign companies can be established as fully foreign-owned enterprises or in partnership with Azeri companies or physical persons. In accordance with the Law on Protection of Foreign Investment of April 7, 1992, companies with foreign investments enjoy national treatment and the same rights as Azeri companies. 14. All legal businesses are required to register at the Legal Entities Registration Department at the Ministry of Justice. The procedure to establish a legal business entity i s detailed inTable 2. Inorder to register an LLC, the following documents must be submitted: 9 Thecharterofthenewlyestablishedlegalentity 9 Thefoundation documentofthe legalentity 9 The documentconfirmingthepaymentof necessaryregistrationfees 9 Thepostaladdressofthefounder 9 The certificate designating the identification code received from State Statistical 9 The bankconfirmation for thecapital deposit9' 15. Incasesof participationby aforeign legalperson, the following additional documents are required: 9 Personalidentification 9 The extract from the trade register submitted by the diplomatic representation of Azerbaijan in the home country P Documentation certifyingthe business activity submittedby the diplomatic representation of Azerbaijan inthe home country The completed application packagemust be certified by a notary. 16. The necessary documents for the registration of the new business can typically be preparedin3 to10 working days, with the assistance of a local law firm. Once the application i s submitted, it i s examined to assert conformity with the relevant legislation and procedures. While the submission itself i s free of any official fees, there are reports of widespread informalpayments to assure a favorable examination. Incase an application i s deemedfaulty, it i s reported that officials are often unwilling to specify the precise nature of the problem. According to the law, after 10 working days at the latest the applicant will receive notice whether his application has been approved. 17. After the application has been approved, the Registration Department is obliged to complete the registration and issue the registration certificate. The registration certificate i s useduponpayment of applicable registration fees, as follows: 94 The special identification code i s for statistical purposes and is obtained by an application to the State Statistical Committee. The application process is simple and can ordinarily be completed in 30 to 60 minutes. No official fees are required, though interviews with the private sector suggest that informal payments of AZM 10,000-20,000 (US$2-4)are typical to facilitate the process. 95 The temporary account must be manat-denominated. Foreign depositors may therefore have to open two accounts, one for foreign currency and one to deposit the authorized capital inmantas. 141 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan P For businesses involved in banking, insurance and also branches and representations of foreign legal persons-AZM 1,100,000 (US$225). 9 For anon-agricultural legalentity -AZM 55,000 (US$11). 9 For anagriculturalentity - AZM 11,000 (US$2). 18. Since the law does not specify the exact timeframe for this last step, private sector interviewees suggest that informalpayments are frequently made to acceleratethe process. Analysis 19. Some improvements have already been made to the business registration process. Untilrecently, the certification by a notary was a serious bottleneck that required substantial informal payments to the notary. However, since a working group was assignedto reform the Notary and Civil Acts Registration Department at the Ministry of Justice, the system has improved significantly. The new personnel recruitment policy and improvement of professional skills have helped to raise the professional standards of the (state) notaries significantly. Nevertheless, reports of small-scaleinformal paymentspersist. 20. While the business registration procedures are relatively straightforward, interviews with the private sector indicate that, inpractice, businessregistration tends to be overly time- consuming and subject to arbitrary decision-making, Registry officials have discretion to review almost every detail of a company registration. This stems from the tradition that registration of a company signifies compliance with all legal requirements. It requires or at least invites officials to examine the contents and form of all filed documents, to review and pass on the work, and to reject a registration that the official feels i s deficient. While the Law on State Registration sets a limit of ten days for processing registration applications, interviews with the private sector suggest that actual processing times can take several months. Delays due to insufficient information or documentation are reportedly common, as are requests for additional documentation, beyondthose required by law. 21. Table 6.2 provides a comparative picture of the average length of time to register a business in Azerbaijan and neighboring countries, as well as some selected other countries. As can been from the table, Azerbaijan lags behind many of its neighbors. Business registration takes more than three times as long as in Georgia, the Kyrgyz Republic, and Table 6.2-Average Length of Time to the Russian Federation, where registration averages 18 to 20 days. Table 3.3 provides business registration requirements in several I Ukraine I 10 I other countries. In the United States and the Georgia 18 United Kingdom, where business registration Kyrgyz Republic 19 i s a simple public notification process, it takes RussianFederation 20 only a fraction of the time to formally establish a business presence. When seeking help on documentation andor procedures, some observers suggest that staff members are Source: World Bank Rapid Response's Doing generally not well informed or helpful. While Business database. Note-average length of time is large investors can afford to hire lawyers basedon surveys of incorporation lawyersinthe andor other facilitators to guide them through respective countries and are actual length of time once documentation is complete, rather than time the business registration process, SMMEs limits set by law. typically cannot afford to hire facilitators and 142 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan are, therefore, often faced with long delays and/or requests for informal payments to pave the way. iirementn ...-.- .._ _ __ Approx. 10 Flat fee of f250 for an No involvement of days LLC and E20 for all chamber of other forms of business commerce; no application to Flat fee basedon cost of statistics office service 5 days; same Flat fee: E20 for any Company has its own day service type of company; same database; no exists day service for 5100 involvement of other authorities Flat fee basedon cost of service Varies from California business Section has its own state to state, filings section charges database usually within 1 $100to register a week corporation, $70 to register an LLC and general partnerships Flat fees basedon cost of service 1-2 weeks No stamp duty Agency has its own database. No application to the statistics office About 2-4 Basedon number of Request to chamber weeks personsto be registered o f commerce for depending on company name if 0 local courts and Sole proprietor: doubts exist. No type of -US $80 application to company LLC: minimum$550 statistics office (average -$800) Branch of foreign company: -$800 JSC: $880 minimum 1-15 days LLC: -US $175 Register has its own Expedited JSC: -, $445 database. No service: 4 days Hat fee basedon cost of application to the (2 x fee), service statistics office 1day (3 x fee) 143 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan 2-3 weeks Sole proprietor or partnership: US$20 Branch of foreign company: $170 LLC and JSC: $170 to $2,800 Flat fee for sole proprietor, branch, and partnership. 0.2% of sharecapital for limitedliability and joint stock companies with a ceiling of US$1,400 for a limited liability company and $2.800 for a JSC About 4 weeks Sole proprietor, Chamber of dependingon US$lOO; Partnership, commerce if doubts local court and $120 for 2 partners plus regardingcompany type of $60 for each additional name exist; no company partner; LLC and JSC, application to $140; Stamp duty for statistics office changes depend on the capital of the company and percent of the capital Partly flat fee, partly a percentageo f share caDital 22. While such delays can impose additional costs on entrepreneurs, in its most severe form non-transparent registration procedures can act as a screening process that effectively blocks business development. Although requiredby law only to determine that documents of enterprises seeking registration are in order, the Ministry reportedly operates in a non- transparent and sometimes arbitrary way. According to the most recent Country commercial Guide (2003) published by the U.S. Foreign Commercial Service in Baku, credible reports indicate that Ministry officials make extra-legal determinations of whether individual investments, particularly those with foreign participation, are of an appropriate nature before making decisions about registration. Recommendations 23. Introduce private notaries. Despite the dramatic improvements in the state notary system, it has been suggestedto explore the advantages of moving to a private notary system could be explored. However, in a cross country comparison there does not be appear to be a strong argument for or against either a public or private notary system. In some countries, such as Germany, bothapproachesco-exist indifferent parts of the country. 144 INOTIS-IntegratedNon-Oil Tradeand Investment Strategyfor Azerbaijan 24. Simplify business registration. Box 6.2 illustrates guidelines that a recent EU commission has issued for the reform of company registration procedures in member states. These guidelines comprise best practice and their adoption in Azerbaijan would greatly reduce the scope for undue administrative discretion and bureaucratic delays. The submission of the application should be reducedto a mere formality and incase closer evaluation reveals faults or omissions in the application, these findings should be specified to the applicant in writing. Legal standards for the maximum acceptabledelays for the final registration and the issue of the official certificate should be introduced to reduce the potential for corruption. The registration procedure should be simplified by replacing the submission of an identification code of the State Statistical Committee with inter-agency communication between the Ministry of Justice andthe State Statistical Committee, thereby also reducing the potential for informal payments. The same holds for the final registration with the State Statistical Committee, Ministry of Taxes and other mandatory registrations after the business entity has been registered with the Ministry of Justice (see next section). Overall, the workflow and efficiency of the registration system should be closely monitored to identify bottlenecks and to measure improvements. Shifting from a system of control to one of notification, as in the United States or the United Kingdom, could further minimize the administrative burden and scope for discretion. 25. Provide clear guidelines. Whatever system i s ultimately in place, an important priority i s to establish a better information system for the registration process. The provision of clear written guidelines, for use by both the private sector and officials responsible for registration, would provide increasedtransparency and ensure that the streamlined procedures that are laiddown inthe law are put into practice. 26. Provide training. Additional training should be provided for staff at the Registration Department on the overall process of starting up a company. This training should focus on general customer service skills as well as the steps, requirements, and dependencies that exist inthe company registration process. 27. Move to computer-based system. The business registration system in Azerbaijan i s currently a paper-based, manual system. In the medium-term, if the process could be computerized, even partially, it could be made faster and more efficient and reduce 145 INOTIS-Integrated Non-Oil Trade and Investment Strategy for Azerbaijan opportunities for rent-seeking behavior by government officials. An increasing number of countries have introduced web-based systems that allow investors to download and, in some cases, file all the necessary forms, obtain information on registration requirements, and perform company name searches. The Registrar of Companies in Ireland, for example, offers these services on its website. A similar fee-basedsystem has beenintroduced inLatvia. 1II.b. Other Mandatory Registrations 28. After a business entity i s legally established with the Registration Department, it i s required by law to register with a number of other state bodies, including the Ministry of Taxes, the State Statistical Committee, and the StateFundfor Social Security. Untilrecently, many businesses avoided paying taxes altogether by simply not registering with the tax administration. In order to prevent such fraud, the Legal Entities Registration Department now automatically informs other state structures of the registration of any new legal entity. The following provides an overview of these additional registration procedures. 29. Ministry of Taxes-All legal entities are required to register with the Ministry of Taxes within 30 days of their company registration. Applications must include a copy of the company's foundation documents and certificate of company registration. No official fees are assessed. By law, applications must be reviewed and a registration certificate issued within 10 days (15 days in case of changes to an existing registration, such as change of address). Together with a registration certification, the business will be issued a taxpayer identification number. 30. State Statistical Committee-All legal entities are also required to register with the State Statistical Committee within 30 days of their company registration. Applications must include a certified copy of the company's charter and certificate of company registration. Additional documentation may also be requested. The process ordinarily requires no more than one day to complete and requires no official fees. Upon registration, the company i s assigned a statistical code. Thereafter, the company i s required to submit regular statistical reports to the Committee. 31. StateFundfor Social Security-All legal entities are required to register with and pay social taxes to the State Fundfor Social Security. Registration must be completed within 30 days of company registration. Applications must include a certified copy of the company's charter and certificate of company registration. The process typically requires no more than half a day to complete andrequires no official fees. Analysis 32. While each of these additional registrations ordinarily require little additional effort by a new business, taken together with all other start-up procedures, they unnecessarily add to the burdenof investors. The information to be submittedi s redundant, particularly in light of the fact the Registration Department already notifies each of these agencies once a company i s issued a certification of company registration. In addition, businesses report the frequent payment of small, unofficial amounts to facilitate the processandcircumvent any requestsfor additional documentation. 146 INOTIS-Integrated Non-Oil Tradearid Investment Strategyfor Azerbaijan Recommendations 33. Introduce a single application. Given the redundancies involved, it would be possible to introduce a single application form that can be filed with the Registration Department at the Ministry of Justice. As the Registration Department already notifies the other agencies of the establishment of new business (and no fees are required for the other applications), the necessary information could be forwarded directly by the Registration Department to these agencies, with no additional applications required of the investor, reducing time and effort in providing what is, essentially, redundant information. This would also reduce the opportunities for rent-seeking behavior by minimizing the interface between investors and government officials. Hungary, for example, recently introduced a one-step registration process, which has been welcomed by the businesscommunity. 34. Introduce single registration number. Also to consider i s the possibility of introducing a single registration number that the company would use for all its interactions with various government agencies, including the Registrar, the Ministry of Taxes, the State Statistical Committee and the State Fund for Social Security. This system is useful not only to businessesthat need to use only one identification number, it also simplifies the management of databases and information sharing among government agencies. Such a system has already been successively introduced in Bulgaria and Slovenia, and ina number of EUcountries. 147 Ece, 2 -0 3 '3e, 0 h rc, 0 x x .e a s sc 2 0 0 2 P Y e Y 5 3 J ti 6 INOTIS-IntegratedNon-Oil Tradeand Investment Strategyfor Azerbaijan IV. BUSINESSLICENSING 35. In addition to company registration, businesses operating in certain sectors are required to apply for sector-specific licenses. Following a recent Presidential Decree "On Improvement of Regulations o f Granting Special Permissions (Licenses) for Some Types o f Activities" (September 2002) substantially reducedthe number o f types o f activities requiring licensing, from 240 to 30. Licensing i s carried out by the relevant ministry, and one company may require separate licenses from more than one ministry, depending on the nature of their activities. While different ministries or state agencies are involved in sector licensing, the MEDacts as plenipotentiary to provide control and administration over licensingprocedures, including the preparation of directions and draft legislation, the supervision of implementation by other public organs, and the maintenance of a unified register. 36. Sector licensing i s limited to those activities that require some degree of oversight to protect consumers and the public interest (such as the production and distribution of alcohol and tobacco, banking, professional services, and the like). Following on the Presidential Decree, in November 2002 the Cabinet Ministers issued a Resolution "On Additional Conditions for Issuing Licenses due to the Specificity of Licensed Activities." The Resolution specifies the application documents required for each types of activity subject to licensing, including any certifications regarding standards andor other technical requirements. premises of 1'` and 2ndlevels of responsibility in Committee accordance with national standards 2. Cartographic activities State Land and Cartography Committee 3. Storage and buryingof radioactive and ionizing Ecology and Natural ResourcesMinistry substances 4. Utilizationof toxic production wastes Ecology and Natural Resources Ministry 5. Production, processing and sale of color metals Ministryof Economic Development and industrial and production wastes containing costly metals and stones 6. Sale of oil products Ministry of Fuel and Energy 7. Sale of gas products Ministry of Fuel and Energy 8. Medical activities Ministry of Health 9. Pharmaceutical activities Ministry of Health 10. Production, import and saleof ethyl spirit and . . Ministry of Economic Development, City alcoholic beverages and regional (except for city districts) executive powers 11. Production, import and saleof tobacco products Ministry of Economic Development, City and regional (except for city districts) executive powers 12. Use, production, sale, purchase, import and Ministry of National Security export of technical devices designed for illegal obtaining of informationby physical and legal persons not entitled to conduct searchand seizure activities 13. Cargo and passengertransportation by water Ministry of Transport transport 149 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan 37. A license application typically needs to contain the following documents: 9 Completedapplicationformfor specific license 9 Copy ofthe registrationcertificate ofthebusinessentity inquestion 9 Proof ofregistration with the MinistryofTaxesandproofoflicensing taxpayment 9 Proof ofrightofuseofrelevantpremises 9 Additionaldocumentationasrequiredfor specific activity inquestion 38. The official processingfee is AZM 55,000 (US$11).Inaddition to the application fee, businesses are obligated to pay a license tax, which varies according to the type of license. Licensing taxes range from AZM 550,000 to AZM 27,500,000 (US$112-5,615) and must be paid to the relevant licensing agency. Certification of payment i s required before a license i s issued. Similar license taxes are also due when a license is renewed. 39. The processing of the license ordinarily takes no longer than 5 working days. If an application is faulty or incomplete, the authorities are instructed to clearly point out the problem. However, the current legislation leaves some room for interpretation over the exact obligation of the administration in case of a faulty application. By law, the whole processing of the license application and the issuance of the license certificate may take no longer than 15 working days. The registration of the license with other government agencies, especially the Ministry of Taxes, i s achieved through inter-agency communication and requires no additional applications on the part of the investor. 150 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan Analysis 40. Like the company registration process, the licensing process has been both time- consuming and has often been used as an unofficial screening tool by public officials. While larger investors can absorb the costs associated with bureaucratic delays, smaller entrepreneurs can be discouraged from entering the formal sector. 41. Until recently, special licenses were required for over 240 different economic activities. These various licenses had to be renewed frequently. This old system of licensing placed a heavy burden on the development of the private sector, especially SMMEs, in terms of unnecessary restrictions, bureaucratic exposure, and informal payments to obtain licenses. The September 2002 Decree, which ratifies the Regulation "On Granting Special Permissions (Licenses) for Some Types of Activities," seeks to improve the licensing regime in a number of ways. In addition to reducing the number of activities requiring licensing down to 30, it prohibits implementing agencies from demanding documents that are not envisaged in the regulation. It also grants the MED the authority to act as plenipotentiary in the field of licensing to provide control and administration over licensing procedures, including the preparation of directions and draft legislation, the supervision of implementation by other public organs, and the maintenance of a unifiedregister. 42. While it i s too soon to assess the impact of these new reforms on investors, it i s expected that the substantial reduction of licensing requirements and the introduction of clear documentation requirements and criteria will increase transparency and reduce the opportunities for undue discretion on the part of public officials. However, some businesses believe that the documentation requirements for the license application continue to be too demanding. Recommendations 43. Provide clear guidelines. As in the case of company registration, an important priority i s establish a better information system for the licensing process. The provision of clear written guidelines, for use by both the private sector and officials responsible for licensing, would provide increased transparency and ensure that the streamlined procedures that are laiddown inthe law are put into practice. 44. Provide training. Additional training should be provided for staff with the licensing departments within the relevant state agencies. This training should focus on general customer service skills as well as the steps and requirements for licensing. As with other application procedures, more transparency and better information for the applicant both before and duringthe application process would be helpful. Incase an application i s rejected, a written explanation of the reasons for rejection to help prepare for re-submission would be helpful. 45. Monitor implementation. The recent reforms have been welcomed by the business community as an important measure to ease the business start-up process. While the elimination of hundreds of activities from licensing requirements, it will be important to ensure that the new provisions for licensing-which are meant to ease the process for those activities that must still be licensed-are properly implemented. The new system shouldbe monitored to ensure that it works as intended, and that new timelines and document requirements are met. 151 INOTIS-Integrated Non-Oil Trade and InvestmentStrategyfor Azerbaijan v. LOCATING A BUSINESS 46. A competitive business environment requires that investors have access to the resources they require, including land, at market prices and that procedures for obtaining land are streamlined and efficient. This chapter describes the various procedures related to locating a business in Azerbaijan, including land acquisition and site development. While locating procedures may vary somewhat from location to location, the following provides an overview of typical locating procedures and the range of processing times and costs a representative investor would be likely to encounter. V.a. Land Acquisition 47. Legislation regulating land rights in Azerbaijan consists of the Civil Code, the Land Code (June 1999), the Law on Land Reform dated (July 1996), the Law on Land Lease (March 1999), andthe Law on LandMarket(May 1999). 48. All Azerbaijani citizens and all legal entities, including foreign-owned legal entities, may own, buy, sell, or leaseland and other property inAzerbaijan. Non-legal entities (such as branches and representativeoffices) and foreign individuals may only lease property, though long-term leases (from 15 to 99 years) are available and can be automatically renewed. Ownership transfer of land is possible through privatization, purchase of private land, inheritance, donation, exchange and others, including sharing of the land in the collective investment fund of the enterprise. If a foreign juridical and natural persons end up owning landthrough inheritance or otherwise, they must transfer their land back into local ownership within a year. Otherwise the ownership of the land will revert to the local municipality in exchange for a nominal purchaseprice. 49. The State Committee for Land and Cartography maintains a land cadastre. In major cities, including Baku, the local authorities administer the primary land cadastre but forward all relevant information to the State Committee for Land and Cartography where the central cadastre i s kept. The development of a unified land and real estate registration system and cadastre i s to be developed with assistancefrom the EU. The required legislation has already been drafted-this legislation provides for the register to be administered by the Ministry of Justice. 50. Azerbaijan i s divided into cadastral 19 districts (plus 3 sub-districts), each of which has been assigned a standard minimumprice. The "market" price for land, includingprivate land, may not below that standardprice. 51. A large proportion of publicly held land has been vested with local municipalities. Most transfers of land from public to private hands are realized through auctions or other competition methods, though direct applications are also considered. Applications for leases rights to publicly help property are, likewise, submitted to the relevant municipality. Upon application for public lands, investors must, in fact, provide information on previous land ownership, the purpose for which the land will be used, and, if to be purchased by an individual, particulars regarding other family members and their land ownership. In cases where more than one individual or entity has expressedinterest inobtaining ownership of the same property, preference i s given to those who already work and/or live on the site in question, or to shekhid families (Karabakh war victims' families), war veterans, or other similar special interest groups. The sale or lease of public land for industrial purposes i s also subject to approval by the Head Administration of Fire Safety (of the Ministry of Interior), 152 INOTIS-IntegratedNon-Oil Tradeand Investment Strategyfor Azerbaijan the Administration of Sanitary and Epidemiology of the Ministry of Health and the Ministry of Ecology andNatural Resources. 52. Prior to the transfer of ownership, a site plan must be prepared by the State Committee of Land and Cartography. The Committee registers the document and gives its copy to the owner. The plan must be approved by the current owner, i.e. State Committee for Land and Cartography for state or municipal lands, or by the private owner. The payment of the given work i s allotted from the national budget if these areas are state or municipal sites or by the private landowner if these sites are privately owned. Fee rates may vary depending on the size of the landplot. 53. Based on the approved site plan, the site itself must be physically demarcated. The demarcation generally takes up to month to complete, depending on the size of the land parcel. Then State Committee for Land and Cartography checks the accuracy of the demarcation and approves it. The payment i s also allotted from state budget in case the land areas are pertained to the government or municipality, or can be made by the private owner (fee rates were not available from the state agencies). 54. The legalization of the purchase or lease of publicly held lands i s subject to the issuance of a State Certification provided by either the local municipality or the State Committee for Land and Cartography, or, if publicly held buildings are located on the land, the MED.The fee for the Certificate i s AZM 27,500 (US$6). 55. Inthe caseof privately heldland, sale andleaseagreements mustbenotarized. Notary fees for property transactions are standardized in the Law on the Payment of State Duties, based on the location of the property. For example, in Baku, the fee i s AZM 550,000 (US$112). Notarization can typically be done inone day. 56. All property transactions must be registered with the State Committee for Land and Cartography. Transactions relating to state owned land parcels and rights to use of such parcels mustalso be registeredinthe Register of State Owned Property kept by the MED. 57. Applications must be accompanied by the following: 9 The saleor leaseagreement 9 An original site planof the land area (ifnot already obtained by previous owner, may be obtained from the State Committee for Landand Cartography) 9 The State Certificate, ifapplicable Approval is generally grantedwithin two to three weeks. Analysis 58. Compared to many countries in the region, the relative ease of access to land in Azerbaijan, particularly for foreign-owned enterprises, i s laudable. However, the real estate market remains relatively underdeveloped in Azerbaijan and a multi-purpose, unified land cadastre has yet to be established, making the identification of land and other property and their ownership rights time-consuming, particularly for foreign investors who are less familiar with the territory. Information on privately owned land i s difficult come by-some websites and other advertising are available, but are often out of date. 153 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan 59. Moreover, land allocation continues to be a politically sensitive issue in many transition economies, and Azerbaijan is no exception, though land acquisition tends to be less cumbersome than in some other countries in the region. However, acquiring ownership or land use rights to publicly owned land tends to be particularly difficult, as it ordinarily requires multiple reviews and approvals by the public authority to which the property has been vested, as well as, in some cases, the State Committee of Land and Cartography or the MED. The reluctance in some jurisdictions to privatize publicly owned lands and other property remains an impediment to private sector development. FIAS findings indicate that Baku Municipality, for example, - - i s perceived to be less than Figure ~.~-BUS iness Perceptionsof Land Acquisitionin cooperative with investors 1 TransitionCoun,,.,,, ,+..;DE 7002 seeking to obtain property within 100% the city.96Moreover, preferential 90% treatment on the sale of public 80% property, though designed to 70% alleviate sensitivities toward land 60% allocation, can hamper private sector development and can 50% result in the inefficient allocation of resources and reduce the 30% overall gains to the Azerbaijani 20% economy. 10% The registration process i s 0% presently inefficient and non- 2 ,E ; ; .!m `f b c C 5 4 transparent. It can reportedly take 5 :=. m 5c several weeks, and sometimes a 5s 8 8 E % Z$ $ several months, to complete the " J g2 y" registrationpr0cess-a procedure 0 NOobstacle I IModerateobstacle I obstacle Minorobstacle Major 61, Develop unified cadastre. The real estate market remains relatively underdeveloped inAzerbaijan and a multipurpose, unified landcadastre has yet to be established, making the identification of land and other property and their ownership rights time-consuming. 96 FIAS, p. A-5. 9 154 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan Information on privately owned land i s difficult come by. Efforts are now underway to establish a unified cadastre under newly drafted legislation. This work should be completed in as timely a manner as possible in order to ensure that the most up-to-date and comprehensive information is available. 62. Simplify transfer of state owned property. Acquiring ownership or land use rights to publicly owned land tends to be difficult, as it ordinarily requires multiple reviews and approvals and, in some cases, preferential policies, though designed to alleviate sensitivities toward land allocation, can hamper private sector development and result in the inefficient allocation of resources, reducing the overall gains of privatization to the Azerbaijani economy. While land can be politically sensitive and needs to be handled accordingly, the difficulties encounteredby investors in accessing land need to be addressed, if the country i s to be successful in attracting private investment. Only by opening up more land for investment can a greater level of investmentbe realized inthe comingyears. 63. Streamline title transfer. The registration process i s presently inefficient and non- transparent. I t can reportedly take several weeks, and sometimes several months, to complete the registration process-a procedure that, ideally, should be an automatic filing process and take no more than one day once all documentation has been submitted. The procedures for registering landand other property should be streamlined and made available to the public. 155 e, 2 E: ; 2a> (I) L4 > .^ 0 . a5 -0 rc a5 0 -3 5a ."*e, v) se, rc .-c 0 0 Y 8k cd w INOTIS-Integrated Non-Oil Trade and InvestmentStrategyfor Azerbaijan V.b. Constructionand OccupancyPermits 64. In order to start construction of their facilities investors have to obtain a building permit from the municipality or regional body that has jurisdiction over the site. Upon completion of construction, a building safety clearance and occupancy permit must be obtained. Most steps in the construction process are completed by a contracted building engineer, rather than directly by the investor. 65. In order to initiate the construction planning process, all investors must submit a businessplan or feasibility study to the GeneralDirectionof Architecture and Construction of Baku city (or similar bodies in other parts of the country). Only upon approval of the relevant authority, may the investor proceed to contact the relevant utility providers (Bakkanalizatsiya for sewage; Barmek or Absheron Electricity Network for electricity; Catel, Azeurotel or other phone company; Bakgaz for gas lines) to obtain the'necessary technical requirements. In the case of large investments,the MEDmay provide this approval. 66. Separate applications must be submitted to each of the utility providers. Technical requirements are typically provided within 3 to 7 days. The fee for each varies from provider to provider. The cost of works must be paidby the investor. 67. All project designs must be prepared by a licensed engineering andor construction contractor, in accordance with SNIP building regulations. For the most part, SNIP building regulations date back to the Soviet era and have not been substantially modified. 68. All project designs must be submitted to the relevant authorities for approval-in Baku, the General Direction of Architecture andTown Planning; inother large cities, the City Direction of Architecture and Town Planning; and in other regions, the State Committee for Construction and Architecture. No official fees are generally required at the time of submission. All plans must also be submittedto the relevant utility providers for approval. In some cases the relevant authority will forward the designs on behalf of the investor. In the case of industrial projects, approvals must also be obtained from a range of other agencies, including: 9 GeneralDirectionofFireSafety underthe Ministry ofInternalAffairs for fire safety 9 General Direction for Sanitary and Epidemiology under the Ministry of Health for sanitaryhealth standards 9 Ministry ofEcology andNatural Resourcesfor environmentalclearance 9 StateCommittee for ConstructionandArchitecture for seismic stability 69. While there are no official fees in place for the examination of the proposal, some informal payments are typically required to accelerate approval. Unofficial payments between US$300 to US$500 are not unusual. The approval process ordinarily takes 30 to 60 days. 70. During the construction process, no state inspections are conducted. Once construction has been completed, the building has to be approved by the State Trial Board. To prepare the approval, a Working Commission is appointed by the investor within five days of completion of the major construction works (including installation of equipment). T h i s Working Commission typically consists of the following representatives: 9 Investor-chairman ofthecommission 9 GeneralContractor (constructionorganization) 159 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan 9 Sub-contractors 9 Generaldesigner 9 Representativefromthe GeneralDirectionofFireSafety 9 Representativefromthe GeneralDirectionof Sanitary andEpidemiology 9 Representativefrom the MinistryofEcology andNaturalResources 9 Representativefrom the Ministry of Labor and Social Security (to verify compliance of equipment andlayout with occupational safety requirements 71. The contractor must submit the following documentation to the Working Commission: 9 The list of organizationsthat took part during the constructing andmounting works with the indication of the work performed by them and the names of engineers and technical staff who were responsible for the implementation of these works 9 The set of the design drawings presentedfor the acceptanceof the site andelaboratedby the project design organizations P Certificates, technical passports and other documents that certify the quality of the materials, constructions and details used during the implementation of the constructing and mounting works 9 Statements on the examination of the latent works and intermediate acceptance of the separateparts of the construction 9 Statements on the individual tests of the installed equipment, pipelines, internal and external water supply system, sewerage system, gas supply, heating and ventilation 9 Statementsonthe tests ofinternalandexternalelectricity networks 9 Statementsonthe tests of the telephonyequipment 9 Statementsonthe tests of thefacilities thatensure thefire safetyandlightingprotection . 9 Theregistersofthe works done 72. The Working Commission must conduct all necessary inspections and verify compliance with construction plans and all relevant rules and regulations. The working commission ordinarily requires 30 to 60 days to complete the verification process. Once verified, the Working Commission issues a statement of acceptance to be presentedto a State Trial Board. 73. Following the issuance of the statement of acceptance and the completion of all works, a State Trial Board, appointed by the local authority is formed. The members of the State Trial Board include: 9 Representativeofthe investor 9 Representativeofthe constructioncompany 9 Generalsubcontractor P Generalproject designer 9 Representativefrom theGeneralDirectionofFireSafety 9 Representativefrom theGeneralDirectionof SanitaryandEpidemiology 9 RepresentativefromtheMinistry ofEcologyandNaturalResources P Representative from the Ministry of Labor and Social Security (to verify compliance of equipment andlayout with occupational safety requirements 9 Representativefrom financing bank (insomecases) 160 INOTIS-Integrated Non-Oil Trade and InvestmentStrategyfor Azerbaijan 74. The following documentation, to be obtained from the Working Commission, must be submitted: 9 Documentonany defectsdiscoveredby theWorkingCommission 9 Approved project estimate documentation and the document on the main technical and economic indices of the site 9 The list of the project, scientific-research and other organizations taking part in the site projection 9 Documentsonthelandareaallotments 9 Documentsonthe geologicalandhydrology situation of the construction area 9 Certificates for the equipmentandfacilities 9 Statementsonthe siteandinstalledequipmentmadeby theWorkingcommission 9 Document thatcertifies theguaranteedsupportoftheacceptedsiteby the technical staff 9 Document indicating the sufficient quantity of the material andtechnical resourcesof the accepted site including the raw materials, electricity power, water supply, vapor, gas, compressedair and others 9 Documents (conclusions) of the public utilities organizationscertifying that the external lines of cool and hot water supply, sewerage system, heating system, gas supply, electricity and the links will allow the normal use of the site and that they have accepted them for the use 9 Document certifyingthe conformanceof the appliedcapacity of the site envisagedby the project 9 Document onthe costof theconstruction, signedby investor andsubcontractor 75. The State Trial Board again verifies the conformity of the building with the relevant regulations. Each member of the State Trial Board must sign an Act on State Acceptance of Finished Construction (occupancy permit). Within one month, the relevant local authority must approve the Statement. If a period of more than one month lapses, a new State Trial Boardmust be appointed. 76. Following approval, the local Department for Technical Inventorying and Registration of Ownership Rights (or, in the case of state land, the Department of Technical Figure 6.3-Time Required for Construction Permitting in Inventorying of State Properties under Selected Countries the MED) prepares a technical passport. Inpractice, it takes one to two months to Malaysia prepare the passport and it i s Azerbaijan recommended that full operations not Romania start untilit is completed. Hungaly Morocco 77. The last step i s the registration of Jordan the rights of ownership for the built-up site with the local Department for Georgia Technical Inventorying and Registration Bulgaria of Ownership Rights (or, in the case of Labia state land, the Department of Technical Russia1 7 ' - 1 Inventorying of State Properties under + , i the MED). Any outstanding duties, 0 10 20 30 40 50 60 together with a registration fee of AZM Average Number of Weeks 55,000 (US$112) must be paid before Sources: Private sector interviews and FIAS Administrative Barrier Studies in selected countries. 161 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan the registration certificate i s issued. The total time requiredto process the registration i s 10 to 15 days. Analysis 78. Once land has been acquired, the site development process i s often perceived as a long and complicated process. While such procedures can be time-consuming and frustrating in many countries, developing and developed alike, the process appears to be particularly arbitrary and unduly long in Azerbaijan. Buildingregulations and standards date back to the Soviet era and are not readily available to investors. Construction permitting can be a lengthy process, though Azerbaijan compares favorably to a number of other developing and transition countries (see figure 6.3). Obtaining environmental clearances are complicated by the lack of adequate resources at the Ministry of Environment. According to the recent FIAS procedures for obtaining utility connections are unpredictableand often problematic. 79. The occupancy permitting process tends to be even more time consuming. Redundant reviews are carried out by a Working Commission to be adjournedby the investor and a State Trial Board appointed by the relevant authorities, which must be done sequentially, implying 162 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan a minimum two-month delay before a newly constructed property may be occupied. Throughout the site development process, in the absence of clear guidelines and procedures, investors are often subject to illegal rent extractions by public officials in order to accelerate the process. 80. The problems faced by investors in the site development process are indicative of the problems faced throughout the administrative system-unclear rules and lack of access to information, bureaucratic delays, public sector interference into private sector development beyond the scope of law, and illegal rent extraction. Given the wide range of difficulties associated with the site development process, it i s not surprising that, according to FIAS' Investment Climate and Administrative Cost Survey, many in the private sector rated site development as a major obstacle to doing businessin A~erbaijan.~~ Recommendations 81. Review building codes and standards. While it i s beyond the scope of this study to provide an in-depthreview of Jordan's building codes and standards, it i s recommendedthat a comprehensivereview be done inorder to ensure that these standards are up to international best practice and allow a sufficient degree of flexibility in the application of new materials and/or technologies. 82. Streamline permitting procedures.The occupancy permittingprocess appears to be particularly onerous, with redundant inspections and approvals by the Working Commission and the State Trial Board. The roles of these two bodies should be re-evaluated, with the possible elimination of one of these bodies. In any case, time-bound timeframes for inspections and approvals should be introduced. At the same time, periodic inspections by the relevant bodies during the construction process could ensure that construction i s proceeding according to the plans and regulations, reducing the possibility of violations discovered upon completion. 83. In many jurisdictions worldwide, including the United States and most European countries, for minor works, construction permittingi s an "automatic" filing process, subject only to the submission of a notice, which includes confirmation that all codes and standards have been observed. The necessary documentation is simply filed. Enforcement comes in the form of thorough inspections and high penalties for non-compliance. The normal approval process i s reserved for only major works. And even in the case of major works, in some countries, such as the United Kingdom, investors may contract an "Approved Inspector" in lieu of the normal permittingprocess. Box 6.4 provides a sample of how such procedures work in the United Kingdom. As a general rule, the site development regulators should move to approachbasedon compliance monitoring. Inthe longer run, thought should be given to moving away from the vast number of approvals and pre-approvals that are required in approving architectural designs to a system based on more effective monitoring and compliance. This would reduce the workload for the relevant agencies and investorskontractors, alike. The effective implementation of such a regime must follow, however, a comprehensive review of existing buildingcodes with a view to simplifying the systemandimproved compliance monitoring and the impositionof appropriate penalties. 84. Provide guidebooks. Given the complexity of the construction process, it would also be valuable to create guidebooks and other materials that clearly explain the process, the 97 FIAS, p.A-6. 98 FIAS, p.53. 163 INOTIS-Integrated Non-Oil Tradeand InvestmentStrategyfor Azerbaijan documentation that is required at each step, and so on. This could be incorporated into a comprehensive guidebook covering the full range of locating issues and procedures. This would be further enhancedby the availability of standardizedapplication forms, which many of the agencies presently lack. 85. Encourage the development of industrial estates and zones. The availability of industrial land andready-to-occupy facilities is one of the most important contributing factors to an investor's location decision. Typically, governments play a key role in facilitating investment start-up when they actively encourage private industrial park development and enter into partnerships to develop the legal and physical infrastructure for industrial and commercial location. The availability of such facilities can substantially reduce the burden of company start-up by simplifying andor reducing procedures for construction and occupancy permittingand by providing easy access to utilities and other infrastructure. In this respect, the regime for acquiring land in Azerbaijan falls short. The establishment of a Special Economic Zone, currently under consideration by the Government, will require a careful definition of the overall legal and operational framework buildingon worldwide experience. The development of a world-class economic zone regime offers the potential to improve trade efficiencies, promote processing activities, and facilitate regional trade. The zone could have an important "demonstration effect" by de-regulating and de-monopolizing services (such as telecommunications), expedite the implementation of IT systems (such as a computerized customs system), and be a model of good governance. It can assist enterprises to use Azerbaijan as hub to serve markets inthe Caspianregion more cost effectively. 164 8 .3 > 2 r= 0 3 8 ci 13 13 e, F Z 0 5 M c 0 E ?;' 0 6) rr 0 i 3 INOTIS-Integrated Non-Oil Trade and InvestmentStrategyfor Azerbaijan VI. ENTRY EMPLOYINGWORKERS AND 86. This chauter examines the various ~~ procedures related to immigration and employment issues. Specifically, this chapter will detail the procedures involved in obtaining 1 For 24 hours I US$lO I visas to enter Azerbaijan, obtaining work and For 48 hours us$20 residence permits for expatriates, and For 72 hours US $30 From 3 days to 1 month US $40 proceduresfor hiringand firing Azeri workers. I From 1to 3 months 1 For . . ... . . - ...-.....- I US$80 I _ -_-. delayedvisa (per month) I US $50 I V1.a. ObtainingBusinessVisas 87. A prospective foreign investor must obtain an entry visa inorder to enter Azerbaijan. Inorder to obtain a businessvisa, prospective investorsmustfirst obtain a letter of invitation from a private business, state entity or non-governmental organization that i s accredited to register such invitations. 88. If the inviting entity is not yet accredited, an application for accreditation must be filed with the Ministry of Foreign Affairs, together with the following documentation: 9 The application to Consular Department of the Ministry of ForeignAffairs of Azerbaijan Republic signed by the headof the company andcertified by an official seal 9 Notarizedcopy ofthe charterofthe company 9 Notarizedcopy ofthecertificate about stateregistrationof the legalperson(ifcompanyis the foreign legal person, a notarized copy of the certificate about registration of branch or representationinAzerbaijan) 9 The reference from the Ministry of the Taxes of Azerbaijan Republic about the fact of registration of the company as the tax-payer 9 The passport of the manager of the company, if hehhe is the citizen of the Azerbaijan Republic (if the manager of the company i s a representativeof other state, then certificate on the right to work in Azerbaijan certified by Department of Migration of the Ministry of Labor and Social Security of Azerbaijan Republic) 89. No official fees are collected. Approvals can take anywhere from 10 to 30 days. Accreditation is valid for one year, but can be renewedprior to its expiration. The application for a business visa must be filed in the investor's country of residence. Applications should be filed with the diplomatic representation of the Azerbaijan Republic, together with the following documents: 9 Theoriginal of foreign passportof the visitor 9 Color photos 9 The original of the letter of invitation of the company in Azerbaijan (the inviting entity may also forward the letter directly to the Ministry of Foreign Affairs). In some cases, other documentationcontaining informationon the purposesand terms of visit may be requested. 90. Business visas are available for single entry, double entry, or multiple entry (one- year). Fees are, respectively, $40, $80, and $250. Each entry may be for up to 90 days. Visas may, however, be extended for an additional fee, depending on the duration requested. Visas are generally issuedwithin 5 days. 168 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan 91. Within 3 days of entry into Azerbaijan, visa holders must register with Ministry of Internal Affairs. If the investor is staying in a hotel, the hotel can complete the registration, with the requisite state dues added to the price of hotel accommodation.If the investor i s not staying in a hotel, registration may be done at a local branch of the Visa and Permit Department of Ministry of Internal Affairs (one branch is present at the airport). In addition to presenting their passport and visa, applicants must provide documentation proving their right to reside intheir place of accommodation (e.g. lease contract). Registration is ordinarily completed in one day. State dues are AZM 27,500 (US$6) for visits up to 30 days, and AZM 49,500 (US$lO) for more than 30 days. Visitors must notify each changeof accommodation. Analysis 92. Ingeneral, the proceduresfor obtaining a business visa are similar to other countries and are not particularly onerous. While the procedures for obtaining a business visa are relatively straightforward, interviews with the private sector suggest that there i s a lack of adequate information regarding the accreditation process. While the process is, itself, simple and approval more or less automatic, there i s a general level of misconception among the private sector, particularly SMMEs, about the process and required documentation. As a result, many investors obtain, instead, tourist visas for their visits to Azerbaijan, which do not require a letter of invitation. 93. While entry into Azerbaijan i s relatively simple if the visitor arrives by air, it i s reported that clearance at the land or sea borders tends to be more difficult and arbitrary as these entry points, due to their distance, are generally outside the scrutiny of the national government and/or private sector. Recommendations 94. Simplify visa processing. While the visa processing does not constitute a major obstacle to doing business, there still is room for improvement, making the visa process more transparent and reliable, faster, and cheaper. The number and speed of approval for tourist visas could serve as a benchmark for improvement. It may make sense to do away with visa requirements for visitors from an increasing number of visitor categoriesas i s current practice inotherparts of the world. 95. Improve land and sea border controls. The border control system for car and train passengers clearly needs more attention. It i s necessary to systemize the examination procedures carried out at all border points and monitor, in particular, procedures at outlying borders. 96. Provide written guidelines. As a short-term measure, the dissemination of practical information regarding the visa procedures could be reviewed and improved where necessary to avoid delays due to faulty or incomplete visa applications. This includes the provision of informationto the local business community regarding the accreditation process. V1.b. ObtainingWork Permits 97. All expatriate workers must obtain work permits in order to be employed in Azerbaijan. The process for obtaining a work permit is regulated by the Law on Labor Migration. 169 INOTIS-IntegratedNon-Oil Tradeand Investment Strategyfor Azerbaijan 98. As in the case of foreign investors, entry of expatriate workers into Azerbaijan are subject to invitation by accredited entities in Azerbaijan (see previous section on accreditation procedures). Work permits are granted by the Migration Department of the Chief Employment Department of the ministry of Labor and Social Protection. 99. Work permit applications must be filed by the prospective employer, with the following documentation: 9 Copy of accreditation 9 Certified documentationof the qualifications of the foreign worker (diploma, certificates, etc.) 9 Indicationof thenecessity torely onaforeign employee (as opposedto alocalone) 9 Copy of document certifying prospective employee's right to stay in Azerbaijan (if already present incountry) 100. Applications are generally processed within 30 days. Permits are issueduponpayment of state dues inthe amount of AZM 220,000 (US$45). Permits are validfor one year and may be renewed up to 4 times. 101. As inthe case of other visa holders, work permits holders must register with the Visa and Permit Department of Ministry of Internal Affairs within 3 days of arrival inAzerbaijan. Analysis 102. As in the case of other visa applications, the procedures for Figure6.4-Time Requiredto ObtainWork Permitsin obtaining a work permit are generally straightforward. Hong Kong Singapore 103. Nevertheless, procedures and Malaysia documentation requirements are not well Hungary understood, leaving scope for delays in LaMa processing and rent-seeking. Reports of Lithuania delays and unofficial payments to Croatia facilitate processing are, reportedly, Slovenia relatively common. The need to receive Azerbaijan accreditation prior to submitting work permit applications appears to add an 20 40 60 80 100 120 unnecessary burden, without serving a Average Number of b y s particular interest on the part of the state. The average length of time to obtain work permits inAzerbaijan, compared unfavorably with many other transition countries (see figure 6.4). Recommendations 104. Streamline permit processing. The procedures for obtaining work permits, which includes accreditation of firms to hire foreign workers, tend to be overly cumbersome. Eliminating unnecessary application procedures or rolling them into a single application (accreditation and work permits) can reduce red tape without compromising Azerbaijan's interests in limitingexpatriate employment. Introducing time-bound deadlines for application processingwould further improve the environment. 170 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan 105. Provide clear, written guidelines. As in other areas of administration, the provision of clearly documented procedures and information requirements would reduce delays due to application errors and increasetransparency. V1.c. Hiringand Termination 106. Labor relations, including hiring and firingprovisions, are regulatedby the new Labor Code that entered into effect in 1999. Employing procedures for registered companies are the same whether the investors are locals or foreigners. There i s no need for government approval when hiring local employees. However, all registered companies must register the employees with the StateFundfor Social Security (see chapter 111). 107. The Labor Code establishes the necessary provisions for a contractual agreement between legal entities and employees, whether the employee i s local or an expatriate. Written employment contracts are compulsory and are usually valid for an unlimitedperiod. Fixed- term contracts, either for five years or less, or for the duration of a project, are possible under certain conditions. Collective contracts are also permissible. Contracts may be concluded with any individual aged 15 or older, however, for those between the ages of 15 and 18, parental or trustee permissionmust be granted. 108. All labor contractsmust include the following information: 9 Thename, surnameandpatronymic of theemployee P Thenameandlegaladdress of the employer 9 Theproposedposition ofhiredemployer 9 The date of signing of the contractandstartingthe activities 9 Validity of theconcludedlabor contract 9 Thejob description oftheemployee 109. According to labor legislation, an employer must provide employees working at their primary place of employment for more than five (5) days with a work book. A work book i s the key to establishing the employee'srights to state-provided pension benefits. An employee entering into an employment contract (except in cases where a contract i s concluded for the first time) must present to the employer his or her work book. However, this requirement does not apply to expatriate employeesworking for the first time inAzerbaijan. 110. All employers in Azerbaijan are required to contribute to the State Fundfor Social Security and the Employment Fund, 30% and2% respectively, basedon gross salaries paid to employees. All categories of employees (except for foreign employees unless otherwise provided by interstate agreements) are also obliged to contribute 1% of wages to the Social Protection Fund (deducted from paycheck and remitted by employer). Additionally, 1% of the entity's balance sheet profit must be remitted to the Fundfor Social Protection of Invalids. Employers are not obliged to make contributions to the Social Protection Fundwith respect to the income of foreign employees except as otherwise provided by interstate agreements. 111. The regular work week is forty hours. Overtime work as a rule is not allowed unless necessary for state defense, public safety, ensuring the supply of public utilities and incertain other situations, and may not exceed 120hoursper year. 112. Wages may not be lower than the minimum monthly wage. The current minimum wage is AZM 27,500 (US$6). Statutory benefits include paid holidays, annual leave, 171 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan maternity leave, illness and disability leave. There are 15 official days off. The minimum paidannual leave is 21 calendar days. Wages must be paid for temporary illness or disability. Sick leave pay i s provided by the Social Protection Fund, not the employer. Women are entitled to paid maternity leave for seventy calendar days prior to and an additional fifty six days (incertain cases seventy) after the birth of a child. Maternity leave pay i s provided by the Social Protection Fund, not the employer. 113. Employment contracts may include a three-month probationary period during which an employee may be dismissedwithout reason. Thereafter, dismissals for economic reasons are restricted. Dismissals without notice are limited to cases of drunkenness, theft, and "immoral activity." Dismissal for other reasons, such as incompetence, must be precededby a history of under-performance. Under fixed-term contracts, notice of dismissal must be made at least one day before the contract expires, otherwise the contract will be regarded as renewedand the appointment madepermanent. Analysis 114. Hiringprovisions are relatively liberal, with no quantitative constraints on the employment of expatriate workers. More important, however, are the relatively strict provisions for dismissal and generous statutory benefits that especially impact Dunparv - . I 43 I 22 SMMES. Armenia 49 40 Georgia 49 51 115. Dismissals for economic reasons are /Kazakhstan I 49 I 59 restricted. Dismissals without notice are h a i n e I 58 I 68 limited. Dismissal for other reasons, such as incompetence, must be preceded by a history of under-performance. Consequently, in kussian Fed 68 I ~ 68 practice, many small and medium enterprises Croatia 74 42 do not formalize labor relations unless compelled by circumstances (an upcoming inspection by tax or social fund authorities). While these provisions are viewed as less of a burden thanin some other countries in the region (see table 6.9), their negative impact on investment andbusinessdevelopment. 116. The Labor Code also imposes European Union-style restrictions on working hours and large minimum requirements to paid holidays, maternity leave, and other statutory benefits. Such provisions can substantially increase operating costs, which can weigh particularly heavy on SMMEs. 117. Minimumwage requirements, on the other hand, are not very restrictive as they are far below the average wage rate. Currently it equals approximately one-tenth of the average wage and is below the level of subsistence wages and is, therefore, of little import in the negotiation of wages. Recommendations 118. Relax restrictive hiring and dismissal provisions. While hiring provisions are relatively liberal, more flexible labor provisions, particularly in terms of dismissals, together 172 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan with investments to assist unemployed persons-such as skills training and an adequate social safety net-are generally more helpful in achieving the increased efficiencies that ultimately determine competitiveness and promote sustainable economic growth and reduced poverty. 173 c c 0 c 0 .-C 0 .-C 0 c c cm C c m C 8E 8E Q aa, Q a 8 2 -I fa .-c 0 e m s OB -'i.9p'i; E .! E < 0 c 5 n ; .e4 0 4 0 C c Is) E I- .-C0m +0 .-c c > sa, .-C c0 c 0 .-3 > a, L -a,a, L V + c C 2 .-0 c c .-a> S c c a, 0 0 C m .-0c a, gg 5mL : .-a P c > a , c ? Is) u.E e 4 ,".E v ) > aa, c\i i cd INOTIS-Integrated Non-Oil Tradeand InvestmentStrategyfor Azerbaijan VII. OPERATINGA BUSINESS 119. This chapter reviews the taxation system and tax reporting requirements for investors in Azerbaijan, other reporting requirements, and the Customs regime, including the procedures for importingand exporting goods to and from Azerbaijan. VI1.a. ReportingTaxes 119. All Azerbaijani enterprises, representative offices, branches andforeign entities which conduct business activity in Azerbaijan through a "permanent establishment" must register with the Ministry of Taxes without regard to whether their activities are taxable in Azerbaijan. In order to reduce the incidence of tax evasion, the necessary information i s forwarded to the Ministry of Taxes from the Ministry of Justice at the conclusion of the business registration process. Registration for tax identification number must still, however, be completed by the business entity (the procedures for which were described inChapter 111). 120. There are presently three separate and distinct tax regimes that are applicable in Azerbaijan: the statutory regime, the oil consortia regime, and the Main Export Pipeline regime. The Main Export Pipeline regime applies to enterprises working on the Baku-Tbilisi- Ceyhan oil export pipeline. The oil consortia regime i s governed by the PSAs that have been ratified by the Milli Majlis. The statutory tax regime i s applicable to all other entities operating in Azerbaijan. All legal entities that are tax bearers are required to submit annual tax reports to the Ministry of Taxes. 121. Recent policy reforms inAzerbaijan include a substantial overhaul of the statutory tax regime, including the introduction of a new Tax Code, the first codified digest of Azerbaijani tax law which came into effect in January 2001. In addition to the consolidation of tax law into a single unified code, the new Tax Code provides for revised rates and new procedures for filing and auditing. 122. The following provides a brief overview of the main types of taxes assessed under the statutory tax regime: 9 Corporate profit tax is levied on all legal entities inAzerbaijan, both Azerbaijani and foreign. Legal entities, including those entities with foreign investment, are taxable on worldwide gross annual income, less allowable deductions. Branches and taxable representative offices of foreign enterprises are taxed only on profits from activities performed in Azerbaijan. The corporate tax rate is presently 27 percent on worldwide income. Deductions are limited to wages, doubtful debts related to the sale of goods and services, and depreciation. Deductions for travel, advertising, and other business expenses are minimal. Taxes must be paid on a quarterly basis and all records must comply with local accounting standards. The tax declaration for the past financial calendar year needs to be submitted before April 1of the following year. 9 Simplified turnover tax is assessed in the place of corporate tax rates on small businesses with less than AZM 30,000,000 (US$6,125) turnover in the last 3-month period. Taxes are to be paid on a quarterly basis and the tax declaration needs to be submitted no later than 20 days after the end of the quarter inquestion. 175 INOTIS-IntegratedNon-Oil Trade and Investment Strategyfor Azerbaijan 9 Value added tax is levied at a rate of 18 percent and must be declared and paid by all legal entities operating in Azerbaijan on a monthly basis. The declaration due date i s no later than the 20th of the following month. Exports are zero-rated and limited exemptions exist for certain goods and services, including leasing, currency or securities transactions, goods and services purchased under international loans agreements, equipment imported under financial leasing agreements, publications, fruits and live animals, certain chemicals and metals, and energy. 9 Excise tax is levied on the production or import of certain products, including tobacco products, alcohol, diesel fuels, fuel, and oil. Tax rates range from 26 to 65 percent. Excise taxes must also be declared and paid on a monthly basis. The declaration due date i s no later than the 20th of the following month. 9 Property tax is assessed at the rate of 1.0percent of the average annual value of fixed assets, except for vehicles and aircraft, which are subject to tax at rates that depend on engine capacity. Enterprises must make advanced payments on a quarterly basis. Those legal entities in the possession of taxable objects submit their asset tax declaration annually together with the profits tax declaration. 9 Land tax is levied as a fixed payment on all land plots, irrespective of the financial results of the economic activity of owners or users of the land. Tax rates depend on quality scores assigned to each parcel of land based on the quality, location, and level of water supply. Both individuals and legal entities are required to pay their land tax in two equal installments. The landtax declaration i s due on May 15 of the following year. P Tax on trade must be paid by companies engaged inresource extraction in Azerbaijan. The accounting periodi s the calendar month. The tax on trade declaration i s due no later than the 20th of the flowing month. 123. All the above taxes must be reported to the Ministry of Taxes during the specified periods. No fees are collected for the submission of tax reports, though penalties of 220,000 to AZM 330,000 (US$67) apply for late submissions. 124. Tax payments may be submitted through local banks to the State Treasury. Typical bank charges amount to 1%of the total sum transferred. Incertain cases, such as VAT due on imports, tax collection is also exercisedby Customs. 125. Tax control by the Ministry of Taxes i s carried out through audits, including onsite inspections and office audits. A large taxpayers unit has been established inBaku to facilitate the processing and auditing of large-scale taxpayers. 126. Routine, paper-based audits are carried out each time a taxpayer files a return. The audit i s carried out within 30 days of the submission. If errors are detected, the taxpayer has 30 days to respond. Incases of underpayment, the taxpayer has 5 days to pay the sum due and any penalties. 127. Comprehensive, onsite audits may also be carried out, based on a substantiated decision of the tax authority. Onsite tax audits may be conducted once per year, over a maximum 30-day period (which can be extended to three months by the decision of a higher tax body). Such audits may only cover a maximum of three years of activity. Repeat 176 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan inspection of the same declarations are not permitted. Taxpayers are notified at least 15 days prior to the inspection date. 128. Extraordinary tax audits may be carried out in special circumstances, including when there i s a determination of deliberate misrepresentation of information or repeated failures to file and pay taxes. In case the inspected legal entity disagrees with the results of tax audit, a second audit (by a different team of officials) may be requested. 129. Annual internal audits are mandatory for joint-stock companies, enterprises with foreign investments, banks and other credit organizations, insurance companies, enterprises with limited liability, investment funds, and also financial and industrial groups. The audit must be conductedby independent auditors. Analysis 130. Taxation i s often cited as one of the top issues concerning the private sector in developing countries and Azerbaijan i s no exception. Evidence from the first decade of transition across the region shows that the most dynamic parts of transition economies are new or restructured enterprises that employ fifty or fewer workers. Though Azerbaijan comparesotherfavorably with Figure 6.5-Business Perceptionsof Tax Administration in many transition countries in the region, interviews with the private sector in Azerbaijan suggest that taxation continues to be among the most prominent of the difficulties in the investment climate facing such firms. Unduly high rates of taxation, combined with a complex tax code, can lead companies to either purposefully or inadvertently underestimate their income andor tax liabilities. No obstacle Minor obstacle Moderateobstacle Major obstacle 131. While Azerbaijan's ' Source: EBRDandWorldBank,BusinessEnvironment andEnterprisePerformance new Tax Code has made Sumey72002. substantial progress towards introducing standards and concepts common in international practice, several issues remain to be addressed: > The tax system undergoes amendment on a frequent basis and remains one of the more complex aspects of the Azerbaijan business environment. The absence of clear, readily available printed materials explaining the tax code in layman's terms makes it difficult for investors to keep pace with changes, particularly small entrepreneurs that cannot afford the services of facilitators. > The new Tax Code, while it has provided a substantial improvement in terms of clarity over the previous range of legislation, still falls short in specific areas, where contradictions with other laws and regulations are evident or definitions remain ambiguous and/or contradictory. 177 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan 9 Presently, there are no special tax incentives offered to stimulate foreign investment. While a single, flat tax rate i s generally considered less distortionary and easier to administer than tax holidays and/or differentiated tax rates, the effective tax rate in Azerbaijan i s relatively high due to the limited range of deductions and the absence of double tax treaties (beyond a small group of countries) that would lower the overall tax burden in light of the worldwide tax jurisdiction that is presently imposed. P While the large taxpayers unit that has been set up in Baku will greatly facilitate compliance by multinational and other large taxpayers, the required use of local accounting standards i s seen as problematic. Azeri Accounting Standards (AAS) differ in many ways from International Accounting Standards (IAS). Suchtaxpayers must keeptwo separate set of accounts, one in compliance with AAS and one in compliance with IAS for their headquartersabroad, which increasesthe burden of compliance. 132. Interviews with the private sector indicate that the process of filing returns i s difficult and subject to illegal rent extraction. The forms are complex and difficult to understand. While large companies have the resources to hire accountants and other facilitators, small companies must go through the process without any guidance. It has been reported that tax officials are either unableor unwilling to provide guidance and little i s available inthe way or written instructions. As a result, tax reports are often rejected and/or taxpayers are solicited for illegal payments to facilitate their processing. 133. Likewise, interviews with the private sector indicate that auditing procedures tend to be highly problematic and are a regular source of illegal rent extraction by government auditors. Informal payments are often solicited by government auditors to overlook small, unintentional infringements resulting from the complexities of the Tax Code, as well as larger, intentional infractions. The abuse of audits has also been perceived as a source of harassment and interference with private enterprises. In light of this growing problem, the September 2000 Presidential Decree "On Prevention of Interferences Impeding the Development of Entrepreneurship" included explicit proscriptions on the auditing activities of the Ministry of Taxes, including a prohibition on audits that last longer than envisaged by the legislation and that go beyond the limits of their authorities; a reduction on the number of on-site audits and the prevention of repetitive, unjustified audits; and the dismissal of 40 percent of the structural divisions of the Ministry engagedinauditing andrelated functions. Recommendations Specific actions that can further improve the tax system include: 134. Further Strengthening of Tax Code. A comprehensive review of the Tax Code i s required to ensure that all issues are addressed in the next round of revisions-a frequently changing tax environment creates uncertainty for investors that require a certain degree of stability to plan their operations. Some issues that should be addressedinclude, inter alia, the following: 9 Gaps and inconsistencies with other laws-For example, while the Insurance Law classifies insurance brokerage services as insurance activities, the Tax Code does not, precluding such services from the more beneficial tax treatment accorded to income derived from insuranceandfinancial services activities. 9 Tax regulations-Currently, tax regulations are dispersed and are not harmonized with the new Code, adding a further layer of confusion. 178 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan 9 Provisions regardingtax administration-Currently, a number of administration related issues are contained in other legislation and need to be incorporated into the new Tax Code in order to create a truly unified set of legislation. 9 Allowable deductionsfor businessexpenses-The provisions for allowable deductions are unclear and lead to discretionary interpretation by both the public and tax officials. Moreover, the limited range of deductions leads to a relatively higheffective tax rate inA ~ e r b a i j a n . ~ ~ 9 Dispute settlement-Dispute settlement mechanisms are insufficient to address the concerns of taxpayers. An impartial appeals mechanism should be established to protect taxpayers and increase confidence inthe system. 99The MOT claims that the determination of deductible expenses i s consistent with IMFrecommendations and international norm. 179 INOTIS-Integrated Non-Oil Tradeand InvestmentStrategyfor Azerbaijan 9 InternationalAccounting Standards-Currently, localaccountingstandards mustbeused. Azeri Accounting Standards(AAS) differ inmany ways from International Accounting Standards (IAS). Multinational taxpayers must keep two separate set of accounts, one in compliance with AAS and one in compliance with IAS for their headquartersabroad, which increasesthe burden of compliance.loO 135. Further streamline tax reporting. The Ministry of Taxes has improvedtax reporting practices by revising procedures for receiving tax returns and permitting taxpayers to submit returns personally, through an authorizedrepresentativeor by mail. However, interviews with the private sector point to other issues that need to be addressed. The forms are deemed to be relatively complex, particularly for small entrepreneurs. Simplifying tax forms and increased use of no-contact filing mechanisms-including, eventually, electronic means"'-would reduce the burdenon investors, particularly SMMEs. 136. Improve transparency of auditing practices. Auditing procedures also tend to be highly problematic and have been a regular source of illegal rent extraction by government auditors. The abuse of audits has also been perceived as a source of harassment and interference with private enterprises. The introduction of a risk-based system, whereby audits are targeted at non-compliant businesses, would further ensure that audits are no longer a source of administrative abuse. 137. Increase public awareness. The tax system undergoes amendment on a frequent basis and remains one of the more complex aspects of the Azerbaijan business environment. The absence of clear, readily available printedmaterials and training programs explaining the Tax Code in layman's terms makes it difficult for investors to keep pace with changes, particularly small entrepreneurs that cannot afford the services of facilitators. Foremost among these i s the provision of clear and well-defined procedures and rules for calculating and submitting tax returns to increase the understanding of the private sector and reduce the discretionary powers of the tax authorities in interpreting tax law. Better access to consolidated, simplified written materials i s essential to increasing transparency and simplifying the system. 138. Introduce Taxpayer's Charter and Customer Service Training. A charter of rights for taxpayers, such as the one described in the box below, coupled with customer service training for tax officials can further improve the environment and improve revenue collections as taxpayers will be more inclined to report their activities accurately if they know that they will be guaranteedfair treatment. 139. Negotiate double taxation treaties. Azerbaijan has entered into bilateral tax treaties with 13 other countries,l02 including several CIS partners, as well as Great Britain, Norway, Germany and Poland. N o such treaties have beenconcluded with a number of other potential sources of foreign investment, including the United States, Canada, Japan, France, and Italy, among others. Tax Treaties play an important role in curbing fiscal evasion and encouraging foreign investment through the prevention of double taxation-Azerbaijan should actively seek to conclude tax treaties with the most promising sources of foreign investment. looThisis being achievedthrough the Draft Accounting Law, which i s currently beingfinalized. A draft law on digital signatures andelectronic documentation i s under review. lo*Double tax treaties are in force with Great Britain, Germany, Austria, Norway, Turkey, Poland, Russia, Moldova, Ukraine, Georgia, Kazakhstan, Uzbekistan, and Pakistan. 180 INOTIS-Integrated Non-Oil Tradeand Investment Strategyfor Azerbaijan VI1.b. Other ReportingRequirements 140. Inaddition to tax reporting, companiesarerequired to report their activities to several other entities, including the State Fund for Social Security and the State Statistical Committee, which are describedbelow. 141. All legal entities are required to register with and pay social taxes to the State Fund for Social Security. Registration proceduresare describedinchapter 111.While reporting only i s requiredevery quarter, the social insurance contributions themselves need to be paid to the State Social Security Fund on a monthly basis. Like the tax authorities, the State Social Security Fundalso has the right to perform audits. Routine, paper-basedaudits are carried out at the time of reporting. Onsite audits may also be carried out. Due to the narrow focus of such inspections, they rarely last for more than three days. 142. All legal entities are also required to submit regular reports to the State Statistical Committee. Registration procedures are described in chapter 111. Reporting of various activities are conducted on a monthly, quarterly and/or annual basis. Types of information that mustbeprovided includes: investments of the entity, investments to the entity, sourcesof the investments, information on financial state of the entity, information on number of 181 INOTIS-Integrated Non-Oil Tradeand InvestmentStrategyfor Azerbaijan employees and wage rates, information on production volumes and sales, kinds of given services and manufactured goods. Penaltiesare imposedfor late submissions. Analysis 143. As in the case of tax reporting, while the reporting process i s simple in principle, complex and confusing forms for reporting to both the State Fundfor Social Security and the State Statistical Committee creates bureaucratic delays and opens the door to illegal rent extractions. The lack of clear instructions, in written form or by officials, leads to further frustration and unnecessarydelays. Likewise, the auditing procedures for the State Fund for Social Security, though less problematic than tax inspections, have been a subject for bureaucratic delays and illegalrents. Recommendations 144. Simplify forms and publishclear guidelines. While the information that needsto be provided i s relatively straightforward, the forms themselves lead to much confusion among the business community. For example, businesses have reported that calculating social contributions i s relatively easy, but filling in the forms correctly i s often difficult. A re-design of the forms, together with clear written guidelines for both businesses and government officials, would reduce unnecessary delays, as well as the scope for illegal rent extractions. 182 2ce, mA a 3 ."e, v) ."> Y .e 2enc Y B e7 9 a5 .Y m5 ru 0 5 4 3 & m9 a ."1 2 F se,2 P ee, E Ym X ru 0 sEx3 Y .9 e, L a m e , m INOTIS-Integrated Non-Oil Trade and InvestmentStrategyfor Azerbaijan VIII. IMPORT AND EXPORT PROCEDURES 145. The State Customs Committee (SCC) is the central governing body for customs administration in Azerbaijan. Overall policy and operational responsibility i s vested in the SCC. Azeri customs operations and import and export procedures are governed by the following set of legislation: 9 CustomsCode(1997) 9 Tax Code (2001) 9 Law onCustomsTariffs 9 Rules of RegulationofImportExportOperations(1997), hereinafter"Rules" 9 Decrees of the Cabinet of Ministers to fix import/export duties, which are regularly updated 9 Regulations onCustomsDelivery of Goods, Transport Facilities, andRelatedDocuments (adoptedby the SCC onNovember 29,2001) 9 Instructions on SimplifiedandPrivilegedRegime of Transportation through the Customs Borders of the Azerbaijan Republic of the Goods for Non-Production and Non-Commercial Needs (adoptedby the SCC on August 28,2001) 9 Rules of Transportation through the Customs Borders of the Azerbaijan Republic of the Goods for Non-Production and Non-Commercial Needs (approved by the Decree of the Cabinet of Ministers of the Azerbaijan Republic from May 30, 2001) 9 Bylaws ofCustomsCarrier (fromFebruary28, 2002). 146. The Customs Code provides for 15 different types of regimes that serve to determine the status of goods moved through the customs border. The customs regimes can be classified, broadly, into three groups. The first group includes import, export, re-export and re-import, temporary import and export, the destruction of goods, transit, production under the customs supervision, or refutation for state's benefit. The following text box provides the detail on all the different regimes. These different regimes may be obtained by receiving, where required, the permission of the customs authorities, issued on a case-by- case basis, and by conforming to the procedural requirementsof the Customs Code. Inpractice, not all the regimes provided for in law are in use, either due to lack of demand (e.g. duty-free trade stores, free depots) or the lack of implementing regulations (e.g. free customs zone). The following discussion focuses on the most common regimes in use, namely import, export and transit. 147. Import and export licenses and permits are required for some selected goods. Table 6.12 below provides the different categories and speciifc products that are restricted. 184 INOTIS-Integrated Non-Oil Tradeand InvestmentStrategyfor Azerbaijan Veterinarydrugs andequipment, food products of animal Medicaldrugs Goodswith ozone-destructingcontent Exportssubjectto permissionby 0 Wild animals andwild plants relevant authorities Snake and scorpionpoisons, animal or plant-originateddrugs 0 Antiques andfine art objects Strategic commodities, includingoil products, cotton, electric power, non-ferrous metals Importssubject to license by Ethyl spirit andalcoholicbeverages MED(also subject to Nicotineproducts quantitativerestrictions) 149. Both importers and exporters must notify customs of its intent to transfer goods and transport to or from the customs border. Goods and transport delivered must be conveyed to the customs control at the designatedplace and the documentation i s furnished to the customs authorities. Conveyance means notification of customs about arrival of goods and transport within 1hour from time of arrival (or 1hour after beginning of customs' workday, if delivery took place during nonworking hours). 150. Once the goods are conveyed to Customs, it is authorized, where necessary, to take at its own expenses samples from goods and send them to customs-operatedlaboratories, where quality and other analyses may be done. The owners of goods or other authorized persons are entitled to participate in sample taking and be furnished with a copy of laboratory's report. Other state agencies (e.g., veterinary) may also take samples, provided customs officers and owners of goods are present. Size limits are not provided for samples, but they must be "reasonable". 151. The carrier or owner of goods may, at request of customs officials and where it is necessary, present a short declaration during or at the latest a day after the conveyance of goods to customs. Transport and commercial documents, as well any other document in any language known by customs officials, may serve as a short declaration. The declaration may not be presentedonce the goods have beenplaced under some customs regime, but only prior to that. 152. From the time of conveyance until the goods are allowed to cross the border or be placed under some regime, Customs takes the goods for temporary storage in a special storage warehouse, until it furnishes the carrier with declaration forms. Documentation for goods and transport i s required for pro tem storage. Pro tem storage i s up to 2 months or shorter for perishable or other goods. The following operations may be carried out while goods are in the storage: measuring, sample taking, and preventing goods from getting destroyed. 185 INOTIS-Integrated Non-Oil Trade and InvestmentStrategyfor Azerbaijan 153. All goods crossingthe customsborder of the country or beingplacedunder a different customs regime must be declared to the customs authority, either orally, written, or electronically by giving information on goods and the selected customs regime. The declaration must be filled in and given to Customs not later than 10 days from date of conveyance of goods and transport to Customs. Goods for non-commercial use delivered in hand and accompanying baggage must be declared immediately. The carrier of goods or a customs broker may act as a declaring person. 154. Once the declaration is filled, the declaring person giveshends it to the customs office, which registers it. In cases in which the declaring person cannot provide all information required for the declaration, it fills in a temporary or partial declaration with the rest of information to be provided within a period of time determined by the customs office. For those who regularly deliver the same goods and transport, a regular declaration exists for the defined period of time. Also, a simplified declaration system may be in use for some operations. 155. After the declaring personfurnishes the Customs with full declaration, within 10days (for perishable goods, postal for courts, and other goods per Article 131of the Customs Code the term i s 3 days) the Customs must complete the inspection of the customs declaration and documentation, all goods and transport. All documents related to goods and transport are checked. Other state authorities, conducting control over importedexported goods, may conduct inspections as well. Those authorities are: sanitary and plant control; veterinary control; environmental control; and others, as the case may require. The time for conducting by these controls their inspections is not included in above 10 (3) days. Depending on the sizes, quantity and other characteristics of the goods, their overall inspection time may take anywhere from 30 minutes to 2 days. Once all inspections are completed and duties assessed, a seal i s placed on the inspectedtrailer or container andthe goods are deemedcleared. 156. Imports into Azerbaijan are subject to ad valorem customs duties, at uniform rates of 0.5, 3, 5, 10, 15 and 20 percent (the highest band presently applies to only one nine-digit Harmonized System item) of the declared customs value, or are duty free. Certain products are subject to specific tariffs, i.e. defined as a fixed amount per unit of quantity or volume. In addition to customs duties, imports are subject to VAT (currently 18%) for most goods. This VAT i s creditable against output VAT. Any excess input VAT over output VAT should be offset against a future VAT liability, or may, with tax inspector notification and acknowledgement, be applied against other tax liabilities. The export of goods, works and services i s VAT zero-rated. The following items, regardless of their country of origin, are also exempt from import customs duties: assets imported into Azerbaijan by a foreign investor as a contribution to the charter fund of ajoint venture or for the establishment of a 100% foreign-owned enterprise; goods in transit; property of expatriate personnel, if only for their personalneeds. 157. Most goods, irrespective of their nature, are exempt from export customs duties. However, certain restrictions and licensing requirements were introduced for export of some goods from Azerbaijan. Thus, in April 2001 export duties have been introduced on scraps of black and other metals (USD5 and 15 per ton, respectively), as a temporary trade measure. The special tax applies to exports of oil carried by State Oil Company of the Azerbaijan Republic (SOCAR). It amounts to 20% of the price difference between domestic and world price. 186 INOTIS-Integrated Non-Oil Trade and InvestmentStrategy for Azerbaijan 158. Azerbaijan i s in the process of implementing WTO rules on customs valuation, which require that customs duties be levied on the imported good's transaction value rather than on some reference price constructed by the government. In the past, issues have been raised concerning additions to transaction value, methods of applying deductive value, valuation using reasonable means, currency conversion, confidential information, the right of appeal, and definitions of some terms. Some of these discrepancies have already been addressed and the SCC is working to remedy others to bring customs valuation in full compliance with the WTO (to which Azerbaijan is still inthe process of acceding). 159. Various customs fees and other charges are applied for clearance and inspection. The actual amount of the charge, ineach case, i s assessedby Customs or other relevant authorities on the border. The customs fees for customs clearance (customs processing fee) i s based on the type of good imported or the means by which a good was imported: movable property and/or goods imported to Azerbaijan as charter fund contributions are subject to a customs clearance charge of 0.25% of the customs value; goods imported and/or exported are subject to a 0.15% customs clearance charge on the customs value; goods on a consignment are subject to customs clearance charges of 0.25% of the customs value. Other fees include customs fee for customs storage; customs fees for customs conveyance of goods; consulting fees; customs fee for participation in customs auctions. For goods in transit, the fee i s USD30, plus USDlO for each additional transit declaration. 160. These customs charges may be paid in advance of or at the time declaration to the SCC, though the payment term may be extended up to 2 months on a case-by-case basis. For goods delivered by post, payment may be made through the post office. Payments may be secured by pledging the transferred goods or transport, by third person's guarantee or by depositing the amount due (with no interest). Payments are due in Azeri manat and, in some cases, in other currencies, based on National Bank's official exchange rate for the declaration date. There i s a penalty for late payment of the customs charges, which i s 0.3% of the amount due per each day of delay, including the date when the payment was due. The payer may claim any excess payment within a year from the date when the payment was made. Analysis Figure 6.6-Customs Delays, Number of Days 161. The legal framework related to Customs has improved over recent years. The Customs Code complies broadly with the principles of the Kyoto convention and forms the basis for an effective Customs regime. The SCC has already committed to a substantial reform agenda based on recent TRACECA programs and other studies, including a comprehensive review of SCC operations by PriceWaterhouseCoopers (PWC) in2002.'~~ Source: EBRD and World Bank, Business Environment and Enterprise Performance Survey, 2002. PriceWaterhouseCoopers (2002), "Evaluation of the Structure and Activities of the State Customs Committee," a reportpreparedfor the Republic of Azerbaijan. 187 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan 162. There have been a number of visible improvements in the SCC, with increased interactions with the private sector, through the introduction of a consultative committee, regular training sessions, creation of a website andprovision of specialist advice to traders on an ad hoc basis. The Government, particularly the SCC, has made visible progress over the past three years in improving the environment. This is confirmed by enterprises in Azerbaijan, which seem to ex erience fewer difficulties with their Customs administration than in the rest of the region.'& These efforts have already had a positive impact on transit and customs operations in Azerbaijan, which currently rate among the least cumbersome in the region (see figure 6.6). A number of additional measures, introduced through a Presidential Decree in September 2002, will alleviate several of the issues identifiedin early 2002, notably regarding the introduction of a bonded warehouse system, of WTO-compliant valuation and of a guarantee systemfor goods under a suspense regime not covered by a TIR Carnet. 163. However, the process of customs clearance continues to represent a significant impediment for many businessesin Azerbaijan. Insurveys and direct discussions, members of the business community in Azerbaijan often describe the customs procedures as time consuming and highly discretionary. While many agree that the paperwork and processing requirements are not unreasonable, delays and discretionary decision-making are common. The following table summarizes the results of a recent survey undertaken by a professional market research firm in Azerbaijan, where respondents, who comprised a representative sample of firms in the area of trade and transport, were asked, firstly, whether they experienced any delays in the clearance process, secondly, which public institutions were responsible for those delays, and what was the precise form of the delay.lo5 The following table illustrates the frequency that respondentsexperienced delays, and those establishments that contribute most frequently to the delay of the delivered goods. Table 6.13-Frequency Respondents Experience Delay in Clearance Due to Public Sector 164. One contributing factor to the delays is the absence of an automated, risk-based system for customs clearance. Existingsystems are essentially paper-based system and do not provide the needed support to facilitate clearance, control transit and related bonds and guarantees, or perform targeting and selectivity functions using intelligence and databases. Other factors include the absence of an advance declaration system for pre-clearance of goods; no simplified procedures for consolidated shipments, which are ordinarily used by SMMEs; and working hours that do not meet the needsof traders. lo4Customs in Azerbaijan was rated only 21"factor inhibiting the development and growth of business with an intensity of 2.4 on a scale of 4 in a sample of 40 respondents (HAS 2002). lo5Halcrow Group, Trade Facilitation in the Caucasus - Defining the Mechanisms of Change: Azerbaijan, 2002. 188 INOTIS-Integrated Non-Oil Trade and Investment Strategyfor Azerbaijan 165. In Azerbaijan, the customs charges-tariffs, processing fees, consulting and storage fees-are specified in separate normative acts. There is no single document defining the rates of all customs charges. Moreover, existing legislation i s vague, does not impose set time limits for processing, or allows the customs officials over discretionary powers in terms of documentation requirements, grounds for sanctions, and the imposition of unspecified charges. This creates a problem for business planning and forecasting, when a businessentity must deal with numerous, and sometimes contradictory, regulations. Moreover, it provides opportunities for rent-seekingby customs officials-a reportedly routine problem. 166. Other legal and regulatory issues, identified by the PWC review, that need to be addressed to facilitate trade include: (i> unclear definition of Customs reporting the responsibilities; (ii) the use of minimumprices or value for Customs valuation purposes; (iii) the absence of bonds and guarantee system; (iv) the high personal allowance for travelers encouraging suitcase trading; (v) the absence of guarantees from Customs brokers; (vi) the restricted legal authority of Customs regarding post-importation control of intermediaries involved in trade (brokers, shipping agents); (vii) the duplicated description of Customs offences and sanctions in the Administrative Code and the Customs Code (with some differences); and (viii) the absence of provisions in the Code to deal with any case of bribery and corruption for the customs officials. 167. The consistent application of new rules and regulations throughout the territory, particularly in non-computerized areas, represents another major challenge. Rules and regulations applicable to trade are rapidly evolving. The absence of an official publication with all applicable trade laws, rules and procedures generates opportunities for discretionary decisionsand requests for petty payment. Recommendations While progress has been achieved, additional efforts are required to eliminate the remaining barriers to trade inAzerbaijan. Some key reforms that shouldbepursuedinclude: 168. Improve public information. The provision of clear and comprehensive information to the public regarding all customs and other border related requirements would ensure that the public i s well informed of their obligations, as well as their rights. The main recommended mechanism i s a website, which would provide all requirements related to the movement of a consignment in particular through border crossing points and clearance terminals, as well as in transit. This would include in particular the applicable laws such as Customs and tax codes, regulations, documents, procedures, logistic information such as opening hours, frequent mistakes leading to delays and frequently asked questions. Other published information, such as leaflets and guidebooks, should also be developed to provide information on specific topics. 169. Reform Customslegislation. Ingeneral, the Customs Code i s complies broadly with the principles of the Kyoto Convention and forms the basis for an effective Customs regime. At the same time, there is scope for improving the legal and regulatory framework in the areas identifiedby the PWC review, as well as the consolidation of customs charges and the imposition of set timeframes and documentrequirements. 170. Streamline and strengthen customs operations. Simple changes can have a large impact on trade facilitation. Among needed procedural changes, the following would have a 189 INOTIS-Integrated Non-Oil Tradeand InvestmentStrategyfor Azerbaijan significant impact on the situation in Azerbaijan: (i)the introduction of an advance declaration system to allow for pre-clearance of goods; (ii) traders' entitlement to clear imported goods at any clearance facilities in the country, based on their business needs; (iii) simplified procedures for consolidated shipments; (iv) the alignment of working hours with traffic flows, consistent across border agencies and across borders; (vi) the definition of selective controls and post-entry verification mechanisms; and (vii) new procedures to fight corruption and illegal trade. 171. Computerization and Automation. Critical to implementing these procedural changes is the comprehensive computerization and automation of customs operations. Existing systems are essentially paper-basedsystem and do not provide the needed support to facilitate clearance, control transit andrelatedbonds and guarantees, or perform targeting and selectivity functions using intelligence and databases. Computerization would bring important benefits, such as: (i) streamlining and automation of procedures; (ii) the time savings; (iii.) consistency in the application of rules; (iv) improvements in the tracking of transit consignments; (v) improved statistical data; and (vi) improved intelligence. The SCC i s in the process of developing a custom-built system (GRNAS), which will be implemented inanumber of locations on a pilot basis.However, internationalexperience suggeststhat this i s a much less desirable approach than installing an internationally accepted system such as ASYCUDA which i s in use by some 80 percent of developing and transition economies includingmost of Azerbaijan's neighbors. 172. Improve private-public dialogue. The border agencies in Azerbaijan, particularly the SCC, have made progress in interacting with the private sector and in informing companies about new procedures and requirements. A systematic dialogue across agencies and across private stakeholders (freight forwarders, road transport companies, etc.) startedin the spring 2002 as part of this effort, through the creation of AZERPRO, a Trade and Transport Facilitation Committee. Their overall objective i s to improve the dialogue between the different bodies involved in trade and international transport, to define solutions to remove impediments to consignment movements at an operational level, to support the implementation of these solutions, and hence to achieve significant reductions in the costs of clearance, transit or border crossing. This continuous process of monitoring and feedback, supportedby ad hoc working groups, i s intended to maintain the focus on revamped services. As AZERPRO is still in its infancy, both the Government and private sector should commit to developing it into aneffective framework for ongoing public-private dialogue. 190 m U9 u Y 0 x >" 3+ U 0 b) e, 0 b) U Y 'i u 3 30 U u Y e, U 3icd @3 f3 e, e, e, e, Y 30 30 Y Y 2 Y u Y Y b) z id B tj id Y 8 v) 1 0 U 0 5 v1 a 2 2 m 73 e, 33 a* 0 v1 -! -!