Documentof The World Bank FOR OFFICIAL USE ONLY ReportNumber:37812 - AZ INTERNATIONAL BANKFORRECONSTRUCTIONAND DEVELOPMENT INTERNATIONAL DEVELOPMENT ASSOCIATION INTERNATIONAL FINANCE CORPORATION COUNTRY PARTNERSHIPSTRATEGY FYO7-10 FOR REPUBLICOFAZERBAIJAN November8,2006 SouthCaucasusC o d y ManagementUnit Europeand CentralAsia Region The World Bank Europeand CentralAsia Region InternationalFinanceCorporation This document has a restricteddistributionand may be used by recipients only in the performance of their official duties. Its contents mav not other wise be disclosedwithout World Bank authorization. DATE OFLASTCAS FORREPUBLICOFAZERBAIJAN April 29,2003 CURRENCYEQUIVALENTS US$l =AZN 0.9008 (new manats introduced January 1,2006) AZNl =AZM5,OOO (old manats) GOVERNMENT FISCALYEAR January 1-December 31 ABBREVIATIONS AND ACRONYMS AAA analytical and advisory activities IsDB Islamic Development Bank ACG Azeri-Chirag-Deepwater Gunashli JPIC Japan Bank for International Cooperation ADB Asian Development Bank JSA Joint Staff Assessment ADCP Agricultural Development and Credit JSAN Joint Staff Advisory Note Project KfW Kreditanstalt fiir Wiederaufiau ADDY Azerbaijan Dovlet Demir Yolu LIL Learning and InnovationLoan APL adaptable program loan MDG MillenniumDevelopment Goals BTC Baku-Tbilki-Ceyhan MTEF medium-ternexpenditure framework CAPSAP Corporate and Public Sector Accounting NGO nongovernmental organization Project OSCE Organization for Security and Co-operation CAS Country Assistance Strategy inEurope CIS Commonwealth o f Independent States PEFA Public Expenditure and Financial CPIA Country Policy and Institutional Accountability Assessment PEP Private EnterprisePartnership, IFC CPS Country Partnership Strategy PIFC Public Internal Financial Control DRS World Bank Debt Reporting System PIP public investmentprogram EBRD European Bank for Reconstruction and PIPE Public Investment Policy and Efficiency Development PPER Programmatic Public Expenditure Review EITI Extractive IndustryTransparency PRSC Poverty Reduction Support Credit Initiative PRSP Poverty Reduction Strategy Paper ENP European Neighborhood Policy RAMP Reserves Advisory and Management ESW economic and sector work Program FDI foreign direct investment RIDIP Irrigationand Drainage Rehabilitation FIAS Foreign InvestmentAdvisory Service Project FSTA Financial Sector Technical Assistance RMSM- World Bank standard macro modeling GDLN Global Development Learning Network X framework GEF Global Environmental Facility SCP South Caucasus Pipeline GNI gross national income SOCAR State Oil Company o f Azerbaijan GTZ Deutsche Gesellschaft fir Technische SOFAZ State Oil Fund Zusammenarbeit SPPRED State Programme on Poverty Reduction and IBA International Bank o fAzerbaijan Economic Development IBRD International Bank for Reconstruction SPPRSD State Programme on Poverty Reduction and IDA and Development Sustainable Development International Development Agency TACIS Technical Aid to the Commonwealth o f IDF Institutional Development Fund Independent States IFAD Int. Fundfor Agricultural Development UNDP UnitedNations Development Programme IFC International Finance Corporation UNEP UnitedNations Environmental Program IFRS Int.FinancialReporting Standards USTDA US.Trade andDevelopment Agency IMF International Monetary Fund WBI World Bank Institute IPSAS 1nt.lPublic Sector Accounting Standards WTO World Trade Organization The World Bank Group Team IBRDand IDA Vice President: Shigeo Katsu Regional Vice President: EdwardNassim Country Director: Donna M.Dowsett-Coirolo Director: Shahbaz Mavaddat Team Leader: Christian E.Petersen Team Leader: KaikhamOnedamdy INTERNATIONAL BANKFORRECONSTRUCTIONAND DEVELOPMENT INTERNATIONAL DEVELOPMENT ASSOCIATION INTERNATIONAL FINANCE CORPORATION COUNTRY PARTNERSHIPSTRATEGY. FYO7-10 REPUBLICOFAZERBAIJAN Contents I CONTEXT 1 I1 .. ..................................................................................................................................................... CHALLENGESFACING AZERBAIJAN ................................................................................................. 2 . b. ReducingPoverty ........................................................................................................................... a ManagingNatural Resource Wealth............................................................................................... 2 3 c . d. Improving Governance................................................................................................................... Improving Social Conditions and Meetingthe MillenniumDevelopment Goals .......................... 4 5 e . f. Developing the Non-Oil Private Sector.......................................................................................... 8 Cleaningup the Environment......................................................................................................... 9 I11 . MACROECONOMIC FRAMEWORK .................................................................................................... 11 a . Recent Developments................................................................................................................... 11 b. Medium-Term Outlook ................................................................................................................ c. Debt Sustainability ....................................................................................................................... 12 15 IV. THE GOVERNMENT'S STRATEGY FORREDUCINGPOVERTY ................................................. 15 b. The StateProgramme on Poverty Reduction and SustainableDevelopment (2006-15) .............15 a . ThePoverty Reduction Strategy Paper (2003-05) ....................................................................... 15 V. FY03-06: TRACK RECORDAND LESSONSLEARNED .................................................................... 16 a. Achievements of the FY03-05 CAS and Remaining Challenges................................................. 16 b. The FY06Program....................................................................................................................... 17 c. Current Portfolio Status ................................................................................................................ 17 VI. THE COUNTRY PARTNERSHIPSTRATEGY,FY07-10 ................................................................... 18 a . Pillar I: 21 b. Pillar 11:SupportingSustainable Growthofthe Non-OilEconomy............................................. Improving the Quality and Transparency inPublic Sector Governance ......................... 24 C d. Pillar IV: Improving EnvironmentalManagement andFurthering the Climate Change Agenda 30 . Pillar 111:Improving the Quality ofandAccess to Social Services.............................................. 28 e . f. 32 Financing Scenario and Portfolio Management ........................................................................... Knowledge Sharing. Advisory Services. and Capacity Building................................................. 35 h. MonitoringandEvaluation........................................................................................................... 5 Governance -a Crosscutting Objective of the CPS ..................................................................... 37 i. 38 External Partnerships.................................................................................................................... 40 j. Consultations ................................................................................................................................ 42 VI1 MANAGING RISKS . .................................................................................................................................. 43 This document has a restricted distribution andmay be usedby recipients only inthe performance o ftheir official duties. Its contents mav not other wise be disclosed without World Bank authorization . i Tables Table 2: Summary ofK e y Indicators....................................................................................................... Table 1: EstimatedNumber o f People Living inPoverty inAzerbaijan. 2002-05 ................................... 3 11 Table 4: Lessons Learned from the Country Assistance Strategy FY03-05 ........................................... Table 3: Macroeconomic Framework 2006 .2010 ................................................................................. 13 17 Table 5: CPS support to the ongoing Structural ReformAgenda............................................................ 19 Table 6: ProposedAnalytical and Advisory Activities Undertaken by the Bank Group under the Table 7: IndicativeN e w World Bank Group Financing. FY07-10 ......................................................... Country Partnership Strategy.......................................................................................................... 33 36 Table 8: Key Progress Indicatorsunder the Country Partnership Strategy ............................................. 41 Figures Figure 1 Oil Revenues. Profit & Capital Repatriation.............................................................................. . 2 Figure 4: Governance Action Plan .......................................................................................................... 39 Figure 3: Objectives and Outcomes o f the Country Partnership Strategy inAzerbaijan ........................ Figure 2: Azerbaijan Growth IncidenceCurve. 2002-2005 ...................................................................... 4 20 Boxes Box 1:Non-Oil Sector Competitiveness ................................................................................................. 14 Box 2: Safeguarding the Integrity o f the Bank's Portfolio...................................................................... 46 Annexes Annex 1:Azerbaijan CPS Results Matrix (FY06-09) ............................................................................ 47 Annex 2: SPPREDTargets andBaselines............................................................................................... 57 Annex 3: CAS Completion Report. FY03-05.......................................................................................... 63 Annex 4: Likelihood o f Meeting Millennium Development Goals......................................................... 95 Annex 5: CPS Consultations with Civil Society and Non-Governmental Organizations ....................... 97 100 Annex 7: Country Financing Parameters for Azerbaijan....................................................................... Annex 6: Collaboration with Development Partners ............................................................................. 104 Annex 8: Standard CPS Tables ............................................................................................................. 105 Table A2: Azerbaijan at a Glance ............................................................................................................ 106 Table B2: Selected Portfolio Indicators................................................................................................... 109 110 Table B3: IFC and MIGA Program Summary ......................................................................................... Table B3: IBRDADA Program Summary................................................................................................ 111 Table B4: Summary o fNon-Lending Services........................................................................................ 112 Table B5: Social Development Indicators ............................................................................................... 113 Table B6: Key Economic Indicators........................................................................................................ 114 Table B8: Operations Portfolio ................................................................................................................ Table B7: Key Exposure Indicators......................................................................................................... 116 117 118 Map o f Azerbaijan................................................................................................................................. Table B8b: IFC's Held& DisbursedPortfolio......................................................................................... 119 .. 11 AZERBAIJAN COUNTRY PARTNERSHIPSTRATEGY,FY07-10 EXECUTIVESUMMARY 1. Over the past few years, Azerbaijan has put into place both the infrastructure needed to realize rapid growth inoil and gas exports, and a credible framework to manage the increase in resource flows in a reasonably effective and transparent manner. The World Bank Group has been actively engaged inboth tasks - through IFC inbuildingthe oil pipelines which are now generating the oil boom, and through IDA in establishing the institutions responsible for safeguarding and using the resources well. As Azerbaijan's known reserves are more limited than is the case for many other oil exporters, however, the resource boom will also be more shortlived. The challenge facing the Azeri leadership and its international partners will therefore be to use the next 10-15 years very carefully to develop sound growth opportunities inthe non-oil economy and achieve sustainable reductions inpoverty for current and future generations. To meet this challenge, the government o f Azerbaijan is committed to maintain macroeconomic discipline; improve the business environment to encourage investment in the non-oil economy; improve the transparency and quality o f public governance; modernize its basic health and social protection systems; transform both its formal and nonformal education andtraining systems to help its populationbecomebetter educated and more competitive inan increasingly global setting, and address long-neglected environmental problems. The long- term vision is for Azerbaijan to become a prosperous transit center for energy and goods flowing between Europe and Central Asia. 2. Azerbaijan is just completing a first PRSP period, and is now developing a new State Programme on Poverty Reduction and Sustainable Development (SPPRSD) for 2006-1 5. The Bank Group's Country Partnership Strategy (CPS) reflects the objectives of the SPPRSD, which are closely aligned with the vision and challenges mentioned above. The CPS rests on four main pillars: 9 PillarI:Improvingthe quality and transparencyin publicsector governance, by maintaining a stable macroeconomic framework that makes prudent use o f oil revenues; improving public expenditure planning and management; strengthening financial management and procurement systems; establishing proper public sector and corporate governance, accounting, and auditing; creating an administrative and regulatory environment conducive to growth; and strengthening thejudicial system. 9 Pillar 11: Supportingsustainable andbalancedgrowth of the non-oileconomy, by expanding access to financial services; improving the business environment and through IFC direct investments and technical assistance strengthening the private sector; developing essential infrastructure and services, with special attention to both the rural economy and Central Asia-South Caucasus-Black Sea regional transit routes; and strengthening the financial viability and efficiency o fthe utility sectors. 9 Pillar 111: Increasing the quality of and access to social services, by expanding coverage o f good-quality health care services; developing a modern education system and globally competitive knowledge economy; effectively targeting social assistance; creating a more transparent, affordable, and sustainable pension system; and improving livingconditions andeconomic opportunities for internallydisplaced people. > Pillar IV: Improving environmental management and furthering the climate change agenda, by cleaning up legacy pollution, reducing carbon emissions, and promoting biodiversity; supporting more sustainable natural resource management in selected areas; and strengthening natural disaster management. 111 ... 3. The Bank and IDA technical and financial assistance will focus on Pillars I, and IVY I11 and the Bank and IFC will work jointly on Pillar 11. IFC will also continue to oversee the Baku-Tbilisi-Ceyhan (BTC) pipeline and support the development o f financial institutions and small and medium-size enterprises. IFC will actively seek direct investment opportunities in general manufacturing and financial markets, as well as focused on assisting local SMEs. Its technical assistance activities will support the improvement o f the business environment and corporate governance. Although Azerbaijan is not likely to require balance o f payments or budgetary support through development policy lending during the next few years, it has requested that the Bank continue to support the PRSC reform agendaagreed under the previous CAS, through intensive policy dialogue andtechnical advisory services. 4. Implementation o f the public governance and anti-corruption agenda will be closely monitored and prioritized on the basis o f a framework prepared by the government with participation o f civil society, and inpartnership with donors. With regard to the Bank Group's own portfolio, special attention will be given to supervision generally and oversight o f fiduciary requirements in particular, largely through strengthening capacity in the Baku Country Office. 5. Azerbaijan has already begun the transition from IDA to IBRD financing, with the first IBRD loan approved inMay 2005 and a second in January 2006. Based on continued strong economic growth prospects, IDA is expected to be phased out during this CPS period. While the average range o f IBRD lending is established at about US$250 million a year, actual volumes will depend on the degree o f government co-financing and absorptive capacity. IBRD lendingwill be sequenced so that progress in sector and governance reform can be taken into account indecision-making at each step. 6. Primary risks to achieving CPS objectives include: possible delays or waning consensus in implementing structural reforms; state capture and corruption; deterioration in financial management of oil revenues, disruptions in revenue flows due to volatile energy prices, output or pipeline performance; and deterioration in the political or security environment. These risks are mitigated by a strong emphasis on macroeconomic management and sterilizing excess oil revenues through the State Oil Fund, and renewed efforts at improving relations with neighboring countries. The risks are also mitigated by the strong focus of the CPS on improving governance and financial accountability, diversifying sources o f growth, and expandingparticipation o f the civil society inpolicy makingand monitoring. At the same time, it is recognized that many countries experiencing natural resource booms have had difficulty inmanaging macroeconomic and governance challenges. This CPS i s predicated on the belief that Azerbaijan can follow a different path and that the World Bank Group can play a positive role inhelping to bringthis about. The Board will be informed inthe event of any serious deteriorationo f the economic or governance environment. The following issues are suggested for discussion: P Doesthe CPS providea well-focused set o factivities, bothongoing andnew, insupport o f Azerbaijan's development strategy? P Doesthe CPS providethe appropriate mechanisms to further policy and governance support? P Isthe governance framework well balancedbetweenthe Bank'srequirementsandthe political and institutional reality o f Azerbaijan? iv INTERNATIONALBANKFOR RECONSTRUCTIONAND DEVELOPMENT INTERNATIONAL DEVELOPMENT ASSOCIATION INTERNATIONAL FINANCE CORPORATION COUNTRY PARTNERSHIPSTRATEGY, FYO7-10 REPUBLIC OFAZERBAIJAN I. Context 1. This Country Partnership Strategy (CPS) for Azerbaijan covers the four-year period from FY07 to FY10. It is a joint IDA/IBRD/IFC strategy. The last Country Assistance Strategy (CAS) was discussed by the Board in May 27, 2003 (Report No. 25790-AZ), based on Azerbaijan's then new poverty reduction strategy, the State Programme for Poverty Reduction and Economic Development (SPPRED). A progress report on the SPPRED was presented to the Boards o f the World Bank and International Monetary Fund (IMF) in August 2005. In collaboration with civil society and other stakeholders, the government is preparing the follow- on to the SPPRED, the State Programme on Poverty Reduction and Sustainable Development (SPPRSD) 2006-15. 2. Azerbaijan was among the world's leading oil producers in the late 19th century, but duringthe Soviet period exploitation of Azerbaijan's oil resources was not a highpriority and economic policies left little to show for the country's oil wealth and much o f its population in poverty. Since independence, oil and gas discoveries have given Azerbaijan new means of combating poverty and developing into a diversified, sustainable middle-income economy in the coming years. Drivenbythe new oil boom, per capita income rose to US$1,240 in2005, up from a post-independence low ofjust US$470 in 1995. 3. Azerbaijan's national income will be rising substantially over the next several years, as new oil production comes on stream and international oil prices are higher. A significant part o f this income will be leaving the country, however, in the form o f repatriation o f capital and profits by foreign investors. Moreover, the revenue boom is expected to be relatively short lived, peaking inabout 2010 and declining steadily thereafter. 4. Azerbaijan's challenge is to use its oil revenues to stimulate sustainable broad-based growth and ensure the welfare o f current and future generations. The economic transition has been complicated by the armed conflict with Armenia over Nagorno-Karabakh, which led to nearly 700,000 internally displaced people (IDPs) and some 250,000 refugees from Armenia, loss o f control over some 20 percent o f the land area, and disruption o f key regional trade and transport links.' Over the last CAS period, IDA helpedthe government establish a meaningful poverty-reduction strategy and supported implementation o f important reforms in many sectors. IFC helped finance the Baku-Tbilisi-Ceyhan (BTC) pipeline and upstream oil platform development. Azerbaijan now needs to persevere with key reforms and build on the opportunities provided by its oil revenue. Doing so involves raising the level o f development 1 Inaddition, about 50,000 MaeskhetianTurksand 11,000 people fromother countries have sought refuge in Azerbaijan since 1990. 1 o f rural, mainly agricultural, regions and secondary cities relative to the capital area and providing equitable basic infrastructure services across the country. 5. The CPS supports the main objective o f the government long-term program to reduce poverty and achieve the Millennium Development Goals (MDGs) by supporting continued high non-oil sector growth while maintaining macroeconomic stability; improving health, education, and infrastructure services; better targeting social protection; improving gender equality; and achieving environmental sustainability. 6. IBRD financing will support a larger development agenda than did the previous CAS, particularly in regard to managing and implementing essential infrastructure projects and environmental remediation. IDA financing will play a critical role in helping the government improve social andrural conditions and support continued structural reforms. IFC is partnering with the private sector to encourage the continued development o f the non-oil economy. Examples include the development o f the Supplier Finance Facility for SME suppliers, corporate governance and leasing TA andpotential investments infinancial as well as the food retail sectors. Knowledge-sharing, analytical and advisory activities (AAA), and development partnerships will reinforce investments. In all areas, the Bank Group's support will focus on improving governance, bothpublic and corporate. 11. ChallengesFacingAzerbaijan a. ManagingNatural Resource Wealth 7. Azerbaijan's proven energy reserves stood at 7 Figure1:Oil Revenues,Profit& CapitalRepatriation billion barrels o f oil and 1.34 trillion cubic meters o f gas at the end o f 2003. International consortia are 20 investing in and operating the new oil and gas facilities based on produc- us15 $ tion sharing agreements bil with the government. lio Long-term revenue projec- 10 tions, based on an average oil price o f about US$43 5 per barrel for the next 20 years, suggest gross reve- nues o f about US$340 0 billion from Azerbaijan's ZOOS 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 oil and gas fields plus 1ElStateBudget moilFund 0Profit Repatriation OCapital Repatriation 1 pipeline transit fees before Source: World Bank staff estimates operating costs. After operating costs, state fiscal revenues are expected to reach about US$l75 billion, o f which about US$20 billion will accrue to the state budget in the form o f corporate tax revenues and US$l55 billion will accrue to the State Oil Fund (SOFAZ) in the form of royalties. The oil consortia are expected to rapidly repatriate some US$40 billion o f invested capital, plus profits. Roughly speaking, this implies an annual oil windfall o f US$l,OOO per capita for the next 20 years. Unless new oil and gas reserves are discovered, that would be the 2 end o f Azerbaijan's oil boom. Managing this rather short-lived and volatile revenue stream in the context o f the continuing transition from a post-soviet deteriorated command economy to a modem market economy, while avoiding the competitiveness pressures o f Dutch disease and the "resource curse" is a central challenge confronting Azerbaijan.2 b. ReducingPoverty 8. Poverty in Azerbaijan i s declining rapidly, particularly in Baku (table 1). At the national level, the proportion o f poor people fell from about 44.6 percent in 2002 to 24.0 percent in 2005, a drop o f 20.6 percentage points. Extreme poverty fell from 26.9 percent o f the population in 2002 to 9.2 percent in2005. These findings suggest that 1.9 million people lived inpoverty in2005, down from almost 3.3 millionin2002. Total Baku I Non-BakuUrban I Rural poor verypoor poor verypoor poor verypoor poor verypoor 2003 39.7 22.1 34.8 19.3 46.0 27.9 2004 28.5 13.4 18.6 8.0 35.4 19.0 2005 24.0 9.2 14.7 6.6 27.2 11.9 26.9 2004-2005 -4.6 -4.3 -3.9 -1.4 -8.2 -7.1 -2.7 -4.1 2002-2005 -20.6 -17.7 -26.8 -19.1 -21.5 -19.6 -16.8 -15.7 9. Reasons for the sharp drop in poverty are two-fold. Wages and salaries have more than doubled, with the minimum wage raised fivefold since 2001, albeit from a very low level. There has also been a significant surge intransfer incomes for poorer households. Government social transfers to the poorest 20 percent of households increased more than 35 percent in 2004, while pensions, the main component o f the government social program, increased about 44 percent. Remittances from a significant number o f Azerbaijanis working abroad are also an important source o f households financing and has helpedreduce poverty. 10. Systemic reforms to improve the targeting and administration o f social assistance and modernize the pension and social insurance system are well underway. A new targeted social assistance scheme was rolled out inJuly 2006. Its impact now needs to be carefully monitored. 11.Most improvements in welfare have been concentrated in Baku, which saw a 26.8 percentage points decline in poverty during 2002-05 (poverty fell 21.5 percentage points in urban areas outside Baku, and 16.8 percentage points in rural areas). Lack o f employment, assets, and commercial opportunities and weaker access to basic health and education services in provincial towns and rural areas are driving factors behind intense rural-urban migration. Lack o f reliable electricity and other infrastructure has been a major factor discouraging investment and commercial activity outside Baku. Nevertheless, between 2004 and 2005 poverty in non-Baku urban areas fell by 8.2 percentage points, almost twice as much as in * The potential negative effects o f an inadequately managed natural resource boom are often referred to as Dutch disease. They include: (i)macroeconomic adjustment problems stemming from large foreign exchange inflows; (ii) unbalanced growth, leading to crowding out o f the non-petroleum traded goods sector; (iii) ofpetroleum waste wealth through unproductive public expenditures; and (iv) insome cases accumulation o f external debt as the resource boom increases the capacity to borrow. 3 Baku. While poverty prevalence is not significantly higher among refugees and internally displaced people, these groups are particularly vulnerable, because they lack assets and employment opportunities and are heavily dependent on state transfer^.^ 12. The growth-incidence curve below suggests that growth has been considerably pro-poor in Azerbaijan during 2002-2005 (figure 2). Growth was positive for all percentiles o f the Azeri population with a mean annual growth rate in consumption o f 7-8 percent. The poorest decile has enjoyed annual consumption growth o f about 15 percent. In general, consumption growth for the poorer deciles is higher than for the richer deciles. Figure2: AzerbaijanGrowthIncidenceCurve, 2002-2005 Y PercentageChangeofConsumptionPer Capita a" Mean of growth rates Growthrate inmean 5 0 20 40 Percentileof Population 60 80 100 Source: Household Budget Survey and Staff estimates c. Improving Social Conditions and Meeting theMillennium Development Goals 13. Challenges remain inthe social sectors. Reforms are underway to address inefficient use of resources; weak management, planning, and monitoring capacity at the central and local levels; and difficulty in adapting the educational system to the changing skills requirements o f the labor market, but progress has been slow. 14.The education budget has been increased substantially, to 5 percent o f non-oil GDP and 17.8 percent o f the total budget in 2005. The enrollment rate for compulsory education i s high, and the literacy rate i s almost 100percent, irrespective o f gender and ethnicity. Beyond age 16, however, enrollment rates drop sharply, with only 13 percent o f young adults age 17-24 (9 percent among children from poor families) enrolled inpostsecondary educational institutions. Growing inequities in access to education has become an issue. Considerable efforts are needed to foster a globally competitive knowledge economy based on a modem curriculum; higher education brought to international standards; and vocational and adult educatiodretraining that meets the demands o f a modem market economy. The government recently appointed an Education Commission to accelerate progress. The Bank is supporting the government's efforts through an education adaptable program loan (APL),andplans to step upthe engagement duringthe CPS period. While the dynamics and magnitude o f poverty reduction are not questionable, two factors may modify these results: underreporting on the poorest groups andunder-evaluationo f CPI. 4 15. A fundamental reform agenda needs to be implemented in the healthcare system. Life expectancy at birthinAzerbaijan - already low - has been declining, as a result o f high infant, child, and maternal mortality rates, the high prevalence o f noncommunicable diseases, and unhealthy lifestyle choices. The healthcare system does not deliver affordable, good-quality services to meet the needs o f the population, and it suffers from very low utilization rates, particularly among the poor. The sector is undermined by major inequalities in healthcare; underfunded, poorly managed, and highly fragmented primary healthcare services; inadequate and inefficient resource allocation (the sector received just 1.6 percent o f non-oil GDP in 2005); a healthcare workforce that relies on informal payments to cope with low wages and lacks incentives to provide appropriate care; and a weak governance, legal, and regulatory environment. Recent changes at the Ministry o f Health provide an opportunity for moving forward on well-identified and highly needed reforms supported by the sectorwide FY06 Health Sector Reform project. 16. These challenges notwithstanding, the 2005 Millennium Progress Report ranks Azerbaijan as one o f the countries that can be placed on the "fast track" for achieving the MDGs (see annex 4). The SPPRED and the SPPRSD are closely aligned with the MDGs. While both health and education were previously severely underfunded, since 2005 the government has committed a larger share o f the fast rising budget to the social sectors. Given committed resources, the key is to move rapidly on needed structural reforms within the social sectors. The CPS will play an important role inthis respect. d. Improving Governance 17.Azerbaijan is going through the turbulent transition from an externally controlled non-free soviet republic toward more democracy and pluralism.This process takes place inthe situation o f the unsolved international conflict, partial occupation o f the territory, and significant damage to Azerbaijan's economy. Against this background, parliamentary elections in November 2005 showed important progress over previous elections, according to observers from the Council o f Europe (CoE) and the Organization for Security and Co-operation in Europe (OSCE), although they did not fully meet international standard^.^ Presidentialelection scheduled for 2008 will be an important opportunity for making further progress. Constructive and independent media and civil society can be allies to the administration by providing a timely feedback on policies and implementation o f government strategies. As noted elsewhere, this i s already occurring with respect to the oil sector, where an active external multi- stakeholder group participates in the monitoring o f the State Oil Fund. Going forward, a key challenge for Azerbaijan is that the maturation o f the political system keeps pace with and supports the rapid economic development.Azerbaijan is more andmore recognized inthe post- Soviet republics as an important player in international politics able to maintain good relations with different parties. Azerbaijan holds the chair as Secretary General o f the Organization for Democracy and Economic Development o f GUAM, whose other members are Georgia, Ukraine, and Moldova. 18. Progress has been made in some important areas o f governance, particularly in increasing the transparency o f oil revenue management. The establishment o f SOFAZ' and Azerbaijan's Re-elections were held inten precincts, inwhich election observers reported irregularities. 5 The Governance Framework for SOFAZ is published on its website www.oilfund.az and summarized in the previous CAS, April 29,2003, ReportNo. 25790-AZ, p. 8. To a large extent it follows the Norwegian model, with all Oil Fund expenditures mandated to be part of the consolidated budget approved by Parliament, and executed through the single Treasury account. Financial reports are disclosed quarterly, and audited reports annually. 5 participation in the Extractive Industry Transparency Initiative (EITI) have resulted in an upsurge o f activity o f a coalition o f some 90 nongovernmental organizations (NGOs) monitoring oil revenues and has expanded opportunities for civil society to engage indialogue with the government.6 Azerbaijan has already reportedto EITI for the three years 2003, 2004, and2005 and is inaccordance with the EITIMemorandum o fUnderstandingsigned inBakuin November, 2004.7 However, while the State Oil Company (SOCAR) is participating in EITI, the government has not yet committed to a firm timetable for SOCAR to be audited to international standards as required by the international criteria for EITI. Furthermore, regulatory functions are not separated from commercial ones and restructuring has been slow. In general, corporate governance and financial accountability of state-owned enterprises remain major issues weakening overall fiscal discipline. The CPS is directly supporting the EITI through the Corporate and Public Sector Accounting Project (CAPSAP) and hands-on support to implementation o f International Financial Reporting Standards (IFRS) in state- owned enterprises according to the new accounting law. Open Society recently commended Azerbaijan for its leadership role inEITI.' 19.Azerbaijan has established an institutional framework to develop and implement a sustainable fiscal policy. The budget preparation process is governed by the Budget System Law drafted in collaboration with the Fund and the Bank. The law introduces multi-year budgeting through the preparation o f a medium-term expenditure framework (MTEF) to provide the necessary link with the SPPRED and the public investment program (PIP). Both the MTEF and the PIP are to be submitted to Parliament. The law ensures that the budget provides details on expenditure allocations according to international budget classification. All Oil Fund expenditures (except administrative costs) are included in the annual consolidated budget approved by Parliament. The improvements in the budget system have been fbrther enhanced by the introduction o f a single Treasury account and the inclusion o f all previously extra-budgetary operations o f budget organizations in the budget, including expenditures financed by SOFAZ. Yet, inter-ministerial coordination needs to be greatly improved. The MTEF and PIP are not fully developed yet, and require further capacity building at the Ministryo fFinance andthe Ministry o fEconomic Development, while the fullparticipation o f line ministries in the budget formulation process will require extensive training. The CPS is supportingthe budget formulation process through the Programmatic PER. 20. Less than adequate financial discipline, non-payments, explicit and implicit subsidies, and instances o f conflict o f interests in the utility and transport sectors constitute serious and difficult problems facing the economy o f Azerbaijan. The resulting high economic and social costs are manifested in increasing inefficiencies and consumer losses caused by monopolistic behavior, frequent systems breakdown, as well as direct impact on health and poverty. Previously implicit subsidies to energy utilities were in the order o f US$500 million. These subsidies are now explicitly budgetedfor and decreased to about US$320 million in 2005. Yet, domestic prices on energy products are below international prices, thereby causing a significant opportunity cost for the sector. The CPS will continue to support the government's five-point program set out inthe PRSC: moving to cost-recovery tariffs during the CPS period; The CPS follows the guidance set out in the World Bank Group Management responses to the Extractive Industries Review. 'MemorandumofUnderstanding of November24,2004, signedbetweenthe National Committee of EITI, the localandforeign companies operatinginthe ExtractiveIndustriesof the RepublicofAzerbaijanandnon- Fovernmentalorganizations. See Eye on EZTZ, Civil Society PerspectivesandRecommendationonthe ExtractiveIndustriesTransparency Initiative, October 2006, PublishWhat Your Pay/ RevenueWatchInstitute. 6 increasing collections; proper regulation o f natural monopolies; financial accountability through adoption o f IFRS; and implementing a targeted social safety net to alleviate the impact on the poor. The government is strongly committed to the program. In July 2006 President Aliyev instructed the Cabinet o f Ministers to increase collection rates for public utilities within three months at all cost. September collection rates had doubled to 83 percent for gas and 70 percent for water.g Meters are rapidly being installed. Tariffs were raised significantly for gas and water. The new Accounting Law requires IFRS. The targeted social safety net started July 1,2006. 21. The government recognizes the need for civil service reform, but the pace o f progress has been slow. Low salaries, poor organization, and weak motivation have undermined the performance o f the civil service, despite an educated workforce. The Civil Service Law o f 2001 i s generally consistent with international standards, but implementation has been slow. 22. Corruption remains a serious problem in Azerbaijan. Despite some improvements in 2005 and in2006, Azerbaijan still ranks low inTransparency International's Corruption Perceptions Index (130 out o f 163 countries in2006, up from 137 in2005), andweak governance is widely perceived as an obstacle to doing business. Azerbaijan i s ranked 99 inthe DoingBusiness 2007 (out o f 175 countries), and five areas need urgent attention: tax rates and administration; customs; licensing regime; and corruption. The Bank/EBRD Business Environment Enterprise Perceptions Survey (BEEPS) in 2005 also indicates that weak governance is widely perceived as an obstacle to doing business, and that corruption in fact has increased since BEEPS 2002. Nevertheless, it should be noted that o f the 21areas o f "Problems Doing Business" surveyed in BEEPS, Azerbaijan fares better than the E C A average on 15. Inthe five areas mentioned above Azerbaijan is worse than the average. 23. The comprehensive State Programme on Combating Corruption was developed in cooperation with civil society and international organizations. The government has undertaken several initiatives such as passing new anticorruption legislation, strengthening anticorruption institutions, and creating an anticorruption office in the Prosecutor General's Office and an anticomption department in the Ministry o f Interior. The use o f ATM cards for pension payments has reduced leakage. Improvement also appears to have occurred in the traffic police, where salaries increased fivefold recently and petty harassment seems to have subsided. 24. The Group o f States against Corruption (GRECO) under the Council o f Europe published its Evaluation Report on Azerbaijan inJune 2006. The report commends the progress made on the Programme in adopting new legislation, but identifies several shortcomings in implementation, including limited cooperation and coordination by the various authorities, the need to broaden the adoption o f a code o f ethics to all public employees, address conflicts o f interests, and strengthen liability o f legal persons for corruption offences and trading in influence. The Anti-Corruption Network (ACN) for Eastern Europe and Central Asia, based at the OECD Secretariat, issued its Monitoring Report, also in June 2006, with detailed diagnostics and recommendations on speeding up implementation o f the State Programme on Combating Corruption and other issues. 25. Critical reform to improve the judicial system has started, with support o f IDA. World Bank Institute governance indicators show steady improvement in government effectiveness and regulatory quality. The Bank's comprehensive framework o f reform dialogue with the 9 September 2006 collection rates for electricity were not available at the time ofprinting. 7 government will continue during the coming CPS period. However, progress is slow and the govemment, supported by international development institutions, needs to and can do more to combat corruption. The proposed CPS projects and AAA are designed to collectively comprise an integrated and comprehensive Governance Action Plan to support these efforts, see the section below on Governance - a Crosscutting Objective of the CPS.This includes governance reforms on the sector level. For example, corruption in the health sector is being vigorously addressed through the Health Sector Reform project. Issues in the education sector are being addressed through a series o f Education ApLs. The Pension and Social Assistance project is helpingto minimize leakage o f social transfers. e. Developing theNon-Oil Private Sector 26. Azerbaijan's oil wealth offers significant opportunities to improve the environment for economic growth and createjobs inthe non-oil sector. Azerbaijan offers an educated, low-cost workforce for a country at its income level. In addition to oil and gas, Azerbaijan's natural resource endowment includes lead, zinc, iron, and copper ores and a variety o f building materials, such as limestone and marble. Within the non-oil sector, agriculture and agro- processing, manufacturing, transit trade and transport, and services such as communications are expected to be drivers o f growth. However, complacency, due to the immediate oil wealth could slow down the urgency o f necessary reforms in the business environment and hamper competitiveness o fnon-oil sectors. 27. Agro-processing offers good potential for growth and employment creation. At the moment, only a small number o f firms in Azerbaijan process agricultural produce into higher- value products, such as juices, dehydrated fruits, wine, and jams for local and export markets. Keyissues to be addressed include weak factory conditions, unreliablepower supply and other infrastructure constraints, an unfavorable business environment and significant gaps in supporting industry (for example, collection networks, postharvest facilities, glass containers, testing facilities, irrigation infrastructure). Improved transport links, including transit corridors, are also critical. Even modest savings intime, improvements inquality, andreductions incosts associated with consignment movements could lead to a significant increase in demand in target markets, such as CIS countries and Turkey. 28. Growth potential also exists in activities supplyingthe oil and gas industry, includingbasic equipment and machinery, metalworking, a range o ftechnical services, transportation services, food and hospitality services, and upstream chemical and petrochemical industries. Growth in the oil and gas industry is also likely to stimulate demand for a range o f value-added telecommunications and networking services. Challenges include the need to meet strict international standards, large capital requirements, large average orders, and stringent delivery requirements, which may be difficult for local producers. 29. Trade flows are likely to increase, as two o f Azerbaijan's largest and fastest-growing neighbors - the Russian Federation and Kazakhstan - may join the World Trade Organization (WTO) inthe next year. Azerbaijan has set a target ofjoining the WTO within the next couple o f years. The European Union's recent inclusion o f the three Caucasus countries in its European Neighborhood Policy (ENP) could create closer trade links with Europe. Increasing purchasing power in the region i s also expected to generate stronger demand for goods and services and time-sensitive transport services. A key CPS priority i s to enhance the potential for regional transit cooperation to benefit notjust Azerbaijan but the region as a whole as well. 8 30. The long anticipated regional transit corridor has taken o f f with the completion o f the BTC pipeline, through which a million barrels o f oil per day will flow from Azerbaijan through Georgia to Turkey, the Mediterranean, and beyond. The South Caucasus Pipeline (SCP) will provide gas to the cross-Turkey system from the large Shah-Deniz field. These mega-projects provide a major transit source and build confidence in cooperation with South Caucasus countries. Improving the road and rail links are logical next steps now underway. 31. Regarding the financial sector, Azerbaijan's bankingsystem remains quite small relative to the size o f the economy. Presently 44 banks operate in the country, o f which 18 have foreign participation and 2 are branches o f foreign banks. Many o f these banks have received support from IFC and EBRD, and their performance andthe range o f services they provide is gradually improving. However, total bankingsystem assets was still only about 18 percent o f GDP at the end o f 2005-a much lower ratio than the 30-40 percent o f GDP inmost transition economies inCentralEurope. Followingthejoint IMF-BankFSAPin2004, newcentralbank andbanking laws have been enacted. They are broadly consistent with Basle principles, and dejure provide for central bank independence and accountability. The report also made several recommendations regarding the International Bank o f Azerbaijan (IBA), the country's largest and still state-owned bank. IBA presently accounts for about 49 percent o f total banking system assets, down from 53 percent at the time o f the FSAP. While this is a positive development, largely reflecting growth o f other (mainly private) banks, the dominant presence o f one large state bank should be further reduced over time by effectively opening the banking sector to foreign competition by improving the business environment in the sector. Enforcement o f prudential regulations has improved with technical assistance from donors. The low capitalization and large open foreign exchange position o f IBA makes it vulnerable to shocks, particularly credit quality and exchange rate appreciation. The low capitalization and large open foreign exchange positions potentially make the banking sector vulnerable to shocks, particularly credit quality and exchange rate appreciation. Nevertheless, stress tests demonstrate high resistance o f the banking sector against macroeconomic shocks. In general, the banking system should broaden its intermediation of finance to small and medium-size enterprises and to people in rural areas. Improving access to financial services is a key challenge to support savings, credit, commercial activity, andjob creation inrural areas. 32. The unreliability o f electricity and gas supply remains a constraint to business operation and daily life. One in four firms surveyed inthe 2005 BEEPS identified electricity supply as a problem in doing business, and almost 7 percent o f total annual sales were lost due to power outages. Some areas of the country receive only a few hours o f electricity a day, and there are frequent localized outages and occasional widespread system failures. The gas transmission system also needs large-scale rehabilitation, and gas treatment and storage facilities are inadequate. The sector i s far from financially viable. Azerenerji, the state electricity company, depends heavily on SOCAR to provide power plant fuel but lacks the ability to pay for it. Azerigas, the state gas company, is in a similar situation. Explicit subsidies are provided from the state to cover SOCAR deliveries inboth cases. J: Cleaning up theEnvironment 33. 130 years o f oil production on the Absheron Peninsula around Baku has lefi some 33,000 hectares o f oil-contaminated lands. The Caspian Sea is also affected. The bulk o f the pollution was created by Soviet era companies that no longer exist, but the pollution has also continued since SOCAR took over in 1991. Examples of poor practice include oil and waste water spilling pouring out onto the ground at drilling sites. Some o f the contaminated sites are very 9 near Baku, and citizens and developers are building homes and apartments on them. This represents a serious healthrisk and could potentially cause catastrophic fire or explosion. 34. Recently the President has ordered the urgent clean-up o f the oil contaminated land. A substantial portion o f the estimated 700 million barrels o f oil on these lands may be recoverable, and represents a very substantial value. A significant part o f the contaminated land also has high potential value for residential and commercial development once it i s cleaned up. Issues, however, remain concerning ownership o f the contaminated land. Furthermore, efforts are required to ensure that all existing oil operations conform to good international environmental and safety practice. 35. Venting o f gas into the air i s taking place from older fields inthe Caspian. From one field alone about 1million cubic meters o f associated gas is vented into the air daily from wells not equipped with flaring equipment or capacity to pipe the gas. It is expected that this figure may rise to 3 million cubic meters unless new piping and compressor investments are made. This represents an opportunity for Carbon Financing. 36. The Baku sanitation system is in urgent need o f reconstruction. Here, and in several other places untreated residential and industrial wastewater i s contaminating rivers and the Caspian Sea. Again, this has led to heightenedhealth hazards. Furthermore, the sturgeon population is under pressure. 37. Azerbaijan's high biodiversity results from its location at the convergence of three biogeographic regions (Europe, Central Asia and Asia Minor). The Caucasus mountains area, has been identified by the World Wide Fund for Nature (WWF) as a Global 200 Ecoregion, and by Conservation International as one o f the world's 25 biodiversity "hotspots" (the only one inthe ECA region). The Caucasus ecosystem profile identified deforestation, overgrazing and hunting as the three greatest direct threats to biodiversity. Underlying causes include poverty in rural areas, the end o f importation o f wood from other countries, the collapse o f natural gas supply systems, political insecurity and the presence o f large numbers of internally displaced people. With support o f the Bank the government i s improving natural resource management and introducing more sustainable economic activities in two mountainous areas o f Azerbaijan, in order to enhance the ecological quality and the sustainable productivity o f highelevationforests andpastures. 38. Azerbaijan is located inan area o f high seismic activity. The country is also susceptible to heavy flooding because o f its topography and the water-level fluctuation o f the Caspian Sea. Landslides are a highrisk duringperiods o f increased precipitation, causing significant damage to human settlements, industry, farms, and roads. The probability o f annual economic losses exceeding $1.4 billion is about 0.5 percent. The probability o f annual losses exceeding $90 million is estimated at about 5 percent." 10Preventable Losses: Saving Lives and Property through Hazard Risk Management - A Comprehensive Risk Management Frameworkfor Europe and Central Asia, Disaster Risk Management Working Paper Series No. 9, The World Bank, October 2004. 10 111. Macroeconomic Framework a. Recent Developments 39. Azerbaijan's economy has grown rapidly since the late 1990s, particularly in the non-oil sectors (table 2)." Inthe past five years, the non-oil economy has outperformed the oil sector, growing at an average annual rate o f 12 percent. The non-oil sector currently accounts for 60 percent o f GDP and 99 percent o f employment. Since 1995 output in the agricultural, commercial, and social sectors has roughly doubled, non-oil industrial output has tripled, output in transport and communication has quadrupled, and construction has increased by a factor o f 13.'~ 40. Azerbaijan has exer- cised sound macroecono- Table 2: Summary of Key Indicators mic management in the (in percent of GDP unless indicated otherwise) face o f high levels o f net 2001 2002 2003 2004 2005" Real GDP growth (percent) 9.9 10.6 11.2 10.2 26.4 foreign direct investment Real Non-Oil GDP growth (FDI). Sterilization o f oil (percent) 10.4 12.3 15.5 13.4 8.4 receipts, together with Inflation (CPI, period average, 1.5 2.8 2.2 6.7 9.7 prudent fiscal policies, percent) has prevented inflation per Capita (US$ Atlas) 660 720 820 950 1240 account balance -0.9 -12.3 -27.8 -29.8 1.3 and sustained apprecia- Net ForeignDirect Investment tion o f the real exchange (US$ mln) 227 1,067 2,352 2,351 459 rate for most o f the Real effective exchange rate -6.1 -7.1 -10.8 -3.5 7.5 period since 1995. Large (percent, - depreciation) external current account I Consolidated fiscal balance -0.4 -0.5 -0.8 1.0 2.7 Consolidated fiscal balance, deficits in 2003-04 were excl. Oil Fund -1.4 -4.3 -4.2 -2.5 -2.3 associated with high oil Consolidated budget revenues 18.7 27.3 26.8 26.8 26.5 sector imports related to Gross fixed investment 22.9 34.1 52.9 57.7 44.1 the BTC and SCP Externaldebt outstanding 22.8 24.0 24.0 22.8 15.0 pipelines and upstream Externaldebt service to exports 5.3 5.9 6.6 5.3 2.6 oil platform develop- I ratio (percent) Crudeoil price (US$/barrel) 24.4 24.9 28.9 37.7 53.4 ment. The deficit was Source: State Department of Statistics, Bank and Fund staff estimates. *2005 data are estimates fully financed by FDI from international oil consortia, and the overall balance o f payments recorded a surplus. In 2005 the current account turned into a small surplus (1.3 percent o f GDP), as the BTC was largely completed and highoil prices drove up export earnings. Net FDI inflows peaking at 32 percent o f GDP in 2003 declined to around 4 percent in 2005 and are projected to turn into large net outflows in 2006-09, as capital repatriation from the oil and gas investments begins. 41. From unsustainably high levels in the early 1990s, the consolidated government deficit without Oil Fund net revenues declined to less than 2 percent o f GDP in 2001.13 However, "Foradetailedanalysisofdevelopmentsinthe Azerbaijan economy duringthisperiod, seeAn Integrated Non- Oil Trade and Investment Strategy (INOTIS), World Bank November 2003, and Public Expenditure Review, World Bank, December 2002. l2Much of the increase inconstruction is related to the oil sector, but the increase also reflects a housing boom in Baku. 13 Consolidated government deficit excluding the Oil Fund is calculated by deducting the revenues and expen- ditures of the Oil Fundfrom the consolidated government budget balance. 11 fiscal adjustment in the 1990s required deep expenditure cuts, especially in the social sectors, which has led to suboptimal health care and education services. With the 2005 budget the government has started to allocate more adequate resources to the social sectors. 42. To avoid Dutch disease, in 1999 the government established SOFAZ as the main sterilization mechanism for foreign exchange inflows. The government has remained committed to exercising caution over the use o f the expected oil and gas windfall and to ensuring that it benefits all citizens and future generations. 43. Early 2005 saw an upsurge in inflation (12.5 percent in March 2005, on a year-to-year basis), inpart due to higher levels o f public spending but also as state-owned enterprises that benefit from higher oil revenues (SOCAR) and access to credit increased spending. A temporary rise in food prices also increased inflation, and the policy o f fixing the manat to the U.S. dollar resulted in an expansion o f the monetary base. The National Bank's response has been to allow the manat to appreciate by about 10 percent innominal effective terms and raise the refinancing rate. The Ministry o f Finance increased the issuance o f T-bills to absorb liquidity. Inflation returned to single digits by fall 2005, and was 10.3 percent in September 2006 on a year-to-year basis. b. Medium-Term Outlook 44. Azerbaijan's medium-term growth prospects are strong. Real GDP i s projected to grow at an average annual rate o f about 24 percent between 2006 and 2008, due to continued rapid growthinthe oil and non-oil sectors (table 3). The decline inoil-related investments is counter balanced by the government's intensive efforts to rebuild the country's infrastructure and humancapital to catch up with more than a decade o f deterioration. However, competitiveness o f the non-oil sector is likely to be challenged by an appreciating real effective exchange rate due to higheroil revenues andrapid monetary expansion as a result o f the fiscal stance. 45. The 2006 budget contains a major fiscal expansion. While nominal GDP is expected to grow at 42 percent, current expenditures are budgeted to increase over 60 percent, and the public investment budget is planned to triple. The non-oil primary deficit is expected to increase from 11percent o f non-oil GDP in2005 to over 30 percent in2006. 46. The IMF and the Bank have expressed concern that this rate o f public expenditure increase may cause new inflationary pressures. The authorities counter that over the past years, Azerbaijan's economy has been able to absorb FDI o f more than 30 percent o f GDP a year in connection with the BTC, the South Caucasus Pipeline, and upstream oil development. As these investments end, the government i s gearing up for its own large infrastructure investments. The authorities are well aware of the inflation risks and would slow the rate o f infrastructure investment and consider other offsetting measures if inflation gets too high. The government is also fully aware that constraints to institutional and absorptive capacity may slow the execution o f the large investment program. 47. During2007-08 government spendingis projected to increase by about 35 percent p.a. (in nominal terms) as the reconstruction agenda continues.l4Elections are scheduled for 2008. From2009 it is projectedthat the rise inspending will slow down to about 10percent p.a. The 14Basedon estimates from the Bank's sector experts, the projections assume that the reconstruction cost would be inthe order of US$20-30 billion intotal spread over 6-10 years. This figure should be seen incomparison with projected government revenues from oil and gas of US$175billion during 2006-2024, as noted above. 12 non-oil fiscal deficit is expected to peak at over 40 percent in 2007-08 and steadily decline thereafter. Such a government strategy would be fiscally sustainable with today's oil prices. It would result in Oil Fund assets reaching about US$35 billion in 2010. However, the current strategy contains substantial risks o f over-heating the non-oil economy, and as experience in other countries shows, the risks o f Dutch disease and the "resource curse" are substantial. Inflation is expected to rise to about 17 percent p.a. in 2007-08, before falling back to the ten percent range. 48. Mitigating these risks requires aggressive pursuit o f structural reforms, which would unleash domestic resources, reduce operating costs, and increase productivity, to counter the adverse impact o f the appreciating real effective exchange rate (REER), see box 1. However, these structuralreforms and rebuilding a competitive infrastructure will take some time to have effect. Inthe short-term the pressures on non-oil competitiveness are mitigated by the fact that the real effective exchange rate has depreciated considerably against other countries since 1995, and that wages are relatively low ininternational comparison (see box 1). Yet, the trade- off made by the government o f temporarily increasing public investment at the cost o f higher inflation may leadto suboptimal private sector expenditure behavior formed by expectations o f continued domestic inflation. Azerbaijan's experience suggests that monetary policy may not be sufficient to offset the impact o f fundamentals on the REER dynamics inthe medium term. Therefore the appreciation o f the REER can likely not be avoided in any event. Nominal exchange rate appreciation can counteract inflation and these expectations. Both domestic inflation and exchange rate appreciation would lead to a capital loss in domestic currency on accumulated resource revenues denominated inU S dollars. - 1 Table 3: MacroeconomicFramework2006 2010 2005 2006 2007 2008 2009 2010 Real GDP growth (percent) 26.4 24.6 27.1 19.9 11.6 5.7 RealNon-Oil GDP growth (percent) 8.4 8.9 8.4 8.1 6.8 6.8 Inflation (CPI, period average, percent) 9.7 13.0 17.0 17.0 13.0 10.0 GNIper Capita (US$ Atlas) 1,240 1,650 2,400 3,330 3,940 4,450 Current account balance 1.3 14.4 21.3 25.0 24.4 21.3 Net Foreign Direct Investment (US$ mln) 459 -1,539 -4,120 -1,456 -667 81 Consolidated fiscal balance 2.7 7.5 8.5 24.5 27.0 24.7 Consolidated fiscal balance, excl. Oil Fund -2.3 -7.2 -13.8 -17.8 -16.1 -14.1 Consolidated budget revenues 26.5 40.8 45.3 63.9 64.7 61.4 Gross fixed investment 44.1 39.7 36.6 36.4 36.0 37.3 External debt outstanding 15.0 10.5 8.9 7.9 7.5 7.8 External debt service to exports ratio (percent) 2.6 0.9 0.9 0.8 0.8 0.9 Crude oil price (US$/barrel) 53.4 65.3 60.1 56.1 52.5 49.1 Source: Bankand Fundstaff estimates and projections. 49. Highinflation has been shown to have a negative impact on resource allocation, investment incentives, trade, financial intermediation, and, as a result, economic growth. It is potentially more costly than the short-term repercussions on exporters and foreign currency deposit holders related to nominal exchange rate adjustments. Moreover, lower income segments o f society likely suffer disproportionally from high inflation. Greater exchange rate flexibility could also support financial market development and discourage purely speculative inflows. However, although nominal exchange rate appreciation could help reduce inflation pressures, prudent macroeconomic and structural policies will be essential. Fiscal restraint by phasing the implementation o f the public investment program remains an important instrument for curbing 13 the inflationary impact of excessive domestic demand. It should be accompanied by a prudent monetary policy framework, geared toward containing upward pressures on the real exchange rate. The main sterilization instrument will continue to be the Oil Fund and restraint on its financing o f non-oil deficits. Box 1:Non-OilSector Competitiveness Sincethe beginningofAzerbaijan'stransitionprocess, three differentperiodsof inthe real effectiveexchange rate(REER) series can bedistinguished: The REERappreciated steeply, by 46 percent, Selected CIS Countries: Real Effective Exchange Rates for the Region, 1995-2005 (Hl), (1995=100) betweenJanuary 1995and I70 September 1998. IM)- , Inthe immediateaftermathof IS0 - the Russiancrisis, the REER 140 ,, I begana depreciationthat Russia ~ lasteduntilJuly 2004, as a resultofwhich it hadfallento 110 - a level36 percentbelow its I00 - Ukraine peakof September 1998and 7 percentbelowthat ofJanuary Azerbaijan 1995. 70 1995 1996 1997 1998 1999 2wO 2001 2W2 2W1 2W ZWS BetweenJuly 2004 and Sources INS andFund %ffen~mata November2005, the REERappreciatedby 14percent, however remaining27 percentbelowits peak. Azerbaijan's REERhasremainedthe most depreciatedinthe regionsince 2001. Fundamentalfactors will likely cause strong real appreciation pressure.In fact: (i) exports oil Selected CIS Countries: Dollar Wages are projectedto increase by 45 percenton average _ _ _ during2006-09, reachingabout 60 million tons 24C. towardsthe endofthe decade; (ii) 22c. the external 20c environment is assumedto remainfavorable; (iii) 18C. investment inflows are expectedto continue l6C. against the backgroundofAzerbaijan's ongoing 14(. 12c. transitionto a marketeconomy; (iv) substantially IOC. highergovernmentexpenditures are expectedto 80. leadto demandand inflationarypressures; and (v) 60. large-scalewage increases, inducedby 40. 20. government-ledincreases inthe minimumwage 0 I will continueto exert cost pressures. 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 everth he less] the wage levelinAzerbaijan l / First 9 monthsof 2005. Sources:INS; and Fundstaffestimates. 31First 8 monthsof 2005. remainsbelowthe averageattained inregional comparator countries. Source: Republic of Azerbaijan SelectedIssues, IMFMarch 2006. - 50. During 2006-07 about a quarter o f gross national income (GNI) is expected to leave the country, as foreign investors repatriate capital. While GDP is expected to almost triple in U S dollar terms between 2005 and 2009, the production-sharing agreements with the oil consortium call for accelerated capital repatriation when oil prices are higher. Foreign investors are projected to repatriate about US$8.2 billion in 2006, about the size o f GDP in 14 2004. Adjusted for capital repatriation, per capita GNI in2005 was US$920 and is projectedto be US$1,140 in 2006 and US$1,690 in 2007. The CPS takes account o f repatriation in its transition planningfor the phasingout o f IDA support to Azerbaijan. c. Debt Sustainability 5 1. Azerbaijan's external debt, about 50 percent o f which is on concessional terms, i s expected to remain sustainable. External debt, at about 15 percent o f GDP, and debt service obligations, at 2.6 percent o f exports o f goods and services in 2005, are moderate (DRS data). Both ratios are expected to decline further. IDA total debt outstanding from Azerbaijan is US$525 million, with a debt service to export ratio o f 0.1 percent. IDA debt service represented 4.9 percent o f total public debt service in 2005 and is expected to increase to 7.3 percent by 2008. In November 2005 Fitch increased its sovereign rating for Azerbaijan on long-term liabilities in both foreign and national currencies from BB- to BB. The rating on short-term foreign currency remained unchanged at B. The long-term rating forecast i s "stable." Moody's assigned Azerbaijan a foreign and local currency issuer rating o fBal inSeptember 2006. IV. The Government's Strategy for Reducing Poverty a. ThePoverty Reduction Strategy Paper (2003-05) 52. The SPPRED recognizedthe role o f the private sector as crucial to sustaining development and strengthening public social service delivery. Key strategies for reducing poverty and increasing living standards included improving public expenditure management and strengthening the financial and utility sectors. 53. The Joint Staff Assessment (JSA), presented to the Board inMay 2003, concluded that the SPPRED presented a credible poverty reduction strategy and provided a sound basis for Bank and Fund concessional assistance. It noted, however, that poor governance and weak implementation capacities were bottlenecks. 54. The Joint Staff Advisory Note (JSAN) on the second Annual Progress Report found continuing evidence o f poverty reduction and strong real growth performance. It also noted other areas that require continued attention, such as strengthening poverty diagnostics, enhancing coordination of macroeconomic policies and reducing inflation to single digits, improving the fimding and effectiveness o f social services, reducing energy subsidies, reforming customs, deepening financial intermediation, improving governance, and addressing the barriers to private sector development, including underdeveloped infrastructure. b, TheState Programme on Poverty Reduction and Sustainable Development (2006-15) 55. The SPPRSD will continue to pursue similar strategic goals: ensuring economic growth and maintaining macroeconomic stability; creating enabling conditions to improve income- generation opportunities, especially in the non-oil sector, in the regions, and in rural areas; improving the quality o f and ensuring equal access to basic health and education services; improving public administration and good governance; improving public infrastructure; reforming the social protection system to better protect vulnerable groups, especially children; improving the live conditions o f refugees and internally displaced people; ensuring that government policies and programs in all sectors promote and protect gender equality; and ensuring that all economic development policies, programs, and related legislation respect the principles o f environmental sustainability. 15 56. The SPPRSD is aligned with the MDGs andwith other programs inAzerbaijan. It sets both general and specific targets. It is intended to be integrated with the Medium-Term Economic Framework (MTEF), Public Investment Program (PIP) and State budget processes. It is based on a broad participatory process involving the government, international organizations, and civil society. It provides for a system o f monitoring the implementation and impact o f the measures on living standards, and it incorporates gender, youth policy, environmental, and other cross-cutting issues. V. FY03-06: Track Record and Lessons Learned a. Achievements of the FYO3-05 CASand Remaining Challenges 57. The experience in Azerbaijan over the past few years generally has been positive. The Bank worked with the government to establish a meaningful poverty reduction strategy and, based on this, provided adjustment credits to support the government in implementing significant reform inindividualsectors. The Bank Group strategy to support the SPPRED was organized into four strategic goals: (i) manage the oil boom to maintain macroeconomic stability, avoid "Dutch disease" and facilitate non-oil growth, employment and pro-poor expenditures; (ii) generatejobs and non-oil growth by improving the business environment and access to financial services, building SME support infrastructure, and stimulating agriculture; (iii)improve infrastructure and social services by reversing the decline in social services and assistance and developing energy, transport, and water infrastructure; and (iv) help realize the oil potential to the extent and within the time-frame the SPPRED presumes. 58. The CAS period saw substantial progress inall four strategic directions. Particularly strong results were seen in the first and fourth pillars: managing the oil boom and helping realize the oil potential. GDP grew on average 11percent per year over the past four years with non-oil GDPgrowing at 13 percent a year; the BTC pipeline was completed; development o f gas fields and other pipelines are on schedule; the Oil Fund is firmly inplace, the budgetary framework i s being implemented, and the government's commitment to maintaining high standards of governance and transparency in the utilization o f its energy revenues was demonstrated by its groundbreaking participation in the EITI, as the first and only country in the world reporting for 2003 and2004. However, progress on SOCAR restructuring has been slow. 59. Good progress was also made toward the second goal, although progress was slower in some important areas. Sustained growth was seen inthe non-oil sector andprogress was made inmost areas supported by the Bank, including the financial sector, landmarket, rural credit, irrigation, and environment. However, considerable work remains to be done to improve the business environment, competition in the banking sector, and eliminate corruption. Progress on privatization and improving the transparency o f state owned enterprises has been slow. 60. In the social sectors, IDA had significant impact through the dialogue on pension and social assistance and comprehensive reforms are underway. The government also strengthened its care to IDPs and began seeking sustainable solutions to improving their living conditions and economic opportunities. In the education sector, progress was made in developing new cumcula, provision o f free textbooks, and monitoring education outcomes. Restructuring continued in the water and energy sectors, although limited progress was made on increasing private sector involvement. The health sector remained an area o f serious concern, but time was well spent on completing a Health Sector Review. The change inthe ministerial leadership 16 in 2005 made it possible to move rapidly forward with a major and well-researched Health Sector ReformProject. 61. Table 4 summarizes lessons learned. The CAS Completion Report in annex 3 provides a detailed evaluation o f the FY03-05 CAS period. Table 4: Lessons Learned from the Country t rsistanceStrategy FYO3-05 Key Lessons Implicationsfor the Bank Intensive and consistent Bank policy dialogue Maintain a consistent policy dialogue. over a considerable time periodplayed a critical Continued Bank policy dialogue can play a role inbuildingconsensusand advancing policy pivotalrole inadvancing arange of difficult and institutionalreforms ina range of areas. reforms. Close integrationo fpolicy dialogue and Ensureclose alignment ofpolicy advice, investment lending and a closely knit country team investment lending, and technical assistance. enhancedthe Bank's effectiveness. Maintainintensive coordination among Bank Group team membersinprogramcontent, advice. and moiect suDervision. The shift toward "programmatic" economic and Expandprogrammatic analytical work to other sector work, rather than traditional large analytical sectorsto enhancepolicy dialogue andthe reports, resultedina series o f timely policy notes disseminationofknowledge. and workshops. Regional cooperation and integrationhas been Anticipate and prepare for increasingregional politically difficult, but it will be increasingly integration and possible regional-level important for the region to sustain growth. assistance, such as development o f the transit corridor. b. TheFY06 Program 62. The objectives o f the CAS were successfully continued duringFY06, despite Parliamentary elections in the fall o f 2005 that brought new ministers to the ministries o f finance, economic development, health, and agriculture. The Bank supported major intensification o f governance reform with the new Judicial Reform Project (SDR14.8 million [US$21.6 million]) and the new Health Sector Reform Project (SDR34.3 million [US$50 million]). The second phase o f the Agricultural Development and Credit APL (SDR20.1 million [US$29.2 million]) was also negotiated, and all three projects were presented to the Executive Board in June 2006. Furthermore, Azerbaijan i s now rapidly moving to IBRD status with the Highway-I1Project o f US$200 million approved in January 2006. FY06 also saw additional financing of SDR3.5 million (US$5 million) for the Rehabilitation and Completion of Irrigation and Drainage Infrastructure Project and the restructuring o f some undisbursed funds o f IBTA-2 for avian flu emergency purposes. IFC invested US$13.3 million in four projects in financial markets to support leasing and financial intermediation to medium, small and micro-enterprises (SMEs). On the technical assistance side IFC PEP-Central Asia continued working on developing the expansion o f leasing and housing finance as well as helping local banks and companies build capacity through its corporate governance project. IFC also continued working with BP on supporting local suppliers through the ACG/BTC SME linkage program. c. Current Portfolio Status 63. The current IDNIBRD portfolio consists o f 18 projects (16 IDA plus two IBRD).To date total commitments are about US$940 million, o f which US$423 million remains undisbursed. Eight ongoing infrastructure projects are designed to enhance economic growth. These include 17 major commitments to rural development, irrigation, water supply, and the highway sector. These commitments will be continued through new operations that will come on board as the current ones expire during the new CPS period. The Bank has also entered into its first IBRD project in power transmission, which will continue for the life o f the new CPS. As o f June 2006, IFC committed portfolio is US$49 million and outstanding portfolio is US$41 million. The portfolio is mostly in the BTC project (63 percent) and financial markets (34 percent), specifically infour local financial institutions. 64. Inthe social sectors, the Bank i s currently providing support for an education APL, a next phase o f which is expected in the new CPS. The Health Reform LIL closed this year and is followed on by a sector-wide approach. IDA is also supporting pensions and social assistance reform as well as raising the living standards o f internally displaced people through ongoing projects. 65. Generically, there are few problems with project performance and the average FY05-06 disbursement ratio was about 20 percent. The 2005 Country Portfolio Performance Review (CPPR) stressed the importance o f strong supervision o f TA activities, and o f increased attention to project processing to avoid delays. VI. The Country PartnershipStrategy, FY07-10 66. The main thrust of the earlier agenda was helping the government manage and use its oil revenues. The new challenge for the government i s to build on the opportunities provided by this revenue to establish a diversified market economy. The CPS is designed to help mitigate the current risks o f Dutch disease and the "resource curse.'' The Bank will help ensure that oil revenues are used wisely, that institutional and policy reform i s undertaken, and that appropriate capacity buildingand fiduciary oversight are provided. 67. The objective o f sustainable and balanced growth involves integrating rural regions and secondary cities with the capital area and securing equitable basic service standards, such as electricity, gas and water supply, and easy access to markets across the country. It also requires regional integration o f markets across the South Caucasus, the Caspian, and the Black Sea area. Human development will be a critical element in helping build a competitive diversified economy. Maintaining a clean environment and ensuring prudent use o f natural resources is also essential to ensure sustainable growth and to improve health outcomes. 68. Strengthening governance i s a key element o f this agenda and a crosscutting, high-priority objective o f the CPS. The new strategy will improve public sector management and support judicial reform; strengthen the system o f checks and balances, external and internal audit functions, and institutions supervising financial markets; and increase local participation and community empowerment. 69. The CPS will support four mainpillars (figure 3): > Pillar I:Improving the quality and transparency in public sector governance, by maintaining a stable macroeconomic framework that makes prudent use o f oil revenues; improving public expenditure planning and management; strengthening financial management and procurement systems; establishing proper public sector and corporate governance, accounting, and auditing; creating an administrative and 18 regulatory business environment conducive to growth; and strengthening the judicial system. Pillar 11: Supporting sustainable and balanced growth of the non-oil economy, by expanding access to financial services; supporting the development o f SMEs and investing directly in the private sector; developing rural infrastructure and services; improving the quality o f and access to roads and other transit routes; improving the quality and coverage o f water and sanitation nationwide; increasing the reliability of electricity and gas supply; and strengthening the financial viability o fthe utility sectors. Pillar 111: Increasing the quality of and access to social services, by expanding coverage o f good-quality health care services; developing a modern and globally competitive education system; effectively targeting social assistance; creating a more transparent, affordable, and sustainable pension system; and improving living conditions and economic opportunities for internally displaced people. Pillar IV: Improving environmental management, by cleaning up legacy pollution, reducing carbon emissions, promoting biodiversity, supporting more sustainable natural resource management inselected areas, and strengthening natural disaster management. 70. The government andthe Bank will continue to implement the reform framework laid out in the PRSC. Although early in the CPS consultation process, the decision was made to discontinue the second and third PRSC operations, as there is little rationale for providing general budgetary or balance o f payments support given the rapid inflow of oil revenues, the government has nevertheless affirmed its commitment to the PRSC agenda, which remains the underlying policy framework for the CPS, as summarized in the Results Matrix (annex 1). From a practical standpoint, the CPS selectively supports the implementation o f the reform agenda through a combination o f the programmatic AAA and reform components o f the various investment projects. Table 5 summarizes the reform areas o f the PRSC and the main CPS instruments that support their continued implementation. The CPS interventions also form a comprehensive and coherent governance actionplan, which is described insection g below. Macro management ICEM, Quarterly monitoring reports Prudentuse of oil revenuesandEITI ICEM, ProgrammaticPER, CAPSAP 19 L I 0 N ...... a. Pillar I:Improving the Quality and Transparency in Public Sector Governance 71. Weaknesses in basic public service delivery stemming from governance problems and institutional capacity constraints remain important impediments to sustainable development and poverty reduction in Azerbaijan. Addressing these weaknesses is a key medium-term objective o f the government's public sector reform program and an important strategic goal o f the CPS. Maintaininga Stable MacroeconomicFramework 72. Macroeconomic management to date has been prudent, preventing Dutch disease. Maintaining macroeconomic stability during the current investment boom and imminent spike in oil revenues remains a challenge. The IMF will continue to assist the authorities in macroeconomic management through close policy dialogue in the context o f Article IV consultations and TA. The Fund will take the lead on exchange rate and monetary policy advice. The Bank will support macroeconomic management in the medium term and develop long-term projections for sustainable fiscal and monetary policies under alternative oil price trajectories through just-in-time policy papers and a Country Economic Memorandum (CEM). A two-sector RMSM-X, an elaborate Oil Model, the IMF Financial Programming Model, and monthly time series-based early warning systems will be used to monitor the macroeconomic situation. ImprovingPublicExpenditurePlanningandManagement 73. The Programmatic Public Expenditure Review (PPER) will support efficient and transparent budgeting and fiduciary arrangement, starting with the state consolidated budget and SOFAZ. Informed strategic priority setting and vertical as well as horizontal accountability to Parliament and civil society i s at the core o f good governance. Appropriate governance frameworks were established under the previous CAS. They now need to be fully implemented and used. 74. With IDA assistance, the government has established the MTEF and PIP for the budget formulation process. As inother countries, it will take some years to buildthe capacity to bring these strategic exercises to sufficient quality. During the CPS period, technical assistance and the PPER will support the MTEF and PIP mechanisms to secure financing for priority needs while strengthening the linkage between policy objectives set in the SPPRSD and the annual public expenditure programs. With these mechanisms, the government aims to strengthen the coordinating framework for all ministries to operate within a strategically prioritized expenditure framework and a predictable resource envelope. The budget calendar, as stipulated in the Budget Systems Law, entails a much stronger participatory process that includes line ministries and other budgetary organizations. The regulations related to the Budget Systems Law have been adopted, and budget process manuals will be approved. Considerable training will also be undertaken in the Ministry o f Finance and other line ministries. The Bank will work closely with USAID through its Public Investment Policy and Efficiency project and with the US.Treasury budget advisor. Results o f these interventions will be monitored within the Public Expenditure and Financial Accountability (PEFA) self-assessment framework 21 75. The Chamber o f Accounts was established and initial capacity buildingprovidedunder the previous CAS. Under the CPS, a twinning arrangement will be sought to help the Chamber o f Accounts conduct audits o f public institutions and connect on line to the new computerized Treasury Information Management System (TIMS), which should be hlly functioning in 2007.l5The capacity to conduct transparent procurement processes will be hrther strengthened through an e-procurement grant from the Institutional Development Fund (IDF). Results will be monitored using the Public Internal Financial Control (PIFC) framework and the CPAR Update. Strengthening Governance Mechanisms and Increasing Financial Transparency 76. To promote good governance in the financial and the corporate sectors, including state- owned enterprises, the CPS will focus on enabling high-quality financial reporting and accounting and auditing standards through adoption o f IFRS and International Standards on Auditing(ISA). SupportedbyIDA, Technical Aid to the Commonwealth o fIndependent States (TACIS), and other donors, the government has enacted a new accounting law and started draftingrelated secondary legislation.l6CAPSAP will also support the transition o f corporate financial reporting to international standards, as stipulated in the law, including the hiring o f accounting companies and installation o f systems such that major state-owned enterprises can comply with these standards. SOCAR i s now training the accountants who will implement IFRS and eventually make it possible for SOCAR to have auditing and disclosure to international standards. The Bank is supporting this important transformation and training programs over the next several years, which will also support EITI. Results o f this program will be monitored through the CFAA Update and Reviews o f Standards and Codes (ROSCs) on corporate governance, accounting and auditing l7 . Furthermore, IFC Corporate Governance Project will continue to provide in-depth technical assistance to Azerbaijan's joint-stock companies and banks that are interested improving their corporate governance practices. '* In addition to the general introduction of international best practice corporate governance standards to banks and joint-stock companies, the project will also assist government agencies to improve corporate governance legislation and regulatory framework. ''Development o f TIMS, based o n an IMF-supported design, i s supported by IDA. IDA i s finding the computer hardware; USAID i s finding the software. 16 This legislation mandates the use o f pure IFRS by public interest entities (defined as entities representing a noticeable public interest because o f their activity, their size, their personnel or their legal status) and the use o f National Accounting Standards (simplified IFRS) by all entities except microenterprises and natural persons, for which a simplified accounting system is sufficient. It also establishes an appropriate framework for the governance o f accounting standard setting, under the responsibility o f the Ministryo f Finance "TheBankandthe IMFare alsoproviding technical assistanceto the AzerbaijanNational Bank, whichis in charge o f developing anti-money laundering/counterterrorism financing measures, including drafting an anti- money laundering law and creating a financial intelligence unit. The current draft anti-money laundering law, which is expected to be submitted to Parliament soon, is broadly consistent with the FATF 40+9. Consistency o f the overall legal framework o f Azerbaijan with anti-money launderinglcounterterrorism financing measures i s being addressed. 18Azerigazbank and Azel (Azerbaijan Electronics) have been selected as pilot companies. IFC is working closely with them to revise their corporate documents and improve their governance standards to bringthem into line with worldwide best practice. 22 ReformingPublicAdministrationandthe CivilService 77. A keen interest has developed at the highest levels o f government in quickly making Azerbaijan a twenty-first century information society. The State Programme on Development o f Communication and Information Technologies, approved by the President in October 2005, outlines a wide range o f activities, including e-government. The CPS will support the modernizationofpublic sector administrative systems and organization inclose alignment with the state program and the ENP Action Plan.Ig The Bank will support E-Government and Public Sector Reformactivities inareas such as design and implementation o fe-procurement, systems for personnel and financial management, and public service interfaces. It may also support information and communication technology in education and creation o f regional information training centers; Internet access centers; special economic zones in order to prevent a digital divide, especially among young people; and development of the information and communication technology sector. The Bank's support would be inthe form of analytical work, TA, and possibly project implementation. Progress will be monitored within the framework o f the European Commission, Country Policy and Institutional Assessment (CPIA), andWorld Bank Institute (WBI) Governance Indicators. StrengtheningtheJudicialSystem 78. The Judiciary ReformProject is supporting the government's ongoing reform program to improve the hnctioning o f the civil, criminal, and economic courts by strengthening the management capacity o f judicial institutions, upgrading court facilities by building and rehabilitating courthouses and providing technology and equipment, strengthening the professionalism ofjudges andjustice sector staff by providing training and upgrading training facilities, and improving citizen access to information. The project seeks to have a measurable impact on a national scale, with special attention to the Baku area, which accounts for about 60 percent o f the caseload, as well as other regions that merit targeted attention. Progress will be monitored within the overall framework o f Azerbaijan's Council of Europe membership and the Judiciary Reform Project results framework. ImprovingtheBusinessEnvironment 79.Azerbaijan is inthe process ofjoining the WTO. The U.S. Trade andDevelopment Agency (USTDA) i s funding a resident advisor to support this process by helping identify and amend areas in legislation that need to be changed and ensure that standards, policies, and practices are in line with WTO mandates. The Bank and FIAS will continue to support this process through policy dialogue and TA for the WTO-consistent regulatory development, such as new investment and competition laws. 19The European Commission is leading the efforts o n public sector and civil service reform. These reforms will gain considerable impetus as the ENP Action Plan moves forward and the vast range o f instruments and experience from EU accession countries is activated. Other donors are leading the support to core civil service reform, such as human resource management and ethics; the CPS focuses on efficient public service delivery and transparency. 23 80. IFC with FIAS will continue to help improve the business climate and identify impediments to foreign investments. Removing administrative and regulatory impediments to starting and operatingbusinesses remains a highpriority objective o f the CPS. The Bank/FIAS INOTIS report o f FY03 laid out an overall strategic framework and detailed action plans. FIAS is currently advising the government on streamlining o f the licensing regime. Another barrier identified in the Doing Business Report in 2006 was "starting a business" which reportedly averaged 115 days. Supported by the PRSC, the regulations for registration o f legal entities were streamlined, and the latest Doing Business in2007 shows a reduction to 53 days. The registry will be computerized under the Judicial Reform Project, which will also strengthen economic courts. The Cadastre and Real Estate Registration Project will support the establishment o f a nationwide immovable property registration system. This project aims to make property rights more secure andbetter allow real estate to be used as collateral for credit. 81. FIAS will continue to conduct in-depth administrative barriers diagnosis, and work with the government on Doing Business focused and licensing reforms as well as regulatory governance arenas. IFC is also active through PEP-Central Asia, in strengthening the corporate governance and building financial intermediaries' capability. IFC plans to establish a baseline assessment and progress which will be monitored through the SME Surveys and Policy Recommendations. This will further guide CPS policy interventions and the Bank's Structural Reform TA program. BEEPS, FIAS and Doing Business surveys will be conducted regularly to monitor progress on business environment reforms and will further guide CPS policy interventions andthe Bank's Structural Reform TA program. b. Pillar II:Supporting Sustainable Growth of theNon-Oil Economy 82. Significant investment in infrastructure and transit corridors; continued governance reforms, particularly in the utility sectors; and greater access to financial services will be needed to develop Azerbaijan's non-oil growth potential. Investments will be needed to support agricultural and other rural commercial activities and help small and medium-size enterprises market their products in highly competitive markets. The CPS will provide support inall ofthese areas. Developing the Financial Sector 83. The on-going Financial Sector Technical Assistance (FSTA) established the modem payment systems infrastructure, introduced international accounting and financial reporting standards and governance principles in the banking sector, set the basic infrastructure to facilitate credit risk management and started the infrastructure needed for a widespread use o f electronic payment instruments. The Financial Services Development Project is improving payment systems for the utility bills collection, and access to financial services and basic business infrastructure in smaller urban and rural areas through the postal system. Better financial infrastructure and access will facilitate other government reforms, such as taxes, pensions and social assistance and the postal offices infrastructure will enable the provision o f e-government services to citizens and businesses, including those inrural areas. 84. A Financial Sector Modernization Project would support implementation o f the next phase o f reforms in banking, insurance, and capital markets; further strengthening o f the 24 institutional capacity o f the National Bank o f Azerbaijan; improvement o f financial risk management institutions (e.g., credit risk register, pledges/movable property register, mortgage support systems); strengthening o f the insurance sector including o f the regulatory and supervisory authorities, introduction o f surveillance and monitoring systems, and development o f infrastructure to improve risk management in the insurance industry; and capital market reforms focused on improving access to equity capital and facilitating entry o f foreign equity portfolio investors. 85. IFC has helped establish Azerbaijan's first microfinancebank, which is rapidly growing and branching out. IFC investments and TA will seek to foster a competitive and dynamic financial market, to develop the non-banking sector, and to help expand the range o f financial products. IFC will focus on buildingthe capacity o f financial institutions by improving access to finance to local private banks that serve SMEs and supporting establishment of leasing companies. This includes provision o f technical assistance for institutional capacity buildingas well as sectonvide technical assistance, such as leasing and housing finance development and corporate governance. For example, IFC has surveyed and identified gaps in the country's housingfinance system via PEP-CentralAsia and will continue to support the development o fthis sector inAzerbaijan through follow-up TA and investments. Non-BankingSector 86. IFC will continue to support the development o f the non-banking sector to increase and diversify financial intermediations to SMEs. IFC will build on its ongoing TA in the leasing industry to support expansion o f the industry, including creation o f a transparent and attractive legal and tax environment for leasing and increased public awareness; and well as hands-on training in lease origination, underwriting, credit analysis, monitoring and risk management. IFC recently committed US$30 million to a leasing facility for Central Asia (including Azerbaijan), which is intended to provide long-term credit lines to local financial institutions andinpartnershipwith Switzerland's State Secretariat for Economic Affairs, launched a three- year, $2 million Swiss-funded TA program that aims to increase access to finance and create employment through the development o f leasing sector. Under this program, recently IFC has committed loans of US$8 million to the first leasing transactions by an international development institution inAzerbaijan. SME Development 87. IFC will continue to work on improving access to finance for SMEs and building their competitiveness through its activities to deepen the financial markets and its continued ACG/BTC SME Linkage Program. In order to enable local companies to benefit from international tenders associated with the oil field and BTC pipeline operations, IFC partnered with BP, Statoil and GTZ to pioneer the Linkage Program in 2003. The program delivers training and access to finance through the Baku Enterprise Centre, an entity that reaches out to growing small businesses though a variety o f approaches. In2005 this work led to $68 million incontracts for local firms. IFC has provided business training to 559 SMEs, increasing these companies' sales not only to BP but also to other companies and sector in Azerbaijan. InJune 2006 the Access to Finance Pilot project called the Supplier Finance Facility, implemented through the Micro-Finance Bank o f Azerbaijan provided its first supplier finance loan to a local BP supplier, Azmetco, a company specializing in metering services. This latter initiative 25 is the first step in an important new effort, which will improve access to finance to Azerbaijan's local oil and gas industry supplier and service enterprises. IFC will also seek to invest directly in emerging domestic SMEs in general manufacturing sectors. In its constant effort to improve lending to SMEs IFC is devoting specialized resources to assess this possibility. DirectPrivateSectorInvestment 88. IFC will continue to actively seek direct investment opportunities in areas such as food retail to support growth and employment in the non-oil sectors. IFC will also seek opportunities to support private sector development to include SOEs privatization and South- to-South investments. For example, IFC is presently considering supporting the establishment o f a grocery retail chain inBaku o f about 86 stores. The project will introduce the Azerbaijan market to organized food retail in a chain format, and middle and lower-middle income consumers will benefit from the additional convenience, product range, quality and affordability o f modem grocery retailing. Furthermore, once the government decides on bringing in the private sector, IFC will also support the transparent privatization o f SOEs especially ininfrastructure and telecom sectors. DevelopingRuralInfrastructureand Services 89. Rural areas account for 40 percent o f employment in Azerbaijan. Rural development i s therefore key to supporting sustainable growth inthe non-oil sectors and reducing poverty. The ongoing Agriculture Development and Credit Project (ADCP) is improving land registration and access to rural finance and marketing information. The follow-on ADCP-I1 Project will further increase the earning capacity o f farmers and stimulate off-farm commercial activities by strengthening rural financial services, improving market linkages and product quality o f rural entrepreneurs and producers, further modernizing agricultural knowledge and information activities, and expanding the pilot real estate registration system. 90. An Avian Influenza Preparedness Program is supported by ADCP-I1 and finds from restructuring of the Second Institution Building and Technical Assistance project (IBTA-2). The undisbursed balance of IBTA-2 o f US$5 million has been allocated to finance emergency needs for avian influenza preparedness. The objective o f this program is to minimize the threat posedto humans andthe poultry industry andto prepare for andbe able to control a pandemic. 91. The ongoing Rural InvestmentProjectis increasing rural household access to and use o f basic infrastructure by financing demand-driven microprojects. It includes construction or rehabilitation o f economic infrastructure (roads, water, electricity) and social infrastructure (schools andhealth clinics) based on priorityneeds identified by rural communities. 92. There is an urgent need to rehabilitate irrigation and drainage systems to reverse deterioration and make them more efficient. Nearly all agricultural production inAzerbaijan is irrigation fed. Two ongoing irrigation and drainage projects are improving the effectiveness and financial viability o f distributing and managing irrigation water in target areas. The Irrigation and Drainage Rehabilitation Project (RIDIP), which is helping rehabilitate the first 50 kilometers o f the Samur-Absheron Canal, will close toward the end o f FY07. The IrrigationSystem Improvement Project is helping improve on-farm water management. A 26 follow-on Irrigation and Drainage I1 Project will expand coverage and support the restructuring, institutional change, and further capacity building o f the water resource authority. The new Water Sector Study provides the analytical basis for these activities. ImprovingTransit Corridors and Traffic Management 93. Significant Bank investments will be made to improve Azerbaijan's transit corridors. The government plans to spend about US$1.5 billion to rehabilitate and reinforce major transit highways and secondary roads over the next 10 years, about US$200-300 million o f which may come from EBRD, the Asian Development Bank (ADB), the Islamic Development Bank (IsDB), and bilateral donors. The Bank will use a sector-wide approach to coordinate policy and make investments to help develop the growing transit corridors. The on-going Highways I and Highway I1 Projects are improving access and lower transport costs for goods and passenger traffic moving along the East-West and North-South transit corridors and strengthening the capacity o f the Road Transport Service Department to manage road investment and maintenance, including outsourcing o f periodic maintenance. A proposed continuation of the series of Transit Corridor and Traffic Management Projects will help complete these highways as well as access roads inorder to enhance accessibility from villages and small towns. The projects may also address traffic congestion in urban areas and support the installation o f modern traffic management systems. Financing in the sector is estimated at about US$500 million, depending on government cofinancing, and will be phased through a series o f road operations. A comprehensive Transport Sector Review will underpin the Bank's investment inthe sector. 94. Transit corridor projects will also support upgrading the safety and physical capacity o f the railway network, which transports large and growing amounts o f oil. Tracks will be repaired, and logistics hubs and trade facilitation infrastructure may be upgraded. The Railway Transport and Trade Facilitation Project will seek to improve the competitiveness, commercial orientation, and efficiency o f the national railway company, Azerbaijan Dovlet Demir Yolu (ADDY). The project will support the first phase o f railway modernization (three to four years), including rationalizing the track and rolling stock asset base, increasing productivity, setting up a new legal framework allowing ADDY to operate commercially and to be corporatized, and buildingup management capacity. Increasing the Quality and Coverage of Water Supply 95. Very large investments are needed across Azerbaijan to rehabilitate and improve water and sanitation, not only in Baku but in secondary cities and towns. Underpinned by the FY06 Water Sector Study, a series o f National Water Supply and Sanitation Projects will finance the repair and rehabilitation o f water production and distribution and wastewater facilities in selected secondary cities and towns. Through a sector-wide approach they will support Azersu and its subsidiary companies at the secondary town level to improve their capacity, institutional and operational effectiveness, and commercial and financial viability. The proposed series o f projects may in subsequent phases broaden the scope from water and sanitation to other areas o furban rehabilitation. 27 Improvingthe Reliabilityof EnergyProvision 96. The Bank is providing significant support to improve the reliability and efficiency o f energy provision. Together with other donors (EBRD, KfW, IsDB, and the Japan Bank for International Cooperation [JPIC]), it is providing substantial fbnding to build new generation capacity and rehabilitate generation and transmission systems, helping remedy years o f neglect. Through the on-going PowerTransmissionProject, the Bank is upgrading the power dispatch andtransmission network, which will help alleviate frequent outages. 97. Expansion o f gas storage and treatment facilities would enable Azerbaijan to fully utilize the gas resources that will soon be available from the Shah Deniz gas/condensate field. Azerbaijan currently has two underground storage facilities, located at Galmaz and Garadag. The need for gas storage is expected to increase substantially inorder to accommodate the gas flow from the Shah Deniz field, starting in late 2006. The gas transmission and distribution system suffers from decades o f low investments and insufficient maintenance. This leads to gas leakage and flaring o f associated gas from older oil wells. Investments in rehabilitating the transmission system and upgrading and expanding the treatment plant would substantially improve the cost-effectiveness o f the gas system. Such investments may attract Carbon Fund financing, since they would reduce emissions o f greenhouse gases. Expanded gas storage would help modulate the rigid gas supply flow to meet the daily and seasonal needs o f the domestic gas market. To some extent, it would also support export markets. A possible Energy/Gas Infrastructure Project may include financing gas storage expansion, gas treatment plant upgrade, rehabilitation o f the pipeline system, and/or other investments in energy supply reliability and efficiency. IFC will look into investment opportunities in these areas should private sector, inparticular FDI, interest arise. Increasingthe FinancialViability of the Utility Sectors 98. The government's strategy for improving the performance o f the utility sector aims at commercializing and reducing explicit and implicit subsidies o f more than US$500 million. Key measures include promoting increased private participation in the provision o f utility services; implementing the medium-tern tariff policy for Azerbaijan, which incorporates a transition to full cost recovery for utility service providers; implementation o f the new accounting law, which will require that state-owned utilities adopt IFRS; creating an appropriate regulatory environment, initially by strengthening the Tariff Council; and strengthening competition, through a new competition law. The government recognizes the need to ensure that utility services to consumers are affordable. Implementation o f a targeted social safety net in July 2006 aims to ensure that the most vulnerable are able to afford essential utility services as prices rise toward and eventually reach full cost-recovery levels. The CPS will actively support these reform efforts through AAA; CAPSAP; sector projects in power, gas, water, transport and possibly other essential infrastructure; and the ongoing Pensions and Social Assistance Project. c. Pillar III:Improving the Quality of and Access to Social Services 99. With the support o f the Bank, the government will expand health care; modernize the education system; target social assistance; improve the pension system; and improve living 28 conditions and economic opportunities for internally displaced people. A unique opportunity exits during the next ten years to enter Azerbaijan into the globally competitive knowledge economy, and ensure that health and social needs are properly cared for. Expanding Coverage of Good-Quality Health Care Services 100. IDA has been active in the health sector through a small-scale Health Reform LIL, implemented in five pilot provinces, and through the recently completed Health Sector Review. Together with the new management at the Ministry o f Health, IDA is now supporting a comprehensive sectonvide reform o f the healthcare system. The primary instrument is a Health Sector Reform Project. Key objectives are to buildcapacity inthe Ministryo f Health to guide the reform effort, rationalize and improve the delivery o f both primary and secondary service, ensure sustainable health financing and resource allocation, and address longer-term human resource needs in the health sector. The Bank's projects in support o f clean water and sanitation and reliable energy will also make an important contribution to the health o f the population. A proposed Environmental Clean-up Project will alleviate exposure to health hazards. IFC will consider supporting private investment in the sector with reputable and experienced sponsors. Modernizing the Education System 101. The government intends to accelerate reforms in the education system. The Bank is supporting the government's program through the ongoing Education Sector Development APL, which supports systemwidereformto increase learning achievements for all students and improve efficiency in the system. The first phase o f the project (2003-07) is focusing on quality improvement (through cumculum reform, teacher development, and provision o f textbooks and reading materials); efficiency and financing (through budget reforms, rationalization, and school improvement); equity and access to general education (through school grants in selected less advantaged districts); and management strengthening (through student assessment, management information systems, planning, and monitoring capacity). The IDA Education Sector Development APL I1 will continue the approach and support implementation o f successful pilot school rationalization activities across the country. A proposed follow-on project would focus on reform o f Higher Education to improve the quality and relevance o f secondary and tertiary education and expand access. The vision is to enable Azerbaijan to enter the global knowledge economy as a strong and competitive partner. Specific investments could involve demand-driven investment finds that public and private sector education and training institutions can access to adapt their programs to international standards and monitor the relevance and demand for their programs. The Bank may also invest in other areas of developing the knowledge economy in Azerbaijan, such as modernizing public libraryservices andcultural heritage institutions. Targeting Social Assistance and Improving the Pension System 102. The CPS will support structural reform o f the social safety net. The Bank is active in supporting the government's reform program through its ongoing Pensions and Social Assistance Project. The project aims to assist the government in better administering social protection programs, making the pension system more sustainable, and building capacity to 29 better target social assistance benefits to the most vulnerable groups. The project will also help mitigate the social impact o f utility sector reform. Follow-on Bank support may help streamlining and improving services to the disabled, including improving capacity for assessing disabilities; developing social care services for other vulnerable groups; improving labor market services; developing and scaling up welfare services to facilitate school-to-work transition for youth and foster their inclusion in society. The project may also help develop a multipillar pension system and, based on the design o f the Health Sector Reform Project, a modem health insurance system. Such support could take the form o f AAA, TA, and/or a follow-on project. The Bank will continue to benchmark progress in social protection reform and development o f social services and safety nets. A Social Protection Note, developed jointly with the Ministry o f Labor and Social Protection o f the Population within the Programmatic Poverty Assessment, will evaluate the poverty impact o f social transfers and services. ImprovingLivingConditionsandEconomicOpportunitiesof InternallyDisplacedPeople 103. Thousands o f internally displaced people and refugees live in dilapidated school dormitories, former hotels, and partly finished public buildings. Thousands o f others live in informal settlements that often lack water supply and electricity, schools, or health facilities. Economic opportunities are limited and unemployment is high, especially outside Greater Baku. The ongoing Internally Displaced People Economic Development Support Project builds on the experience of the recently completed Pilot ReconstructionProject to improve the living conditions of IDPs and enhance their economic opportunities and prospects for social integration. Key elements include financing microprojects for essential basic social and economic infrastructure and temporary shelters and extending finance for microenterprises. If the conflict with Armenia over Nagomo-Karabakh is resolved, a supplementto the CPS will be presented to the Board for possible support to rehabilitation and resettlement.20 d. Pillar IV: Improving Environmental Management and Furthering the Climate ChangeAgenda 104. The CPS will provide assistance for the environment in two main areas. The first is managing environmental challenges connected with development o f the oil industry and broader economic development, especially in coastal areas and including legacy pollution (the brown agenda). The second is addressing sustainable natural resource management (the green agenda). The CPS will also provide disaster management assistance. Supportingthe BrownAgenda 105. The proposed Absheron EnvironmentalClean-up Project, potentially supported by the Bank,the Global Environmental Facility (GEF), and other donors, will help launch a large- 2o In the event o f a peace agreement on Nagorno-Karabakh, the Bank would support emergency reconstruction efforts. Possible assistance could be provided for assessing needs, clearing mines, resettling internally displaced people, rebuilding roads and other infrastructure, and providing basic health and education services. The Bank would review a variety o f funding options, including funding through relevant grant programs, establishing a donor trust fund, using government funds, and extending additional IDA credits and IBRDloans. 30 scale, long-term program to rehabilitate the areas around Baku in order to reduce the threat to the health o f area residents and enable reutilization o f substantial areas o f valuable land. The project will build on the technologies piloted under the Urgent EnvironmentalInvestment Project,which closedinFY06. The project's majorobjective is to help put inplaceregulatory, institutional, and incentive structures to channel private sector investment into recovering oil- contaminated land and to ensure that all future oil production meets international environmental standards. The project could also include direct investment in clean-up o f high priority legacy contamination. 106. The Bank's involvement in the sectonvide infrastructure projects will help ensure that such development takes place under clear adherence to international environmental standards and that environmental screening is mainstreamed in Azerbaijan. The Transport Corridor and Water Projects will assess and review the impact o f the infrastructure on the environment. IFC has taken a leadership role in ensuring environmental screening through its ongoing investment inthe BTC pipeline;it will continue to ensure environmental compliance inall its investments. The CPS will also provide for environmentalsector work, particularly in private sector participation in environmental clean-up (which will support the Absheron project) and in standards and regulations governing environmental liability and review (which will support the larger infrastructure agenda). 107. The Bank will actively promote efforts to enable Azerbaijan to reduce greenhouse gas emissions under the Carbon FinancingFacility.Under the Kyoto Protocol, Azerbaijan could attract financing for reduction in gas flaring, as well as clean technology investments in the energy, industry, solid waste, municipal, and forestry sectors, by selling carbon offsets from projects that reduce greenhouse gas emissions. A PHRD grant has recently been signed for the preparation o f a Gas Flaring Project. Opportunities will also be explored for potential carbon financing associated with modernization o f power transmission, gas production, transmission and distribution, and in other areas. To facilitate this work, the Bank may base a technical expert inthe Caucasus. Supportingthe GreenAgenda 108. The ongoing Rural Environment Project, supported by IDA, GEF, and a Japanese grant, aims to improve biodiversity conservation and introduce more sustainable natural resource management and economic activities in two mountainous nature reserves. Bank investments in the irrigation subsector will also provide benefits in terms o f rural environmental sustainability. One of the objectives o f the ongoing RIDIP is to reduce water logging and salinity on 36,000 hectares along the main drainage collectors. The ongoing Irrigation System Improvement Project is helping improve on-farm water management, which will also improve water use consistent with environmental land improvement. The new Irrigation and Drainage I1 project proposed for FY08-09 will provide similar support. ADCP-I1 will help train farmers in sound agriculture practices, including practices related to ensuring environmental sustainability o f lands. 109. Building on its involvement inthe ongoing Caspian Regional Program, the Bank will continue to support the Caspian ecosystem. Together with UNDP, it will examine the potential for a follow-on GEF Caspian Environment Program to assist Azerbaijan and other Caspian 31 countries in implementing policy reforms and priority investments that address sustainable fisheries management, reduction o f transboundary pollution, and biodiversity conservation priorities. The program would support capital investments, implementation o f policy reforms, strengthening o f public institutions, and public participation and donor coordination through a regional technical assistance component, implemented by UNDP and the United Nations Environmental Program (UNEP), and an Investment Fund, implemented by the World Bank. Other GEF opportunities, including Caspian-related pollution and coastal management, will be explored. StrengtheningNaturalDisasterManagement 110. The CPS includes a comprehensive Natural Disaster Management Review. The review will engage the government, private sector, and civil society in a policy dialogue on strengthening the institutional arrangements for risk mitigation and disaster planning; upgrading and refocusing the legal framework for emergency and disaster management; re- equiping, restructuring, and updating hazard monitoring and prediction networks, which do not meet modern standards; and increasing funding for the operation and maintenance o f the flood protection infrastructure. The Review will address the status o f implementationo f the National Disaster Risk Management Strategy and the National Action Plan; identify risks through a comprehensive multihazard risk assessment; identify ways to protect critical infrastructure; and support regional cooperation in risk management, particularly for hazard observations, monitoring, and early warning and dissemination systems. A Disaster Management Project could follow up this review, ifthe government finds such a project beneficial. The ongoing and proposed series o f irrigation projects will address flood mitigation by rehabilitating major canals. e. Knowledge Sharing?Advisory Services, and Capacity Building AnalyticalWork 111. Duringthe last CAS period, the Bank initiated a shift toward programmatic sector work to provide a basis for focused and participatory policy dialogue on key issues. This trend will continue, and additional efforts will be made to increase outreach and knowledge sharing activities (table 6). The AAA and capacity-building program embodies a comprehensive range o f diagnostics and monitoring activities through the Governance Action Plan (see section g below). Technical assistance on structural reform provides a programmatic instrument for continuous high-level dialogue on implementation o f the CPS policy framework as a continuation o f the PRSC dialogue. The FY07/08 Country Economic Memorandum will seek to identify binding constraints to rapid, broad-based investment and growth inthe non-oil economy and prioritize macroeconomic policy and structural reform options. PPERs will support efficient and transparent budgeting and fiduciary arrangements, as well as greater effectiveness in public service delivery. Fiscal sustainability analysis will regularly feed into the dialogue with the government concerning next year's budget envelope, MTEF and PIP. CPAR and CFAA updateswill provide assessments o fAzerbaijan's fiduciary framework and procurement systems. An in-depthWater Sector Study will underpinincreased lending inthis sector. In transport the Bank is working closely with the ADB, which is leading a comprehensive sector review. Programmatic Poverty Assessments will continue to support 32 development o f a cost-effective social safety net and strengthen understandingo f inequality in income distribution. The Health Sector Review completed inFY05 laid the basis for the Health Sector Reform project. An Education Sector Review will focus on improvements in higher education. An Environmental Review will hrther the on-going dialogue on building an effective regime for optimal use o f Azerbaijan's natural resources and protection o f the environment. Duringthe CPS period the Bank will also explore the possibility o f entering into a Joint Economic Research Programwith Azerbaijan. Table 6: ProposedAnalyticalandAdvisoryActivitiesUndertakenbythe BankGroup I CPSobjective Recently completed 1 2006-07 2007-08 2008-1 0 Improve public 0PPER 0PPER with PEFA 0PPER with PIFC 0PPER with sector 0BEEPS Assessment Assessment C F M C P A R management 0Corporate and 0TA on Structural 0C E M updates andreduce Accounting ROSCs Reform 0TA on Structural 0TA on the corruption Statistical capacity TA on the business Reform business building environment 0BEEPS environment 0FSAPUpdate support sustainable and Energy Sector Review Water Sector 0Transport Sector 0Regional balanced growth Review 0Agro-processing Review Development o fthe non-oil - 1 - . Study (withADB) Strategy economy Improve the Programmatic Programmatic Programmatic 0Programmatic quality o f and Poverty Assessment Poverty Assessment Poverty Poverty access to social Education Spending Assessment Assessment services on the Poor EducationReview Social Sector Health Sector Review Review PSIA on impact o f utility sector reform 0PSIA on labor markets Improve 0Environmental NaturalDisaster environmental Review Management management Self-StandingCapacity-BuildingActivities 112. An IDF grant is helping build a more comprehensive e-procurement system. An Accounting and Auditing ReformIDF grant is helping implement accounting and auditing legislative reforms, harmonize sources o f accounting guidance, and strengthen the Chamber o f Auditors. IFC will continue on-going technical and advisory services to improve the business environment, including through FIAS and PEP work. The Financial Sector Technical Assistance Projectis providing technical and advisory services to the government and the National Bank o f Azerbaijan to build financial sector infrastructure, support the next phase o f bankingsector restructuring, andfurther strengthen institutional capacity at the National Bank. 113. The National Bank o f Azerbaijan participates in the Reserves Advisory and Management Program (RAMP) conducted by the World Bank Treasury. As part of the 33 RAMP engagement, which normally lasts three years, Treasury specialists provide on-site consulting and training to National Bank o f Azerbaijan staff in various aspects o f reserves management. The advisory services are combined with an asset management program designed to support the overall technology transfer objectives o fthe program. 114. The Ministry o f Communications and IT has expressed interest in establishing one or more core pilot Global Development Learning Network (GDLN) Centers in Azerbaijan. Several universities with videoconferencing facilities have been identified as potential centers, andthe first center is expected to be established inAzerbaijan in2006. GDLNprogramming is currently delivered through the Baku World Bank Country Office, covering such topics as youth policy, investment climate, judicial reform, e-government, and accounting training. CapacityBuildingunderInvestmentProjects 115. Bank technical assistance in the rural sector helped establish a Rural Policy Unit that has developed a national strategy and investment plan to enhance competitiveness in the agriculture sector. Technical assistance is also being provided to build the capacity o f local communities and regional offices o f the Agency for Support o f the Development o f the Agricultural Private Sector to prepare and implement small-scale, community-driven rural investment projects. Technical assistance under the Financial Services Development Project is helping corporatize and strengthen Azeri Post's capacity to serve rural areas. In irrigation technical assistance to the State Amelioration and Irrigation Committee, and District Irrigation Exploitation Units has helped these institutions take initial steps toward increased operational efficiency and improved irrigation management. Bank-funded technical assistance helped reorganize the Absheron Regional Water Company into a joint stock company, strengthen its capacity through a twinning arrangement, and improve its operational and administrative effectiveness. Technical assistance in the power sector is helpingimprove management o f the state power generatiodtransmission company, Azerenergy, and prepare it for a restructured energy sector. Capacity-building assistance has helped restructure, modernize, and strengthen the management capacity o f the Road Transport Services Department o f the Ministry of Transport, the main agency responsible for national road development. 116. Technical assistance is being funded to buildthe capacity of the Ministry of Labor and Social Protection o f Population to undertake knowledge-based policy formulation, develop targeting mechanisms, and effectively deliver targeted social assistance. Capacity in the State Social Protection Fundis also beingbuilt to improve its ability to efficiently and transparently administer the pension system. Bank technical assistance is helping the Ministry o f Education strengthen financing, budgeting, personnel management, and planning in order to improve the use o f financial, human, and physical resources in the sector. Technical assistance under the Health Sector Reform Project is stimulating a national dialogue on health reform and primary health care and strengthening the capacity o f the Ministry o f Health to plan, implement, and evaluate health reforms. Inboth health and education, the Bank is supporting the Ministry o f Finance's collaboration with line ministries in moving to program budgeting, decentralization, IPSAS, and better internal financial control and expenditure tracking. Several Bank projects support statistical capacity building. 34 $ Financing Scenario and Portfolio Management 117. Azerbaijan is currently an IDNIBRD blend country. IDA allocations on the basis o f IDA'Sperformance-based allocations system are set at SDR53 million (US$79.4 million) for FY07 and indicatively at SDR34.4 million (US$51.5 million) for FY08.** Azerbaijan i s considered creditworthy to receive IBRD financing o f up to US$250 million a year on average. The government has indicated that this figure should be seen as indicative and that the actual level of IBRD lending will depend critically on several factors, including: the degree o f cofinancing provided by the government, the ability o f the country to effectively utilize funds, and on the level o f timely value-added the Bank Group is able to deliver relative to the government financing projects on its own. For its part, the Bank has indicated that it will pay particular attention to the CPS monitoring indicators in Table 8, which draw on the annual CPIA process, with a higher (or lower) level o f IBRD lending associated with faster (or slower) progress toward achieving the targeted outcomes. Azerbaijan's overall CPIA ratings has increased substantially since 2000, especially governance indicators, but remained unchanged from 2005 to 2006 at 3.7. A slight downgrading o f scores for macroeconomic and fiscal policies, due to concerns about the very expansive budget stance, was counterbalanced by increases in scores on gender equality and equity in the use o f public resources. The portfolio quality is good, with no problem projects or projects at risk in2005. 118. In the event of any significant deterioration in either economic conditions or the governance environment, IBRD lending would be reduced to a lower case o f about US$lOO million. In assessing this the Bank would pay special attention to each o f the following economic considerations: serious deterioration in macroeconomic stability, inconsistent aggregate demand policies, significant private sector crowding out, and monetary and exchange rate policies that do not target price stability. Such a scenario would be signaled, e.g., by CPIA indicators for macroeconomic management and fiscal policy falling to the 2.5 range or below. Fiscal sustainability analysis will be a recurrent part o f the programmatic PER activities. Other signals would include a decline in other relevant indicators available from reputable third parties, includingratings by international rating agencies. The low case would also be considered in the event o f a major deterioration ofgovernance and increase in the Bank's reputational risk. Particular attention would be paid to serious shortfalls in progress toward implementationmilestones under Pillar 1(public sector management and corruption) o f the CPS and the relevant CPIA indicators. 119. A summary o f the projects proposed duringthe CPS period is provided intable 7. It is an all-investment program. It i s expected that IDA allocations will be phased out through a managed transition to IBRD-only status during the CPS period, based on Azerbaijan's improved creditworthiness. An appropriate transition period remains critical to ensure that adequate support i s provided to governance reforms and the social sectors inareas inwhich the government finds it hardto borrow on IBRDterms. IDA financing beyondFY07 are indicative only. Actual allocations will depend on: (i) country's own the performance; (ii) performance relative to that o f other IDA recipients; (iii) amount of overall resources its the available to IDA; and (iv) changes inthe list o f active IDA-eligible countries. 35 T v, d g- 0 0 E 5 I c( 0 0 00 0 (u m * z 0 m Q) .-0 sf a 0 rg 0 \o 2 00 d 120. The government has indicated initially that it is able to cofinance 20 percent o f project costs, perhaps providing up to 50 percent later on for high-priority projects. The Bank will also be looking to strategic partners, such as EBRD, EIB and the ADB, inthe field o f infrastructure. The transit corridor and water programs have deliberately been set out as a sequence o f separate projects, so that the extension o f subsequent projects will depend on the speed o f implementation o f the previous project. This phased approach will enable the country to avoid excessive commitment charges, and it will allow the Bank and the government to remain flexible to adjust the focus to emerging priorities. 121. As o f now, Bank procurement and financial management procedures will be used for all projects, as it is too early to consider the use of national systems. On the other hand, the Bank's dialogue and project designs will be comprehensive and sectonvide. In this way Bank procedures will be leveraged by substantial public funds. The government views this arrangement as a welcome way o f safeguarding the proper use o f budget resources and leveraging use o f the Bank's environment and social safeguard procedures. Special attention will be given to strengthening project implementation and supervision ensuring that recordkeeping is transparent, and Bank standards for procurement and financial management are widely understood and adhered to. The Board will be informed inthe event o f any systemic deteriorationo fthe economic or social environment. 122. Country financing parameters for Azerbaijan were established in 2005 in consultation with the government. These provide for added flexibility in allowing Bank financing o f up to 100 percent and recurrent cost financing on a selective basis, Bank financing o f local and foreign costs in any proportion, and Bank financing o f local taxes and duties. The additional flexibility should support project implementation and is fully consistent with the approach o f the CPS in emphasizing government ownership o f the underlyingproject objectives and target results agreed (see annex 7). g. Governance -a Crosscutting Objective of the CPS 123. Taken together the CPS AAA and projects described above form an elaborate Governance Action Plan and strict monitoring o f results and project execution within a coordinated Governance Monitoring Framework. Figure4 summarizes key dimensions o f the governance framework supported by the CPS interventions. In terms o f overall political accountability the CPS will continue the support to the PRSP/SPPRSD process, even though Azerbaijan is rapidly becoming a middle-income country, as well as supporting the implementation o f the associated State Programmes. This will help ensure that the government's stated action planget implementedwith proper oversight o f civil society. 124. In terms of effective public sector management, the CPS AAA will support good macroeconomic and public expenditure planning and management through our continuous policy advice and TA, including a C E M and a sequence o f participatory programmatic PERs. Public financial management and procurement will be supported by public sector accounting reform (through CAPSAP), treasury modernization, e-procurement, and updates o f the CFAA and CPAR. The CPS will support implementation o f Public administrative and governance reform in selected areas o f the relevant State Programmes. Reduction o f subsidies will be supported though CPS policy advice, accounting reform and investment operations in the 37 utilities sector. And in the social sectors targeted interventions will further effectiveness o f public service delivery. 125. Interms ofchecksand balanceswithinthe overall governance framework, the CPS will support judicial reform, the strengthening o f external and internal audit functions, and stronger supervisory institutions inthe financial markets. The CPS with FIAS will help establish better consumer protection against monopolistic behavior and investors' protection through modem laws and agencies according to international standards. The CPS will also support civil society and theprivate sector oversight through enhanced disclosure, transparency and accountability frameworks, such as EITI, disclosure o f Oil Fund, SOCAR and public finances, and structured public/private dialogue on streamlining the business environment. Better corporate governance and financial transparency will be supported through the accounting and auditing reform, while environmental responsibility will be enhanced through Pillar IV o f the CPS. This includes support for SOCAR to move to international standards. 126. In terms o f local participation and community empowerment, the CPS Pillar I1 supports, among other things, rural infrastructure community driven development (CDD), formation of water users associations for irrigation, and farmers' credit cooperatives. At the reform level, a new legal framework for NGOs and streamlined registration o f legal entities andreal estate will be supported. 127. Implementation o f the governance agenda will be monitored and prioritized on the basis o f a sharedframework in global partnership with multilateral and bilateral donors, and with government ownership and civil society participation. A Governance Advisory Group will be established to coordinate these activities, derive lessons and identifybindingconstraints to achieving the objectives o f the Governance Action Plan. Special precaution will be taken to strengthen Project Implementation Units (PIUS), transparent record keeping, and safeguarding Bank standards for procurement and financial management o f projects. The Governance Monitoring Framework includes, e.g., EITI, PEFA and PIFC programs, Public Expenditure Tracking Surveys (PETS), F S M update and ROSCs, Doing Business Reports, BEEPS, CPIA, as well as WBI Governance Indicators. The framework is embedded inthe CPS comprehensive monitoring and evaluation framework. h. Monitoring and Evaluation 128. The CPS contains a detailed Results Matrix (annex l), defines the four-year which development outcomes that Bank Group assistance aims to help achieve. A CPS Mid-Tern Review will be conducted two years into the program, at which point any adjustments to the strategy will be made. A comprehensive evaluation o f the CPS will be carried out in a CPS Completion Report at the end o f the CPS period. This evaluation will assess the extent to which CPS objectives were achieved and draw lessons for future assistance. 38 Citizendlrirms A A A A A A A A A \ \T I I I 129. Progress in implementing the CPS will be monitored through several channels. First, regular reviews o f structural reforms will be conducted in the context o f the CPS program monitoring and support to implementation o f the PRSC policy framework. Second, sectoral reforms and progress reports will be evaluated during supervision o f the various Bank investment projects. Third, monitoring o f public expenditures will be conducted under the three-year PPER. Fourth, monitoring o f progress toward poverty reduction and MDG achievement will be assessed through a Programmatic Poverty Assessment. Detailed monitoring indicators and baselines for health, education, and social protection have been defined. Data from various surveys will strengthen outcome and impact monitoring. The governance agenda i s crosscutting and integrated with the Result Framework. Assistance from other donors also supports strengthened monitoring capacity ingovernment agencies. 130. The Bank will continue the current practice o f formally reviewing the PRSC matrix (with annual adjustments as appropriate) with the government and reporting on progress and issues. Resources are included in the work program to finance technical work on the policy items concerned. This work will feed into the annual CPS reviews o f the overall objectives and intermediate milestones inthe Results Framework. 131. A core set o f higher level progress indicators are outlined intable 8. Inmost cases high level baselines and targets for 2010 are based on the published CPIA methodology. These indicators are selected as aggregate measures o f macroeconomic stability, governance and transparency on the one hand, and economic and social progress on the other. i. Externa1Partnerships 132. The Bank has a strong history in Azerbaijan in collaborating closely with other partners, inparticular on structural reform. Collaboration will continue during the CPS period inavariety o fareasdescribed inannex 6. 133. The Bank and the IMF are coordinating closely on the overall reform program. The fifth review of the IMF-supported PRGF was completed satisfactorily in June 2005, and Azerbaijan has now graduated to surveillance-only status. Critical support is also provided by USAID, the ADB, the European Union, and the Islamic Development Bank (IsDB) for capacity buildingand economic policy formulation. The EU TACIS has helped modernize the tax system and we are working closely on accounting reform. The Bank is working with USAID on treasury systems and advising the government on the PIP. We have also teamed up with the U.S. Treasury on budgetary reform and is working with EBRD and USTDA on SOCAR restructuring. With DFID and other donors, the Bank is actively supporting the EITI in Azerbaijan and monitoring its implementation. The Bank has joined with the ADB, Switzerland, and UNDP to support the formulation and implementation o f the SPPRSD. UNDP has been particularly helpful in integrating the monitoring o f the MDGs into the recent SPPRED progress report. 134. Azerbaijan was admitted to the ENP in2005, creating the opportunity for the European Union and Azerbaijan to develop an increasingly close mutually beneficial relationship. Under the ENP, the European Union i s expected to contribute more actively to resolution o f regional conflict. While the Action Plan is still under discussion, it seems likely that the European Unionwill playa leading role on the continuedimplementationofelectoralreform onthe basis 40 o f the recommendations o f the Council o f EuropeNenice Commission and the Organization for Security and Co-operation inEurope/Office for Democratic Institutions and HumanRights, as well as improving the organization o f the judiciary, with a view to ensuring its greater independence, impartiality, and efficiency. Other priority areas may include improving the business environment; harmonizing laws, standards, and administrative procedures; combating corruption; supporting balanced and sustained economic development; and strengthening EU- Azerbaijan cooperation on energy andtransport and integration o f markets andnetworks. 'able 8: KeyProgressIndicatorsunderthe CountryPartnershipStrategy Goal Progress indicatorsand interventions I Aggregate I I indicator Baseline Target Improvepublic sector management and reduce corruption Maintain Formulation o f integrated macroeconomic and macroeconomic fiscal framework, with due consideration to CPIA- 1 4.5 >4.0 stability development o f the non-oil economy including CPIA-2 4.5 >4.0 close attention to real exchange rate issues. CPIA-3 4.5 4.0 Improve public Concrete progress towards program budgeting, expenditure planning including establishment of medium-term functional CPIA-13 4.0 4.5 and management ceilings; consistency of PIP, MTEF, and annual Budget Law with expenditures prioritized according to sustainable development goals. Improved presentation o f the budget. Increase transparency, Annual disclosure to EITI; strengthening o f accountability, and internal and external audit; start o f e-procurement, CPIA-16 2.5 3.0 decrease corruption in and e-government streamlining processes. More public sector civil society participationand voice. Improve public utility Improvement ininfrastructure service quality and BEEPS Worse Ave- services and coverage. Cost recovery o f utilityservices attained Infrastructure than rage for infrastructure by 2010, withtariffs adjusted periodically and indicators average CIS implicit subsidies largely eliminated. for CIS Improve the quality of and access tosocial sewices Improve efficiency, Improvement inhealth and education outcome quality, and coverage indicators; increased equity inaccess and CPIA-9 3.0 3.5 o f health care and affordability o f health and education services; education implementation o f programbudgeting inplace o f norms-based system Improve efficiency Social assistance and social benefits programs and coverage of social targeting bottom consumption quintile o f CPIA-10 3.5 4.0 protection systems population; fiscally sustainable, affordable, and transparent pension system linking contributions to benefits Improve environmental management Improve Rehabilitationo f contaminated areas o n the environmental Absheron peninsula and reduction ingreenhouse CPIA-11 3.0 3.5 management and emissions. conditions 41 je Consultations 135. In preparation for the CPS the Bank and IFC consulted with a wide range o f civil society representatives, business associations, high-level officials from across the government and with parliamentarians that made the development o f this CPS a very participatory process (see annex 5). 136. NGO representatives felt that the Bank's expertise and technical assistance on managing oil revenues was critical. Participants welcomed health and education as problematic sectors that warranted priority attention from the international community. Other areas emphasized were SME development and irrigation. Participants expressed general appreciation o f their involvement in the government's poverty reduction strategy preparation process but indicated that there was inadequate NGO involvement in the implementation and monitoring o f Bank funded projects. 137. During the CPS preparation the IFC consulted with business associations, the NGO Forum, the Entrepreneurship Development Foundation, as well as with entrepreneurs from various sectors such as agribusiness, IT and telecom, tourism and hospitality and building materials. Entrepreneurs expressed great interest in partnering with IFC. Associations requested more IFC direct involvement to help grow SMEs and improving the business environment. NGOs would like to participate more in providing views on projects IFC is involved with. 138. NGOs and business associations would like to participate more in the whole cycle of Bankprojects, analytical work andpolicy dialogue with the government. The voice o fthe civil society should be accounted for when results o f projects are evaluated. It would also create a good example for the government, which - although gradually becomingmore open to the civil society - still has to make significant efforts to treat the civil society organizations as partners. The donors raised an issue o f the national capacity to implement the CPS infrastructure investment program. There is a risk that the limited capacity combined with political pressure on quick results may lead to compromising on quality. 139. The recent Client Survey reveals a shift in perceptions as to Azerbaijan's major development challenges and the Bank's role. In 2003 the three major challenges identified were poverty (22 percent), the economy (19 percent), and political problems/instability (11 percent). Now the major challenges are seen as the unresolved regional conflict (39 percent), corruption (18 percent), and education (15 percent). The Bank is seen as most effective in: (i) infrastructure; (ii) financial system(which has significantly risen since the last survey); and the (iii)monitoring poverty. The role o f the Bank's knowledge services is increasingly valued. The perceptionthat the Bank plays a relevant overall role inAzerbaijan's development remains positive (with a rating o f 7 on a 1-10 scale). However, the perception that the Bank`s financial resources were its greatest value fell sharply from 38 percent in2003 to 28 percent. There is a strong feeling that respondents like to work with the Bank (8.5) and that the Bank treats clients with respect (7.9). 42 VII. ManagingRisks 140. The primaryrisks to the proposed CPS include the following: Risk of delays or waning consensus in implementing key elements of the reform program. Not having been one o f the `early reformers' among the CIS transition countries, Azerbaijan still has a very substantial reform agenda ahead inboth the economic and social spheres. The reforms supported by the Bank have been solid duringthe past five years, but progress has sometimes been slow and not always linear. To mitigate the risks o f reforms being deterred and/or delayed, the Bank will support an active outreach process centered on the country's PRSP, in terms both o f substance and o f engaging the public in its formulation and monitoring. In addition, the Bank will conduct semestral reviews of progress with respect to the core CPS reforms and monitoring indicators in Table 8, using these not only to track progress but as opportunities for continuing engagement o f a wide range o f public and private actors around strategic reforms and obstacles that may be impedingachieving them. Risk of state capture and corruption. Several surveys have evidenced the perception o f persistent corruption and state capture inAzerbaijan, which could derail achievement o f the development objectives the CPS i s supporting. To mitigate this risk, the CPS, through its AAA and projects, embodies a comprehensive governance action plan o f political accountability with civil society oversight, effective public sector management, financial accountability and disclosure through strengthening institutions performing checks and balances. Implementation o f the governance agenda will be monitored and prioritized on the basis o fa shared framework inglobal partnershipwith multilateral andbilateral donors, and with government ownership and civil society participation. Special precaution will be taken to strengthen project implementation units, transparent record keeping, and safeguarding Bank standards for procurement and financial management o f projects. The Governance MonitoringFramework includes, e.g., EITI, PEFA and PIFC programs, Public Expenditure Tracking Surveys, FSAP update and ROSCs, Doing Business Reports, BEEPS, CPIA, as well as WBI Governance Indicators. The framework is embedded inthe CPS comprehensive monitoring andevaluation framework. Resourceflow risk. Volatile energy prices-or unexpecteddisruptions in pipelines or gas projects-could seriously affect resource flows and public finances, delaying implementation o f poverty reduction measures. These risks are mitigated by the State Oil Fund, which cushions the budget revenues from oil exports by smoothing out potential volatilities inthe current inflows o f oil revenues. Macroeconomic management risk. As oil revenues start increasing dramatically, so will spendingpressures and inflationary pressures. Mismanagement o f oil revenues and Dutch disease could slow implementation o f the reform programs. This risk should be set against a track record o f 10 years o f responsible macroeconomic management, including during the boom in inflows o f FDI, and the avoidance o f large external debt or ill-conceived public investments. Looking forward, the risk is mitigated by the Bank's and the Fund's continued policy dialogue on macroeconomic stability and fiscal sustainability. 43 Azerbaijan's active participation in EITI will be closely monitored and CAPSAP will support financial accountability and transparency o f revenues from extractive industries, including SOCAR. The rules for Oil Fund spending are clearly set out in the Budget Systems Law and SOFAZ's regulatory framework. Spending out o f the Oil Fund must be part o fthe consolidated budgetapprovedbyParliament. 22 All Oil Fundspendinghas to go through the single Treasury account. The CPS will monitor adherence to these principles. The dialogue on macroeconomic management and fiscal sustainability will be continuously supported by the PPERs, which are aimed at assisting the authorities to avoid the risk of too high inflation and too rapid or inefficient public spending, including Oil Fund spending. The large infrastructure projects o f the CPS will directly support proper management o f public funds. The cost o f rebuilding the infrastructure of Azerbaijan to modem standards i s relatively limited relative to the expected oil and gas windfall. Our emphasis is therefore to continuously staying engaged in macroeconomic management, extractive industries transparency, sound long-term oil revenue management, budget preparation processes, financial accountability, and sound implementation o f the public investmentprogram. Regional security risk. There has been a clear shift toward increasing stability inthe South Caucasus over recent years, particularly given developments in Georgia since the `Rose Revolution', which have enhanced opportunities for cooperation indeveloping the regional transport and energy corridor. Nonetheless, the potential for renewed conflict with Armenia over Nagorno-Karabakh cannot be ruled out -- nor can the upside potential o f a resolution o f the conflict during this CPS period. The international community, in particular the Minsk Group o f the Organization for Security and Co-operation inEurope, is carefully mediating this issue. Meanwhile, the Bank will continue to assist government efforts to improve the well-being o f the population which has been displaced by the conflict. Portfolio management risk. While the portfolio quality i s good and there are no reported outstanding issues, the risk o f corruption will be vigilantly addressed. This includes a high level o f precaution and supervision o f procurement and financial management o f projects as outlined inbox 2. Thelikelihood of Bank engagement on the breadth of activities in the CPS is high. The CPS supports the continuation o f our long-term partnership with Azerbaijan from the previous CAS and the PRSC. As noted in the CAS Completion Report (annex 3), all projects proposed in the previous CAS were successfully approved and started. FY06 brought this agenda forward with another four very important projects. The government has shown its strong commitment to move forward rapidly with the reform agenda, including CAPSAP. The e-government and public reform activities will require a flexible and realistic approach 22The Budget System Law requires that: (i) parliament approve the deficit and expenditure ceilings o f the consolidated budget including Oil Fundexpenditure; (ii) all expenditures inthe consolidated budget (except for expenditures on the management o f SOFAZ and its assets) be executed by the treasury, and that all capital expenditures be part of the PIP; (iii) Ministry o f Finance to be responsible for the preparation of the consolidated budget; (iv) that extra-budgetary funds not make portfolio investments indomestic commercial activities or issue loans or loan guarantees; and (v) SOFAZ hold equity positions only through highly rated professional portfolio managers in international markets. 44 in the choice of instruments. Financial sector activities and the infrastructure agenda to a large extent are continuations of well-established sequences o f activities. Likewise in the social sectors, the proposed education projects are natural next steps of the ongoing APL, and the successful social protection reform will be continued. On the environmental agenda, the President on September 28, 2006, issued an important decree delineating detailed plans and time schedules for restoring environmental sustainability on the Absheron Peninsular and for the country as a whole. The CPS will directly engage in this program. Azerbaijan has the monetary resources to implement the agenda laid out in the CPS. With the CPS partnership the government wishes to have the Bank as its trusted fiduciary partner to make sure things are done right and public resources not wasted. The challenge for the World Bank Group is to deliver in a timely manner the quality expert advice and project management services that Azerbaijan needs to continue to succeed inits rapid development. 45 Box 2: Safeguarding the Integrity of the Bank's Portfolio The World Bank Group has been taking a range o f measuresto improve monitoring and strengthen governance o f its own portfolio, and will undertake additional measures inthe CPS. A Existing Measures to Minimize Corruption Risks in theBank Portfolio: i MaintainingdiligentcapacityandriskassessmentsoffiduciaryaspectsofBank-financedportfolio through (i) financial management systems assessment(staffing, internal controls, accounting systems, disbursementsand auditing arrangements), including riskassessmentat country, entity and project level, to ensure funds are used for purposes intended; and (ii)procurement assessment and extensive post reviews conducted to ensure compliance with Bank procurement guidelines; and (iii) financial management and procurement capacity buildingo fproject implementing agenciedentities staff to assure adequateproject implementation performance. 11 Ensuring strong financial management and portfolio review functions and responsibilities inthe ... Country Office. 111 Joint BarWGovernment country portfolio performance reviews, and vigilant Bank follow up on implementation o f agreed-upon Action Planto strengthen overall quality o f portfolio implementation and performance. iv Securing close linkages between the AAA program (particularly the Programmatic PER and Poverty Assessment) and lending support to ensure adequateattention to the efficient andtransparent use o f public resources and monitoring and evaluation o f outcomes. V Regularcapacity assessmento fexternal audit firms interestedinauditing Bank-financed projects. v i Continuous support to the accounting, auditing, procurement, supervisory and regulatory agencies through institutional capacity building, legal and regulatory reforms i.e. introduction o f new Accounting Law mandating International Financial Reporting Standards for Public Interest Entities including State-owned enterprises to enhance accountability and transparency in financial reporting and capacity building o fthe Chamber o f Accounts, the country's Supreme Audit Institution (SAI). vii Vigorous investigation and follow-up to any allegations o f fraud and corruption inBank projects. B New Additional Measures to be implemented during the CPSPeriod: 1 Diligent and consistent application o fthe Governance Action Plan and its principles inall new programs. 11 Focus on accountability and transparency incorporate and public sectors, through the proposed 111 Further capacity building inprocurement capabilities and portfolio review inthe Country Office, with ... Corporate and Public Sector Accountability Project. HQretaining oversight andquality control function iv Operational reviews o f internal controls andkey operations carried out every two years, in conjunction with Mid-term reviews. V Increased frequency o fprocurement audits to ensure implementation o f Bank procurement guidelines to promote greater transparency inthe biddingprocess and contract award. v i Increased supervision resources and intensiveprojects supervision by Bank staff. vii Special emphasis placed on the development o f synergies between Bank-financed projects, to develop country-level safeguards with respect to fiduciary arrangements. viii Bank support to NGOs serving as catalyst to external monitoring and communication to the public on use o f public funds. ix Promotion o f greater transparency and accountability through disclosure o f contract awards and financial information. 46 -d B z' w w V nco 3x e, a .e 0 .e Y 0 c) e t? 3 2 0 v, n E x 3 a $ r: W E W m l v ) VI VI e, se, ."$m 0 * 3 s 0r !i CI uW 0 0 Annex 2 Results Framework and Baselines for the State Programme on Poverty Reduction and Sustainable Development, 200615 Strategic Goals Analysis o f the main characteristics o f the poverty situation in the country has led to the formulation o f the nine strategic goals for 2006-15. These goals are a logical continuation o f the previous poverty reduction program, State Programme on Poverty Reduction and Economic Development (SPPRED): 1. Ensure economic growth andmaintain macroeconomic stability. 2. Create enabling conditions to improve income-generationopportunities, especially in the non-oil sector, inthe regions, andinrural areas. 3. Improve the quality o f and ensure equal access to basic health and education services. Reducingincome poverty is not enough ifpublic services do not work properly. 4. Improve public administration and governance. Good governance and the continuous evolution o fpublic institutions are internationally recognized as essential to successful integration and competition inthe global economic system. Modem states require a capacity for coping with institutional change to ensure strong, transparent, and accountable public institutions, staffedby a professional civil service, guided by appropriate laws, and reinforced by a responsivejudicial system. 5. Improvepublic infrastructure. This is a prerequisitefor attracting foreign and local investment and creatingjobs while reducingdifferences inliving conditions by guaranteeing the entire population access to basic utilities. 6. Reform the social protection system to better protect vulnerable groups, especially children. 7. Improve the living conditions ofrefugees and internally displaced people, particularly vulnerable groups that require special attention andpolicy measures. 8. Ensure that government policy and programs inall sectors promote and protect gender equality. 9. Ensure that all economic development policies and programs andrelated legislation respect the principles o f environmental sustainability. Main Targets Targets have been set to measure the achievement o f the nine strategic goals (table A2.1). The aim is to achieve these quantifiable outcomes by 2015 by implementing policy measures set out inthe five-year actionplanattached to this document. 57 Table A2.1 Targets in the State Programme on Poverty Reduction and Sustainable Development Baseline Target year Baseline Decrease poverty level to 10percent and eliminate extreme 2005 Absolute poverty level: 29.3 percent poverty and food insecurity by 2015. Extreme poverty level: 2.2 percent Increase GDP per capita by 2.2 times by 2015. 2005 AZNl,435.7 ($1317) Increase non-oil GDP by 2.2 times by 2015. 2005 AZN6.9 billion ($7.4 billion) Maintain annual inflationrate at less than 10percent through 2005 9.6 percent 2015. Increase foreign trade turnover by 1.7 times by 2015. 2005 $8.6 billion Decrease unemployment level to 2 percent by 2015. 2003 10.7 percent Bring eligibility criterion for receipt o f social assistanceup to 2006 AZN3O national subsistence minimuminphasesby 2010, with complete transition to single-family benefits by 2015. Ensurethat minimumwage, basic pensions, and unemployment 2005 Minimumwage: AZN30 benefits are at least equal to the national minimumsubsistence Basic pensions: AZN 25 level by 2010. Unemployment benefits: AZN 12 Ensure that all boys and girls complete a full course o f general 2004 Net primary enrollment rate: 93.2 percent educationby 2015. Net basic enrollment rate: 81.1 Net secondary enrollment: 5 1.1 percent Maintaingender equality inthe general education and improve 2004 Net primary enrollment rate: 93.1 for gender equality invocational, specialized secondary, and males, 93.3 percent for females higher education by 2015. Net basic enrollment rate: 81.9 percent for males, 80.3 percent for females Net secondary enrollment rate: 5 1.4 percent for males, 50.8 percent for females Net enrollment rate at specialized secondary schools: 5.1 percent for males, 6.5 percent for females Net higher educationenrollment rate: 9.7 percent for males, 8.9 percent for females Double the numbero f children completing preschool 2005 20 percent (including community/family type) before entering primary education by 2015. Ensure accessby all school children and students to computers 2005 Numberofgeneral secondary school and Internet by 2015. students per computers: 947 Proportion o f schools with Internet access: 4.4 percent Increase proportiono f women participating indecisionmaking 2006 Proportion o f women ministers and to 30 uercent bv 2015. committee chairs: 3.3 percent 2006 Proportion o fwomen heading regional executive authorities: 1.2 percent 2005 Proportion o f women inparliament: 11.2 uercent 2004 Proportion o f women inmunicipal 58 Baseline Target year Baseline legislatures: 4.1 percent 2004 ProDortion o f female iudges: 14Dercent Reduce the gender gap inemployment by 2015. 2003 Share inoverall economic activity rate: 59.5 percent women, 83.6 percent men Share inoverall economic inactivity rate: 68.4 percent women, 31.6 percent men Share inoverall employment rate: 41.5 percent women, 58.5 percent men Share inoverall unemployment rate: 48 percent women, 52 percent men Reduce the under-five mortality rate by two thirds by 2015. 2005 9.8 per 1,000 Reduce the maternal mortalityrate by three-quarters by 2015. 2005 25.8 per 100,000 Halt the spread o ftuberculosis, malaria, brucelosis, and 2004 Numberofnew cases oftuberculosis: helminthiasis by 2015. 3,673 2005 Numberofnew cases ofmalaria: 243 Numberofnew cases ofbrucelosis: 415 Numberofnewcases ofhelminthiasis: 71,947 Halt the spread o fHIV/AIDS by 2010. 2005 Numberofnew HIVinfections: 928 Increase life expectancy at birthto 76 years by 2015. 2004 72.4 (69.6 male, 75.2 female) Increase the proportiono fthe forest areas to total land area to 2004 11.5 percent 12.5 percent by 2015. Increase the share o fprotectedlandarea intotal surface area to 2004 7 percent 12 percent by 2015. Decrease by 20 percent the conditional quantity o f fuel used for 2004 386 gram 1 kilowatt o f energy for reducing greenhouse emissions inthe power-engineering sector by 2015. Maintainincrease incarbon dioxide emissions per 2004 3.6 tonnes capitakilogram at about 10 tonnes by 2015. Construction o fnew settlements and houses for refugees and 2004 35 percent o f refbgees and IDPs innew IDPs settlements and houses Increase the level o f employment among refbgees and 2004 30 percent internally displaced people to the averagenational employment rate by 2015. Ensure complete satisfaction o fthe country's energy demands through internal resources by 2015. Increase the proportionof households with accessto gas up to 85 percent by 2010. Ensureuninterrupted, good-quality water supplyto the entire I 2005 60 percent population o f the Baku-Absheron region by 2015. I Create a reliable water supply system inregional towns and 2005 35-40 percent villages by using local springs and groundwater sources, and supply 80-85 percent of the populationwith water through a centralized water supply system by 2015. Reconstruct 2,800 kilometers of motor roads inline with 2005 n.a. international standards by 2015. Ensuresupply o fheatingpower to all existing residential and 2004 Residential buildings: 17.2 percent nonresidentialbuildings by 2015. Schools: 21.5 percent 59 Baseline Target Health facilities: 22.2 percent Social facilities and public administrative buildings: 38.3 percent Increase number o ftelephones to 50 per 100people incities 2005 21.2 incities and regions, 4.6 inrural and regional towns and to 30 per 100people inrural areas by areas 2015. Increase number of Internet users to 5,000 per 10,000 persons 2004 483 per 10,000 by 2015. Improve governance and the quality o fpublic sector n.a. management to align with EU standards by 2015. 60 Annex 3 CAS Completion Report, FY03-05 The CAS Completion Report reviews the experience in implementingthe FY03-05 Country Assistance Strategy (CAS) for Azerbaijan. The CAS for the Republic o f Azerbaijan (Report No. 25790-AZ) was delivered to the Board May 27, 2003, along with the government's poverty reduction strategy document, the State Programme on Poverty Reduction and Economic Development (SPPRED) (Report No. 25593-AZ). The CAS was designed to assist the government in implementing the first phase of the SPPRED. The Completion Report examines the relevance o f the CAS to Azerbaijan's longer-tern national goals, the achievement of CAS outcomes, and Bank performance infurthering CAS outcomes. Longer-Term Strategic Goals Supported by the Bank Azerbaijan faces the challenge o f translating its temporary oil boom into sustainable economic growth and poverty reduction. During the past few years, the government has set the stage for a period o f large-scale oil and gas revenues. Barring new discoveries, the revenue stream from oil and gas is projected to peak in the next 10 years and to decline thereafter. The critical challenge facing Azerbaijan is thus to ensure prudent and transparent management ofthese resources so that they are used to stimulate economic growth inthe non- oil sector and improve public social service delivery while maintaining macroeconomic stability. The government, with support from the Bank and IMF, established the State Oil Fund (SOFAZ), which mandates a high standard of transparency in managing oil and gas revenues. A large proportion o f revenues i s being saved for future generations in the form o f foreign financial assets, a politically difficult decision in a country with serious infrastructure andpublic service gaps, a highpoverty rate, and pressing immediate needs. To reduce poverty, the government with the SPPRED set medium-term goals o f facilitating an enabling environment for growth o f income-generating opportunities; maintaining macroeconomic stability; improving the quality of and equity in access to basic health and education services; improving infrastructure (including roads, delivery o f utility services, communications, irrigation); reforming the system o f social protection to give more effective protection to the vulnerable; and improving the living conditions and opportunities for refugees and internally displaced people. The Joint Bank-Fund Staff Assessment Note (JSAN) o f the SPPRED concluded that the strategy is credible, that its broad policy priorities are appropriate and consistent with the multidimensional nature o fpoverty reduction, and that it reflected the need for balanced growth through development o f non-oil sectors and a reduction inthe differences indevelopment between Bakuandthe rest o f the country. The FY03-05 CAS was closely aligned with the SPPRED. During FY03-05 Azerbaijan's main challenges were to maintain stability in the face o f high levels o f foreign investment into the oil sector, establish the institutions to enable proper management o f oil revenues expected from FY06 onward, improve the environment for growth in non-oil sectors, and increase access to and the quality o fpublic social services. 61 The Bank Group strategy to support the SPPRED andhelp achieve sustainable poverty reductionwas organized into four strategic goals: Pillar I:Manage the oil boom to maintain macroeconomic stability, avoid Dutch disease, and facilitate non-oil growth, employment, andpro-poor expenditures. Pillar 11: Generate jobs and non-oil growth by improving the business environment and access to financial services, buildingsupport infrastructure for small and medium- size enterprises, and stimulating agriculture. Pillar 111: Improve access to services by reversing the decline in social services and assistanceand ininfrastructure. Pillar IV: Help realize the oil potential to the extent and within the time-frame the SPPRED presumes. Both the government's strategic goals and the Bank's CAS objectives remained relevant throughout the period of the CAS. Given the difficult experience o f many countries inmanaging resource booms, the emphasis on helping to fully realize the oil potential while promoting prudent management o f the revenue flows was highly relevant. Stimulating development o f non-oil sectors, such as agriculture, agro-processing, manufacturing, transit trade, and logistical services, i s also essential to create employment and ensure sustained economic growth after oil reserves are depleted. Key elements o f improvingthe environment for investment and growth in non-oil sectors are governance, removing impediments in the regulatory and administrative environment, and improving infrastructure and utility services. Azerbaijan inherited relatively good social indicators from the Soviet era, but these deteriorated during the 1990's. The challenge i s to turn this situation around and develop a system that meets modem needs. BankGroup AssistanceInstruments Bank assistance comprised intensive policy dialogue through adjustment lending and AAA, complemented by investments in infrastructure, the social sectors, and rural development. Recognizing that a window o f opportunity existed before major oil and gas revenues would come on stream, the Bank Group's overall strategy has been to promote an intensive dialogue to strengthen governance, help define and prioritize policy reforms, disseminate international development experience, and provide high quality technical expertise and know-how in designing and implementing public investment projects. The CAS laid out a base case scenario in which the Bank would lend $163 million ($123 million inIDA and $40 million inIBRD funds) through nine projects. All nine projects were delivered, and a smooth transition from IDA-only to IDNIBRD blend status was achieved (table A3.1). The first IBRDloan went to the Board inFY05. The CAS also laid out a high-case scenario, with enhanced PRSC lending and IBRD lending in infrastructure. Azerbaijan fell short o f meetingthe high-case triggers, mainly because o f inadequate progress in restructuring the State Oil Company of the Azerbaijan Republic (SOCAR), as discussed below. Country performance was sufficient to increase Azerbaijan's performance-based IDA 62 allocation, and a 10th project for internally displaced people was approved. IFC committed $66 million (3 percent equity and 97 percent loans) o f its own funds to nine projects and arranged $61.43 million in syndications, mainly in the financial and oil sectors. IFC also supported a regional project that will benefit Azerbaijan, a $30 million leasing facility for Central Asia, intendedto make leasing a viable alternative to private sector. There was a clear shift to a programmatic approach in both lending (via ApLs and PRSCs) and AAA (such as the programmatic PER and Poverty Assessment). Adjustment lending, closely integrated with individual sector loans and programmatic AAA, was used to spearhead sectoral reforms. Bank investment lending was also used to leverage larger investments by the government, the private sector, andother donors. Projects funded during the CAS period benefited from a range o f AAA on non-oil sector trade, investment, and trade facilitation; public expenditures; poverty; fiduciary and procurement systems; education and health; energy and other infrastructure; and the financial sector. Much o f IFC's advisory work in Azerbaijan focused on creating opportunities in the non-oil sectors, including through improved financial intermediation to support private sector growth and growth of small and medium-size enterprises. Other program highlights included a leasing development project, a corporate governance program, a linkages program for small andmedium-size enterprises, and a FDIconference organizedto focus global attention on the progress o f economic reforms and the future investment potential o f Azerbaijan in non-oil sectors. FIAS has provided advisory services to Azerbaijan's Investment Promotion and Advisory Foundation and consulted on improving Azerbaijan's investment legislation. As noted in the CPS above, during FY06 the strategy was continued through an active AAA program and four major new projects were approved. 1 bleA3.1 BankLendingProjectsinA; rbaiian.FYO3-05 Active projects FYO3-05 Approvedprojects FY03-05 FarmPrivatization (closed FY04) Baku Water Supply (Supplement) Gas Rehabilitation (closed FY03) Education Sector Development APL Institution Buildingtechnical assistance Irrigation Dist Sys and Mgmt (closed FY03) RuralInvestment Education Reform(closed FY04) Pension and Social Assistance SAC I1(closed FY04) Financial Services Development Urgent Environment Investment Economic Development Support to Pilot Reconstruction Internally Displaced People Agriculture Development Credit PRSC I Health ReformLIL Power Transmission Baku Water Supply Rural Environment Financial Sector TA Irrigatiofiainage Rehab Cultural Heritage PRSV IBTA2 Highway 63 Achievementof CAS Objectives OverallPovertyReduction At the national level, the proportion o f poor people declined from 44.6 percent in2002 to 24 percent in 2005, a decline o f 46 percent (table A3.2). The proportion o f people living in extreme poverty declined from 26.9 percent o f the population in 2002 to 9.2 percent in 2005. These findings based on comparable Household Budget Survey (HBS) data suggest that 1.9 million people lived in poverty in 2005, down considerably from almost 3.3 million in 2002. Growth has been pro-poor, with consumption increases o f the poorest decile at twice the average, see figure 2 inthe CPS above. Wages and salaries have increased significantly, with the minimum wage raised fivefold, albeit from a very low level. There has also been significant surge in transfer incomes for the poorer households. In 2004 government social transfers increased by over 35 percent among the poorest 20 percent o f the households from their level in2003. Pensions, which are the main component o f government social program, have increased by about 44 percent for the poorest quintile duringthe same period. A3.2: EstimatedNumberof PeopleLivingin PovertyinAzerbaijan, 2002-04 hercent) Total Baku Non-Baku Urban Rural poor verypoor poor verypoor poor verypoor poor verypoor 2002 44.6 26.9 41.6 25.6 48.7 31.5 43.7 24.7 2003 39.7 22.1 34.8 19.3 46.0 27.9 38.4 20.0 2004 28.5 13.4 18.6 8.0 35.4 19.0 29.6 13.0 2005 24.0 9.2 14.7 6.6 27.2 11.9 26.9 8.9 2004-2005 -4.6 -4.3 -3.9 -1.4 -8.2 -7.1 -2.7 -4.1 2002-2005 -20.6 -17.7 -26.8 -19.1 -21.5 -19.6 -16.8 -15.7 PillarI:Managingthe OilBoom Macroeconomic management over the CASperiod was commendable. The government was highly successful in maintaining macroeconomic stability. Despite large and potentially destabilizing capital inflows, a stable real exchange rate was maintained and inflation was contained to single digits through most o f the CAS period (table A3.3). External debt fell from 24 percent o f GDP in 2002 to 15 percent in 2005. Higher revenues and relatively cautious increases in expenditure yielded an average fiscal surplus o f 0.6 percent o f GDP between 2002 and 2005. The current account deficit rose sharply, from 1 percent of GDP in 2001 to 30 percent o f GDP in 2004, due to higher oil sector imports related to BTC construction and upstream oil platform development. However, this deficit was financed by FDI and the overall balance o f payments recorded a surplus. In 2005 the current account turned to a surplus o f 1.3 percent o f GDP. Given the increase in gross fixed investment, from 23 percent o f GDP in 2001 to 58 percent in 2004, macroeconomic management has been remarkable. In late 2004/early 2005, inflation spiked, due in large part to insufficient flexibility in the exchange rate in the face o f large capital inflows and higher public expenditures. Inthe second quarter o f the year, the government, inconsultation with the Bank and the IMF, introduced greater exchange rate flexibility and increased interest rates to bring 64 about a reduction in inflation. An anti-inflation decree with a wide range o f structural measures was adopted. End-periodinflation for 2005 i s estimated at about 5.5 percent. The Bank made Table A3.3: Summaryof Key Indicators effective contributions (in percent of GDP unless indicated otherwise) toward building the institutional framework Item 2001 2002 2003 2004 2005* to manage the oil boom. Real GDP growth (percent) 9.9 10.6 11.2 10.2 26.4 RealNon-Oil GDP-growth With Bank assistance (percent) 10.4 12.3 15.5 13.4 8.4 the government has put I d a t i o n(CPI, period average, 1.5 2.8 2.2 6.7 9.7 in place a framework percent) that has enhanced GNIper Capita (US$ Atlas) 660 720 820 950 1240 Azerbaijan's capacity to Current account balance -0.9 -12.3 -27.8 -29.8 1.3 Net Foreign Direct Investment manage its oil revenues. (US$ mln) 227 1,067 2,352 2,351 459 A range o f critical Real effective exchange rate -6.1 -7.1 -10.8 -3.5 7.5 institutions for efficient (percent. - depreciation) and transparent oil Consolidateifiscal balance -0.4 -0.5 -0.8 1.0 2.7 revenue management Consolidated fiscal balance, excl. Oil Fund -1.4 -4.3 -4.2 -2.5 -2.3 have been established, Consolidated budget revenues 18.7 27.3 26.8 26.8 26.5 operationalized, and Gross fixed investment 22.9 34.1 52.9 57.7 44.1 strengthened, including External debt outstanding 22.8 24.0 24.0 22.8 15.0 SOFAZ, the Chamber External debt service to exports 5.3 5.9 6.6 5.3 2.6 o f Accounts, the Public ratio (percent) Crude oil price (US$/barrel) 24.4 24.9 28.9 37.7 53.4 Investment Appraisal Division at the Ministry of Economic Development, and the early phases of an MTEF for budget preparation and execution. Extrabudgetary resources have been integrated into the state budget, which has been published since 2003, in accordance with the new budget law. Government Finance Statistics Manual (GFSM) classification has been adopted. All SOFAZ expenditures, except for operating expenditures, are incorporated as part o f the annual consolidated government budget presented to the Parliament for approval. The Ministry o f Finance publishes quarterly budget execution statements that include the use o f the Oil Fund. SOFAZ also publishes quarterly financial statements as well as annual reports audited according to international standards. Bank advice was provided to strengthen the fiduciary framework for governance in public entities and in the private sector via auditing and accounting reform, and reform o f public pr~curement.~~ A new procurement law was adopted and new accounting legislation based on IFRS enacted for private andpublic sector entities. While good progress has been made, a substantial agenda lies ahead in further strengthening key institutions. Progress in creating capacity in government auditing has been slower than expected. The Chamber of Accounts has been established and staffed, but its capacity and access to information are limited, restricting the scope o f its activities. Transparency in procurement practices i s also not yet widespread. Line ministries do not adequately participate in the MTEF process, and the capacity o f the Public Investment 24During the CAS period, the Bank prepared a Country Financial Accountability Assessment and a Public Expenditure Review inFY03.A Country Procurement Assessment Report was completed inFY02. 65 Appraisal Division needs to be further strengthened. Technical assistance programs in these areas by a range o f donors are continuing. The real test o f these institutions will come during the next CPS period, when large-scale revenues begin to flow. Experience suggests the need for gradual but consistent implementation along with extensive consensus buildingon reform issues, many o f which represent substantial shifts from current practices. A long-term time horizon i s essential, given the multilayered and compartmentalized structure o f government in Azerbaijan and comparative weakness o fthe media and civil society. Pillar 11: GeneratingJobs andSustainableGrowth outsidethe Oil Sector The non-oil sector grew 13percent a year during 2002-04, far exceeding the benchmark of 5-7 percent a year (table A3.4). Non-oil exports rose from US$259 million in 2002 to US$766 million in 2005, an average annual growth rate of 43 percent. Such high non-oil export growth, low inflation, low relative wages, and the most depreciated REER in the region (see box 1inthe CPS), are all strong indications that Dutch disease was avoided during the CAS period. The Bank and IFC worked closely with the government to support interventions to improve the business environment, strengthen the financial sector, promote agriculture, and diversify economic development to the regions beyond Baku. Employment growth in the construction, transport, and communications sectors was 3-5 percent per year. With a decline in agricultural employment (which accounts for 40 percent o f the workforce), however, official data indicate that overall employment grew just 0.4 percent a year.25A better measure may be the growth inprivate consumption, which increased on average by 7-8 percent p.a., while the poorest decile enjoyed twice that growth, see figure 2 in the CPS on Azerbaijan's track record of pro-poor growth. Minimumwages rose almost fourfold between 2002 and 2005 (from $7 to $25 a month), and average wages rose substantially as well. The result o f these wage increases was to raise the real incomes o f the large majority o f the population employed outside the energy sector, including teachers and health workers. The Bank made substantial contributions to growth in the non-oil sector through analytical work, close policy dialogue, and investments inthe financial sector, rural sector, and infrastructure, as discussed below. IFC supported local companies by building the capacity of financial institutions and small and medium-size enterprises. IFC's advisory work focused on creating opportunities for local suppliers to the major oil and gas development projects active in the region. The centerpiece o f this strategy is the ACG/BTC Small and Medium-Size Enterprise Linkage Program, which provides capacity buildingto local small and medium-size enterprises that do business with international oil companies. Other IFC technical assistance included a leasing development project and a corporate governance program. These programs are working to improve the country's overall investment climate through policy dialogue, training and public awareness campaigns, in addition to increasing investment attractiveness o f local joint-stock companies and banks. 25Information on employment and the labor market inAzerbaijan i s weak. Although labor market issues are a serious concern inAzerbaijan, where unemployment and underemployment are high, the Bank has had little success inengaging the government o n these issues and agreeing on a strategy and work plan. 66 TableA3.4 GDP Growth Rates,by sector, 2002-05 (percent) Sector 2002 2003 2004 2005e GDP 10 11 10 26 Non-oil GDP 12 16 13 8 Industry 4 6 4 57 Agriculture 6 6 5 8 Construction 82 48 41 2 Trade 6 9 9 10 Transport 4.5 11.5 Communications 10 11 36 36 Other services 8 12 11 111 Source: 2005 State Budget Package Document and Bank Staffestimates. Despite some progress, continuing efforts are needed to improve the business environment. Azerbaijan scored better than the average E C A country on 15 o f the 21 "Problems Doing Business" indicators in the 2005 BEEPS. It scored below average on corruption, business licensing, customs and trade regulations, tax administration, tax rates, and electricity. At least 25 percent o f respondents identified these areas as problems (other problem areas included the cost o f and access to finance). Perceptions in each o f these areas except electricity have worsened since the 2002 survey. This deterioration may be related to the transition in Presidential power in 2003-2004, and as such transitory. WBI Governance Indicators show steady progress during the CAS period on government Effectiveness and Regulatory Quality, areas where the Bank has influence, while progress in areas where the Bank has less leverage has beenmixed. At the beginning o f 2005, according to Doing Business, it took 115 days to start a business in Azerbaijan-three times as long as in the average country in the Europe and Central Asia Region. This figure was reduced to 56 days in May 2005, when the regulations for registering legal entities were streamlined. The cost o f dealing with licenses fell from 1,326 percent of per capita income to 977 percent in 2005, but is still almost twice the regional average. With Bank advisory assistance, the government has begun addressing these issues.26 Income tax on businesses was reduced from 27 percent in 2002 to 24 percent in 2004, tax- exempt income was raised by 50 percent, and the three-tier tax system was consolidated into two tiers. Azerbaijan has joined the Kyoto Convention on Simplification and Harmonization o f Customs Procedures, andpreparatorywork has begunto adjust the country's customs code. A new anticorruption law has been enacted, and the President has decreed an elaborate State Programme for Combating Corruption. However, progress has been slow. The FY06 Judicial Reform project is helping to strengthen governance in the court system and facilitate citizens access. 26Bank Group AAA included the benchmark annual DoingBusiness survey, INOTIS, the Trancaucasus Tourism Initiative IDF(FYOS), and the Trade Facilitation TNpolicy notes (FY04).A B a M M F Financial Sector Assessment Program was completed in2004. 67 Prudential norms and increased competition have been introduced in the financial sector. The Bank worked closely with the IMF to help the government encourage consolidation as well as competition inthe financial sector. Duringthe CAS period there have been significant improvements in the legal and regulatory framework for the banking sector, as well as in supervisory practices. The new Banking Law and the new Law inNational Bank o f Azerbaijan were enacted in 2005 and address the key issued identified by the FSAP. A numbero fnew prudentialregulations inline with BIS standards havebeenissued, a CAMEL- based bank rating systems has been introduced, the prudential reporting systems improved and there is now systematic off-site surveillance. The quality of on-site supervision has also improved. IFRS was implemented inall banks. National standards for banks governance were established, internal controls and audits strengthened, and a credit reporting system became operational inM a y 2005. The Banking sector was characterized by very strong growth, from about USD 994 million at end 2003 to USD 3.12 billion inmid-2006. The competition in the banking sector is increasing, but the dominance o f the state-owned International Bank o f Azerbaijan (IBA) continues to be a problem (although the dominance has been reduced from 80 percent in2000 to about 50 percent o f the total banking assets and about 20% o f the total capital as o f mid 2006). In2003 the 44 private banks had 96 branch offices, while state-owned IBA and Kapital Bank had 125 branch offices. At end 2005, the number o f branch offices o f private banks had increased 2.8 times to 270. Efforts to expand access to financial services outside Baku are moving forward under the new Bank-financed Financial Services Development Project. As the smaller domestic banks continue to grow and become stronger, the market position o f IBA is expected to decline more quickly inthe next couple of years. Furthermore, IBA's previous monopoly on credit cards has now vanished through the IDA-supported introduction o f a second card system owned by the association o f private banks. The issue o f the privatization o f IBA and Kapital Bank remains open. One reason i s that it has been difficult to find interest from fit andproper investors. IFC supportedfour financial sector projects designed to channel funds to the small and medium-sizeenterprise sector. IFC assistance included follow-on credit lines to two local banks that IFC support has helped transform into sustainable competitive financial institutions with the capacity to support small businesses. IFC has also provided assistance to the banks to reduce the risks associated with lendingto smaller businesses by implementing credit review and portfolio management tracking systems and by training branch managers, loan officers, and credit analysts. IFC was instrumental in establishing the first and only commercial microfinance bank in the country, the Micro Finance Bank of Azerbaijan. IFC's initial $1.75 million equity investmentand recent additional $3 million loanto the bank has helpedbuilt confidence inthe banking sector and introduced commercial microfinance techniques to Azerbaijan. Nineteen microfinance institutions now operate in the country, with an overall credit portfolio o f $52 million and more than 64,000 active clients, 39 percent o f them businesswomen. The total amount o f microfinance loans, which range from $100 to $125,000, i s expected to reach $200 million by end-2005. 68 Farm privatization was completed, and rural credit systems are being developed. Under the Farm Privatization Project, which closed at the end o f 2003, land titling and registration models were piloted that were subsequently adopted countrywide. The farm privatization of the late 1990s i s considered among the most successful in the CIS. With decentralization o f land transaction services under the Agricultural Development and Credit Project (ADCP), the number of registered landtransactions reached 10,000 in 2004, far exceeding the CAS target of 3,000 transactions a year. The ADCP also supported access to credit for more than 20,000 rural borrowers, far exceeding the CAS target of 7,000. While the credit unions are still young, most show signs o f operational viability. A follow-on ADCP-2 was approved in June 2006, while enlarging the real estate registration to country-wide coverage was separated out as a self-standingproject for FY07due to its size. Rehabilitation and construction o f irrigation and drainage infrastructure under two Bank projects resulted in a significant increase in crop yields in the target areas. A Rural Investment APL, focusing on community-based management o f infrastructure by rural communities, municipalities, and water users associations, was also commenced during the CAS period. For Azerbaijan these are new concepts that are takingroot slowly; the CAS period saw progress indeepening andbroadening recognition and acceptance o f the key role of grassroots organizations in the rural sector. To facilitate this process, the government adopted new legislation that simplifies the process o f registering legal entities, including NGOs, and established a legal registry. Notwithstanding these important achievements, the agenda in the rural sector remains large, with muchwork remainingto be done to improve access to credit, markets, and infrastructure. Bank AAA in the rural sector included a study o f a marketing and agro-processing issues and a study o f the rural impact o f utility price changes. Several initiatives have been undertaken to reduce pollution and strengthen natural resource management. Azerbaijan's national environmental priorities were defined in the 1998 National Environmental Action Plan, which has since gained increasing attention from both the public and the government. The Bank has placed emphasis on building capacity in the Ministry of Environmental and Natural Resources. Although continuing institutional weaknesses exist, the ministry i s gradually takinga leading role innational policymaking. Under the regional Caspian Environment Program, a National Caspian Action Plan was developed that has received strong donor support. The Urgent Environmental Investment Project helped build a sturgeon fingerling hatchery to help restore the stock o f sturgeon in the Caspian Sea. Six million fingerlings were produced in its first year o f operation, with an eventual target o f 15 million a year. The project also demonstrated several onshore oilfield cleanup methodologies and mercury removal methods by cleaning up a heavily contaminated area. The Council o f Ministers approved a Hazardous Waste Management Strategy in 2004 to mitigate the environmental impacts o f oil production. A National Monitoring Department 69 was established to track pollution emissions, and an Agency for Management o f Toxic Wastes was created to coordinate waste disposal. Further Bank support is being provided under the Rural Environment Project, approved at the end o f the CAS period, which focuses on improving forest and pasture management and biodiversity conservation. Work has also begun on establishing a mechanism to address legacy pollution and begin preparation o f a proposed Absheron Peninsula Environmental Cleanup Project for the next CPS period. Pillar111: ImprovingInfrastructureand SocialServices Azerbaijan is on track to reach most of the MDGs. Duringthe CAS period the MDGs were largely integrated into the SPPRED (see annex 4). The Bankworked to improve the statistical basis for benchmarks and monitoring progress in achieving them. A close partnership through the Programmatic Poverty Assessment strengthened Azerbaijan's capacity for poverty analysis. Notwithstanding this progress, analytical gaps remain, notably the absence o f regular labor market surveys and insufficient understanding o f the economic status of internally displaced people. In health the discrepancy between government statistics and survey data make it difficult to determine whether progress is being made in reducing under-five and maternal mortality. To achieve the MDG on ensuring environmental sustainability, Azerbaijan needs to give higher priority to improving drinking water sources, especially in rural areas. Good progress was made in providingfree textbooks and piloting student assessment as steps toward improving access and quality in the education system. The gross primary education enrollment ratio increased from 98.6 percent in 2001 to 102.4 percent in 2003; the gross upper secondary enrollmentrate rose from 43.2 percent in2001 to 70.5 percent in2003. Higher education enrollment dropped slightly, from 13.4 percent in 2001 to 12.2 percent in 2003. While CAS targets were broadly met, the education system continues to be plaguedby rigidities, inefficiency, and informal payments. The government has adopted a comprehensive reform program and appointed an Education Commission to accelerate progress in implementingthe agenda. The Bank i s continuing to help this process. It approved an Education Sector DevelopmentAPL duringthe CAS period, supported by an Education Sector Note (FY03). To improve equality in opportunity inbasic education, the Bank supported efforts to provide children in grades 1-5 with free textbooks. (According to government data, this target was achieved in both 2003 and 2004.) A Department for the Assessment o f Pupil's Achievement was established in 2004, and a pilot assessment in math and the Azeri language was conducted for 1,900 children in grade 5. Under IBTA-2 a study on financing of education, public education expenditure, and education priorities was prepared and training in expenditure analysis was provided. 70 2001 2002 2003 Life expectancyat birth 71.9 72.2 72.3 Grossprimary enrollmentrate (percent) 98.6 98.8 102.4 Gross upper secondary enrollmentrate (percent) 43.2 63.4 70.5 Grosshigher educationenrollment Rate (percent) 13.4 12.5 12.2 ' I Maternal mortality rate (per 100,000 live births) 25.4 19.9 18.5 Infant mortality rate (per 1,000 live births) 12.5 12.8 12.8 Primary healthcare service delivery was improved in target areas, although systemwide reforms are still required. Azerbaijan has taken steps toward reversing the spread of tuberculosis by expanding DOTS coverage, and its first HIV/AIDS grant funded by the Global Fundhas been approved. Due to limited government commitment to the broader reform agenda and governance issues, Bank objectives for the CAS period inthe health sector were limited to improvements inhealthservice delivery inpilot districts. The Health Reform LIL was successful inimprovingaccess to healthcare services in five pilot districts. The number o f patients at improved primary health care facilities in the target districts rose by 65 percent and patient satisfaction rose from 34 percent to 61 percent. The project was not, however, able to convince key stakeholders to adopt reforms on a wider scale. Health expenditures rose from 5.3 percent to 5.8 percent o f public expenditures but there was little rationalization o f expenditures, including right-sizing o f the number o f hospitals. Although adequately endowed interms o f facilities and staff, the healthcare system continues to suffer from very low utilization rates, particularly among the poor. Experience in the health sector to date indicates that little reform can take place without an adequate governance framework, political will, and buy-in from key institutions involved. When the leadership in the Ministry o f Health changed in 2005, the Bank was ready. The comprehensive Health Sector Review (FY05) defined the main elements o f the comprehensive reform program which are now being pursued through the FY06 Health Sector Reform project. Social protection transfer levels were increased and systemic reforms are imminent. Dialogue on social protection reform advanced significantly during the CAS period, supported by the Pension and Social Assistance Project, a PSIA o f the Impact of Utility Price Changes, and intensive work on poverty statistics and mapping. Both pensions and social assistance payments are being paid on time and there are no apparent arrears. The President approved a pension reform agenda to address both policy and administrative deficiencies. A computerized individual record system for pensioners is being developed and effective January 1, 2005, the minimum pension amount was increased to AZM 125,000 per month, equivalent to the minimum wage at the time. Social benefits were also increased. A new targeted family/poverty benefit scheme was introduced on July 1, 2006. This will also help compensate for the impact o fplannedfuture utilityprice increases. 71 Thegovernment 's strategy toward internally displaced people's has been increasingly oriented toward long-term sustainable improvement rather than "temporary" solutions. The government is increasingly taking the initiative on programs to promote sustainable livelihoods for internally displaced people . SOFAZ has significantly increased resources to refigee settlement ($47 million in 2004). Average per capita income among internally displaced people slightly exceeded the overall population average (table A3.6). Bank assistance since 1995 was focused through the Pilot Reconstruction Project, which built transport, energy transmission, and other infrastructure in war-affected areas, enabling about 36,000 internally displaced people to return to their places o f origin. It also established a targeted social fund, which has financed about 190 micro-projects, with an average cost o f about $35,000, for a total o f about 160,000 beneficiaries. Inlight o f additional IDA resources becoming available due to improving country performance, the Bank added an FY05 follow- on internally displaced people Economic Development Support Project, which is scaling up the social find. There remains, however, a need to better integrate internally displaced people issues into the overall poverty analysis and sectoral programs and improve data inthis area to gauge progress more clearly. Percent Item 2002 2003 2004 change, 2002-04 Refugeedintemally 185,772 199,076 217,127 16.9 I displacedpeople Overall I 179,107I 187,880I 207,558 I 15.9 Refugees/internally displacedpeople 163,350 172,071 217,358 33.1 Overall 164,788 175,863 215,595 30.8 Transport sector management has been strengthened and rapid development of the road network is underway. The government has embarked on an ambitious investment strategy in the transport sector to address critical bottlenecks in developing the non-oil sector and in improving economic opportunities and access to social services outside Baku. Significant budgetary resources have been allocated to road development and are being complemented by strong donor support. The Bank made contributions to institutional strengthening in the Ministry o f Transport, Highways Administration, and other transport- related institutions. Budget increases for road maintenance have exceeded the 10 percent a year target and there has been increasing competition among suppliers and contractors. A finctional classification o f the road network was completed and a Pavement Management System to analyze and prioritize road projects has been operational since January 2005. Work i s underway to rehabilitate sections o f the East-West highway and several rural road maintenance contracts have been completed under the Highway Project. The program provides a balanced approach to: upgrading major highways to 4 lanes; rehabilitating some national and regional roads; and rehabilitating a part o f the secondary and local network. A 72 second Highway Project for the North-South transit corridor was approved in FY06. While good progress is being made in roads, significant additional investment and maintenance is required, with 81 percent o f arterial roads still inpoor/bad conditions. Moreover, considerable work remains ahead in other transport sectors, including maritime transport, railroads, aviation, as well as customs. The 2006 BEEPS reported that the percentage o f firms seeing transport as a problem doing business has increased since 2002. Through dialogue on trade facilitation, the Bank helped achieve some progress indeveloping a publidprivate dialogue on trade and transport issues and in improving cooperation on these issues with neighboring Georgia.27 Regional cooperation on a larger scale is still constrained by political factors, however. Some steps were taken in reducing energy subsidies, increasing utility tariffs, and improving water supply in Baku, although the reform agenda in the utility sector remains large. In energy and other utility sectors, the Bank focused on structural reform, improving governance and financial performance, cutting subsidies, and improving the safety and reliability of services. According to the 2006 BEEPS, the percentage o f firms seeing telecommunications and electricity as a problem doing business declined from 9 percent and 30 percent respectively in 2002 to 5 percent and 25 percent in 2005. Progress was made in removing implicit energy subsidies, both through better collections and through making indirect subsidies explicit through the budget process. The overall level o f energy-related subsidies declined from 7.7 percent o f non-oil GDP in 2002 to 6.5 percent in 2004 and is projected to further decline to 4.7 percent in 2005. Gas tariffs were quadrupled in 2004 and water tariffs doubled in order to move closer to cost-recovery. Survey data in Baku show improvementindrinkingwater safety, although it remains a serious concern inother parts o f the country. Rehabilitation o f the main water treatment plant inBakuunder the Baku Water Supply projectis nearlycomplete, improving source quality. Yet, low quality of utility services, lack of metering and inflated norms hampers bill collections and the financial viability of the companies is questionable. The financial condition o f the utility sector remains weak and increased metering and an improved regulatory framework is needed for electricity, gas and water entities to become commercially sound. Progress toward privatization or increased private sector involvement in utilities has also been slower than anticipated. Limited data also prevents an accurate assessment o f improvements in service delivery in the water or energy sectors. There have been no repeats o f the nationwide electricity blackout o f 2002, but system reliability remains fragile with frequent localized outages and occasional widespread system failures. The government has now started very major investments in power generation and transmission. Further commitment was shown in July 2006, when President Aliyev instructed the Cabinet o f Ministers to increase collection rates for public utilities within three months at all cost. September collection rates doubled to 83 percent for gas and 70 percent for water.28 Meters are rapidly being installed. As mentioned, tariffs were raised significantly for gas and water. The targeted social safety net started July 1, 2006, which eventually will allow for adjustment 27 K e y components of this dialogue included Bank AAA onBuilding Competitiveness:An IntegratedNon-oil Trade and InvestmentStrategy (INOTIS) (FY03) and the Tradeand Transport Facilitation Study (FY03). 28 September 2006 collection rates for electricity were not available at the time of printing. 73 o f tariffs to cost-recovery levels. The new Accounting Law requires IFRS for all utility companies. Pillar4: Realizingthe OilPotential The objective of Pillar 4 was tofacilitate andfinance oil and gas development, and ensuring that theprojects 'social and environmental impact is mitigated. Development o f Azerbaijan's oil sector has proceeded on schedule, fueled by some $8 billion in investments during 2002- 05. The ACG Phase 1 upstream project achieved first oil in February 2005 and is now producing approximately 136 thousand barrels o f crude oil per day. Various factors led to a delay in the completion o f the extremely complex construction o f the B T C pipeline by more thana year. The BTC Company beganfillingthe pipeline inAzerbaijan with crude oil inMay 2005. Oil reached Ceyhan by M a y 2006. The first phase development o f the Shah Deniz gas field is progressing on schedule and with construction o f the South Caucasus Pipeline gas exports are expected to commence in 2006. With these developments, the oil sector is projected to grow at 60 percent a year during 2005-07. After 2007 growth is expected to gradually slow andthen start declining over the medium to longer term. TheBank Groupplayed a catalytic role in helping realize the oil potential. The Bank Group played a key role inhelping realize the oil potential, not just inmarshalling financing for the oil field project and BTC pipeline development, but also in taking the lead to ensure maintenance o f the highest social, environmental and safety standards. IFC supported the second stage of development o f the A C G Phase 1 oil field in Azerbaijan and the associated BTC pipeline inFY04, with loans o f $61.43 million for its own accounts and syndicated loans o f $31 million. IFC has also been instrumental in conducting multi-stakeholder meetings in the country, convening local people, nongovernmental organizations, and others to hear concerns about the BTC pipeline's route and other issues. Regular monitoring of the project continues by multiple independent entities including NGO groups in Azerbaijan and IFC's environmental and social staff. Duringthe B T C construction, IFC staff accompanied both the environmental missions (which occurred four times per year) and the social missions (which occurred twice a year). IFC also interacts on a regular basis with engineering monitors, who work on behalf o f the lenders group, and with the Caspian Development Advisory Panel, which advises BP on their work in the region. As discussed in the first pillar, IDA played a major role in helping Azerbaijan put into place adequate institutions for transparency in revenue tracking and utilization, centered on the Oil Fund, budget systems, MTEF, and the PIP. These institutional reforms played a critical role in creating the enabling governance framework necessary for international oil companies and banks to commit the long-term, large-scale financing for the project. The comprehensive monitoring framework has led to early identification of issues, which the lenders and civil society have worked with the project to resolve. IFC has also encouraged BTC to include civil society in the monitoring framework, which BTC has been able to do so effectively in Azerbaijan. IFC sits on the Steering Committee that reviews quarterly progress. Furthermore, IFC has dedicated a staff based in Baku identifying, implementing and monitoring linkages projects under the ACG/BTC SME Linkage Program. To date, linkages have included supply chain technical assistance to improve the ability o f 74 potential suppliers to win long-term contracts and access to business services delivered through the BP Enterprise Center, and the Energy Bus to disseminate information on energy- saving and alternative energy technologies (4,486 households participated in the demonstrations). The program illustrates IFC's effort to create more opportunities for smaller local businesses. IFC's Corporate Citizenship facility has also dedicated $200 thousand in co- fundingto help sponsors buildthe capacityo f civil society inthe region. Although not an explicit objective of Pillar 4 o f the CAS, a substantial challenge remains in restructuring SOCAR, which has an equity investment in all oil and gas joint ventures in the country, conducts its own production and refining operations, and dominates the domestic oil and gas markets. During the CAS period a major corporate restructuring consolidated SOCAR into 8 divisions from previously 171 business units. Several non-core assets were separated from SOCAR inview o f the preparation o f their privatization. There is still a need to separate SOCAR's commercial and regulatory functions and improve the transparency of its operational activities and financial reporting. A management company was hired and has advised SOCAR on implementation o f the action plan. The 2004 Accounting Law, enacted with the support of the PRSC, stipulates that SOCAR and all other state-owned enterprises should file and disclose according to IFRS by 2008. While this deadline may be optimistic, given the complexities involved, good progress is being made according to SOCAR'S action plan. To begin implementation o f an action program on financial and corporate restructuring o f SOCAR was a high-case trigger o f the CAS, but not a condition for satisfactory im lementation o f the baseline. Supported by the PRSC, the agreed action plan got underway. 8 5. OutcomeAssessment andContributionto Results Outcome: Satisfactory The CASperiod saw substantial progress in allfour strategic directions. Particularly strong results were seen inthe first and fourth pillars: managing the oil boom and helping realize the oil potential. GDP grew an average o f 11percent per year over the past four years with non- oil GDP growing nearly 13 percent a year; the B T C pipeline i s nearing completion; development o f gas fields and other pipelines are on schedule; the Oil Fundi s firmly inplace; the budgetary framework is being implemented; and the government's commitment to maintaining high standards o f governance and transparency in the utilization o f its energy revenues was demonstrated by its groundbreaking participation in the EITI, as the first country in the world to report for 2003,2004 and 2005. Good progress was also made toward the second and third goals, although progress was slower in some important areas. Sustained growth was seen inthe non-oil sector and progress was made inmost areas supported by the Bank, including bankingcompetition, land market, rural credit, irrigation, and environment. 29The CAS high-case trigger on SOCAR was also a core conditionality ofthe PRSC and was met as a prior action. See the Azerbaijan PRSC ProgramDocument, April 19, 2005, table 4 on p. 34, andpp.27-29. 75 Table A3.7. CAS Outcome issessments, by lbjective Objective Outcome Explanation Commendable macroeconomic management; Pillar I:Manage the oil boom Satisfactory substantial improvements in institutions requiredfor transparent oil revenue management. The real test o f these institutions, however, will be inthe next CPS period, when substantial oil revenues come on stream. Sustained non-oil sector growth; good progress in most areas supported by the Bank, including much Pillar 11:Generate jobs and Moderately more banking competition and stronger enforcement non-oil growth Satisfactory o f prudentialregulations, as well as progress on land market, rural credit, irrigation, and environment. However, further progress is neededto improve the small and medium-size enterprisehusiness environment. Azerbaijan is on track to meet most of the MDGs. Good progress was seen with Bank interventionsin Pillar 111:Improve education, social protection reform, and targeted infkastructure and social Satisfactory health care. Systemwide reforms o f the health sector services are now underway supported by the Health Sector Reformproject, which was based on the Health Sector Study completed duringthe CAS period. Road development is proceedingrapidly; reforms in energy and utilities are underway with rising tariffs and collections, and renewedcommitment from the government. Highlevels o finvestment attracted into oil sector; Pillar IV: Realize oil potential Satisfactory allmajor projects on track for completion; oil growth projected at 60 percent a year over next few years. Although not an objective o f the CAS baseline, major SOCAR restructuringtook place and implementation o f IFRSi s underway. However, considerable work remains to be done to improve the business environment, competition in the banking sector, and eliminating corruption in order to fully realize non-oil growth and employment creation potential. In the social sectors, IDA had significant impact through the dialogue on health, pension and social assistance and comprehensive reforms are underway. The government also strengthened its care to internally displaced people and began seeking sustainable solutions to improving their living conditions and economic opportunities. In the education sector, progress was made in developing new curricula, provision o f free textbooks, and monitoring education outcomes. Restructuring continued in the water and energy sectors, although limited progress was made on increasingprivate sector involvement. The government has recently showed renewed commitment inthese sectors. 76 Sustainability: Likely Continued momentum on reforms, underpinned by rising oil revenues makes the sustainability of these outcomes likely. Primary risks to the sustainability o f achievements to date include a delay in implementing structural reforms due to non-reformers and vested interests; a deterioration in financial management as oil revenues increase dramatically; disruption o f resource flows due to volatile oil prices or delays in oil pipeline construction; and a deterioration in the political or security environment. Mitigating factors include an active PRSP process; an emphasis on macroeconomic management, Oil Fund integrity, strategic long-term oil revenue management, sound budget preparation processes, and financial accountability; a SPPREDKPS emphasis on diversifying the sources o f growth and expanding participation in the economy; broadening dialogue with civil society; commitment to furthering the democratic process; and a shift toward establishing stable relationships with neighboring countries. All five projects that closed during the CAS period (Farm Privatization, Gas Rehabilitation, IBTA, Education Reform and SAC 2) were judged to be "likely" or "highly likely" to be sustainable by OED. BankPerformanceand Contribution Strongpolicy dialogue and closely integrated sectoral lending made substantial contributions toward advancing Azerbaijan 's strategic objectives over the CAS period. IDA'S policy dialogue has been a key facilitator o f change in the country's transition to a growing market economy. The Bank Group was able to maintain a constructive dialogue around the PRSCs even in the absence o f urgent funding gaps. The Bank did not "push through" a financing package without the government's demonstrated credibility toward accelerating the reform agenda. SAC-I1 and PRSC-I provided an integrating and consensus-building platform for a wide range o f reform measures that would have been difficult to undertake individually. Reforms were prepared in close collaboration with key implementing agencies and managed to create a new vision and agenda for development as expressed inthe SPPRED. Particularly important was the Bank's partnership with the IMF and other donors in formulating and implementing a coherent set o f policies. Such a strategy required a high level o f coordination among Bank team members in program content, ESW and mission timing. The formula for success was a tightly knit country team creating synergy and leverage betweenthe high-level reform agenda and supporting sector projects. Supervision o f SAC-11, for example, was felt as a responsibility by the whole country team. The Bank and IFC teams managed to build new relationships and trust between Azerbaijan and the Bank. The Country Office played a crucial role inthe dialogue with the government. Portfolio performance indicators remained satisfactory throughout the CAS period. All nine new lending projects targeted for the CAS period were delivered and a tenth project was made possible by higher performance-based IDA allocations. Altogether, twenty five projects were active during the CAS period and a satisfactory portfolio status was maintained. Currently, all projects in Azerbaijan under impiementation are rated satisfactory. The portfolio disbursement rate was satisfactory, averaging 18-20 percent per year over the CAS period. Of the six projects that closed during the CAS period, all were rated satisfactory on completion except one-the Gas Rehabilitation Project, which was judged successful in rehabilitating infrastructure in a sustainable manner, but not in promoting the wider reform 77 agenda in the gas sector. Follow up reviews by IEG rated this and two others as unsatisfactory. In the Education LIL, the project was successful in training in interactive teaching, but IEG felt that the curriculum development and evaluation components were unsuccessful. Inthe Urgent Environment Project, IEGnoted that while some urgent physical targets were met (like the hatcheries) other components were less successful, particularly on the environmental clean-up. IEG rated Bank performance satisfactory in all projects, except the Gas Project, in which Bank performance was rated as "unsatisfactory" because o f the assumption that the project in itself would provide sufficient leverage to carry out gas sector reforms. Not until SAC-I1 leveraged high-level policy dialogue did gas sector reform take off. Inaddition to the above, all four ofthe projects closedinFY06 were rated satisfactory at the time o f closing, though the IEG review has not yet taken place. All projects and ESW reviewed by QAG were judged "satisfactory" with the exception o f the Education Sector Note, inwhich formal dissemination was assessed as unsatisfactory. The general message o f completion reviews was that it was important to have a sense o f realism about the pace o f change and maintain flexibility in implementation. It was also important to pay attention to buildinginstitutional capacity andto clarify legal andfiduciary responsibilities early on. A positive shift towardprogrammatic AAA was made. The CAS period saw a shift in ESW away from long studies toward shorter programmatic policy notes, produced within a longer term phased schedule, to provide a basis for a focused and participatory policy dialogueon key issues. The Programmatic Public Expenditure Reviews and Poverty Assessments are being carried out in the form o f individual modules, tailored with greater flexibility to the interests and needs of policy makers. Likewise, the 2004 Energy Study "Issues and Options Associated with Energy Sector Reform" is a compilation and synthesis o f a series o f shorter studies on individual energy sectors and issues that formed the basis for intensive dialogue with stakeholders in the energy sector. The World Bank Institute focused on an on-going South Caucasus regional program on fiscal decentralization and development o f local government capacity over the past two years andon PRSP dialogues amongthe CIS-7 countries. The Bank collaborated closely with other partners, particularly in structural reform areas. On the overall reform program there has been close coordination between the Bank's support through the SAC-I1 and PRSC and the IMF-supported Poverty Reduction and Growth Facility (PRGF). The fourth review o f the PRGF was completed satisfactorily in December 2004 and the program has come to conclusion in 2005. The ADB, the European Union, and the IsDB for capacity building provided critical support. The EU TACIS also helped on modernizing the taxation system. The Bank worked as one team with USAID on Treasury Systems, PIP and utility regulatory reform and teamed up with U S Treasury on budgetary reform. The Bank worked closely with EBRD and USTDA on SOCAR restructuring. The Bank has also joined with ADB, Switzerland, and UNDP to support the formulation and implementation o f the SPPRED. The latter has been particularly helpful in integrating the monitoring o f the MDGs into the recent SPPRED progress report. An intensive three-way dialogue between the Bank, IMF and the government, and close cooperation supported achievements in the macro/financial management/governance environment with other donors, especially the European Union andUSAID. See annex 6 for highlights o fthis collaboration. 78 Borrower Performance Prudent macroeconomic management and commitment to implementing the SPPRED were keyfactors behind successful outcomes, although reforms in some areas have been slow. The government has chosen to work with the Bank on furthering reforms, strengthening governance and accountability, and opening Azerbaijan up to the market economy not because o f financing needs, but because it feels it benefits from the Bank's advice. Strong ownership o f the SPPRED has led to development o f comprehensive reform agendas in a range o f areas that are being gradually implemented. Azerbaijan's CPIA ratings rose significantly over the CAS period. Borrower performance was judged by OED to be satisfactory or highly satisfactory in all projects closed during the period except for the Gas Rehabilitation Project. Relatively few problems were experienced with counterpart funding. Insome areas, thepaceofstructuralreformwas somewhat slower thanhadbeenhopedfor, in part due to the political transition that took place early in the CAS period. As a result, Azerbaijan remained inthe Base Case throughout the CAS period, rather than moving into the HighCase. The government and Bank team had hoped that a significant acceleration inthe pace o f structural reforms in the utilities sector and tradebusiness agenda would permit disbursement o f PRSC-I and an IBRD Energy Infrastructure loan in FY04, and a second PRSC in 2005. Instead, the reforms moved forward slowly, and the Energy Loan and PRSC-I only went to the Board at the end o f the CAS period. More needs to be done to improve project processing and effectiveness and civil society participation. The government in Azerbaijan remains compartmentalized and government decisionmaking procedures are complex. As a consequence, project preparation and negotiations are delayed and there have been some long lags between project approval and effectiveness, with the risk o f undermining timely implementation. The government has also shown limited acceptance o f international TA, resulting in delays in implementation and analytical gaps that hamper the monitoring o f performance. As a result, 6 out o f the 8 projects that have closed or are scheduled to close during the CAS period required extensions. In addition, implementationinseveral projects has been delayedbyprocurement issues andthere i s a need to carefully continue to ensure Bank standards o f transparency in all projects. Civil society development and participation are also lower than in some countries at a comparable level o f economic development and greater efforts to engage civil society groups in the development and implementationo freforms and investmentprojects are essential. Exogenous Factors There were no significant exogenous shocks over theperiod of the last CAS that affected the achievement of outcomes. The country benefited from higher than expected oil prices throughout most o f the period. A political transition, when President Heidar Aliyev died in 2003 and his son Ilham Aliyev was elected as the new President period impacted the CAS. The transition resulted in some delays in moving forward with economic reforms, but President Aliyev's November 24,2003, Decree and subsequent follow-up has since provided important impetus to reforms. CAS implementation did not have any unintended negative impacts that the team i s aware of. 79 6. LessonsandImplications for FuturePartnershipStrategies ConsistentBank assistanceover a considerable timeperiod helped build a consensus and advancepolicy and institutional change in Azerbaijan. Continuous and long-term Bank engagement in policy dialogue combined with related investments and accompanying technical assistance, helped produce improved governance and transparency in oil revenuemanagement as well as significant policy and institutional reforms ina number o f sectors. Adjustment lending combined with technical support and advisory services proved particularly effective in helping the government formulate and implement policy reforms as well as overcome vested interests. Implications:Stay consistently and constantly engaged inthe policy reform agenda over the medium-term. Continued Bank engagement through policy dialogue can play a pivotal role in advancing the remaining reform agenda needed for Azerbaijan to consolidate its recent gains and ensure sustainable growth andpoverty reduction. TheBank's policy dialogue, knowledge, and technical expertise continue to be in demand in Azerbaijan. The government has recognizedthat the value o fBank assistance goes well beyond the financing involved and welcomes continued Bank support even as energy revenues rise sharply and Azerbaijan enters Middle Income Country status. Implications: Policy dialogue as well as technical and knowledge services will increasingly comprise the Bank's mainvalue added inAzerbaijan and it should be ensured that such support is timely, relevant, and highquality. Theemerging challenge in Azerbaijan is to develop the means to stayfully engaged in the policy dialogue in the absence of urgent balance of payment needs and PRSC lending. With a reduced need for balance o f payment lending and the phasing out of IDA allocations for Azerbaijan, a key question is how the Bank can continue to stay fully engaged inthe policy dialogue. Unlike some Middle Income Countries, Azerbaijan has a continued need for structural reforms to accelerate improvements in the business environment and further encourage growthinthe non-oil sectors. Implications:Develop alternate methods to remain engaged incritical policy issues inthe absence o f PRSC lending, including greater use o f knowledge work as an entry point. Broad dissemination and greater involvement o f civil society in knowledge-generating activities can help foster greater understandingand consensus around key reform areas. Close integration of policy and investment lending and a closely knit country team enhanced the Bank's effectiveness. A key lesson learned from the Gas Rehabilitation project was that the investment credit instrument in itself did not provide sufficient leverage to bring about difficult restructuring and pricing reform. The conditions attached to SAC-I1were more effective intackling such sector issues. Implications:Ensure close integration o f policy dialogue and investment lending and an intensive level o f coordination among Bank team members in program content, advice, andproject supervision. The shqt toward "programmatic" ESW during the CAS period resulted in a series of timelypolicy notes and workshops. The programmatic approach to ESW has enabled both 80 in-depth "core' studies as well as shorter, themed or purpose-driven outputs and more consistent policy dialogue than one-off studies are able to provide. This, for example, has ledto much improved poverty analysis. Implications: Continue and expand programmatic analytical work to other sectors to enhance policy dialogue and dissemination o f knowledge. Complex administrative and decisionmaking procedures in Azerbaijan frequently cause implementation delays. Projects in Azerbaijan continue to suffer from undue delays in project effectiveness and implementation. Implications: Anticipate administrative and decisionmaking bottlenecks in all activities and enhance efforts to engage high level facilitators and broad buy-inat all levels to speed up implementation. Continued areas of weak information undermine analysis and decisionmaking. Inseveral areas, such as the health sector and the labor market, the absence o f accurate data undermines analysis and the establishment o f meaningful objectives and monitoring indicators. Implications: Enhance technical and advisory assistance in areas where information capacity remains weak. A comprehensive review o f the labor market is an important element o fbetter understanding and addressing the employment-generationgoal. While regional cooperation and integration has been politically difficult, it will be increasingly important for the region to sustain growth. Clear economic opportunities exist in greater regional cooperation and integration, including in energy flows, trade and transportation. While the region remains politically volatile and continued tensions exist in some areas, there are signs of progress toward more stable economic and political relations among countries in the region, which i s likely to open up significant opportunities for cross-border interventions. Implications: Anticipate and prepare for increasing regional integration and at the appropriate time, engage in regional-level assistance, such as development o f the transit comdor. 81 cc o g Y O cc m e e e * e e m e e e e e e -r 0 . 0 . 0 . 0 . 0 0 . 0 0 U 0 8 *x B* d Y 8 e .r( .-a 0 m 5 P 2 3 0 a sEs 0 2$1 ." Es2 W 1 0 e 2! G W 4- G -j .3 8 e . . . e . e . . e . e e . . 0 . . .3 V bo e . . e . . . e . . e . e e . . e . e . h +e, P v).E g 0 . 0 0 0 0 0 0 0 0 . 0 0 0 . 0 0 . 0 . 0 . 0 0 . 0 0 . 0 0 0 . 0 . 0 to 00 0 . 0 . 0 0 0 0 0 U- rc W 0 .y e e e e e .-g ax e e e . . . e . e e . . e . . (u a . . . 0 . . . .... . . . . 0 . TableA3.10 PlannedBaseCaseLendingProgramandActual Deliveries (millionsof dollars) Plannedin2003 CAS $ Actual Lending $ for FY03-05 planned for FY03-05 delivered BakuWater Supply (Supp) _ _- . _ _ 12.9 Delivered 12/10/02 12.9 Education (APL) 18.0 Delivered 5/27/03 18.0 Irrigation 30.0 Delivered 6/17/03 35.0 Private Sector Development 10.0 Fin.ServiceDeliv. 1/6/05 12.25 Pensions 10.0 Delivered 6/10/04 10.0 Energy Sector (IBRD) 40.0 Delivered 5/17/05 48.0 Environment 8.0 Delivered June 05 8.0 PRSC-I 20.0 Delivered 5/17/05 20.0 Rural Community Infrastructure 15.O Delivered 6/3/04 15.0 InternallyDisplacedPeople 12.0 Project (added) FY05 Total 163.0 Total 183.15 93 Table A3.11. Planned Nonlending Services and Actual Deliveries Year/plan IResult FY03 Financial Sector Assessment (FSAP) Business Environment Study Health Sector Capacity BuildingTechnical Assistance South Caucasus TelecomsRPIAF Technical Assistance South Caucasus Trade Facilitation Technical Assistance/Policv Notes FY05 Country Economic MemorandumUpdate Postponed to FY08 and substituted with Policy Notes, ongoing Transcaucasus Tourism Technical Assistance (IDF) Delivered Public Expenditure Review Update Programmatic, ongoing Higher Education Note Postponed to FY07 Health Sector Review (added) Delivered FY06 PSIA Labor Market Study (added) Delivered Programmatic Poverty Assessment (added) Delivered first stage 94 Annex 4 Likelihood of MeetingMillennium Development Goals Millennium Current status Prospectsfor achieving Goal by 2015 Development Goal Halfincome poverty About 50 percent o f the population o f Likely. The oil sector boom, combined Azerbaijan lived in poverty in 2001. In with broadening o f employment- 2005, it is estimated that 24 percent o f the generating economic activities in non-oil population was poor. sectors together with safety nets policies, would allow Azerbaijan to achieve this target, probably sooner than 2015. Achieve universal Enrollment rates in basic education Likely. The country inherited an education primary education (grades 1-9) are well above 90 percent, system that provides nearly universal basic although drop-out rates are higher for the education. Sector issues relate more to poor than for nonpoor. Sector concerns quality, than to access. relate more to quality, including the need to build the skills and knowledge necessary to meet the challenges o f an increasingly global economy. Achieve gender Surveys show no significant gender Likely. Although girls drop out o f equality inprimary differences in enrollment rates for basic secondary school earlier than boys and education education (grades 1-9). Concerns relate fewer attend post-secondary education, more to girls' access to upper secondary especially in rural areas, there i s no and higher education, particularly in rural evidence o f gender inequality at the areas. primary level. Reduce under-five According to official data, under-five Unlikely. Assessing progress i s mortality by two-thirds mortality rate was 23.1 and infant complicated by data uncertainties. To mortality 12.8 per 1000 live births in reduce under-five mortality by 213, a 4.4 2002). On the other hand, estimates based percent annual reduction i s needed on surveys indicate that in 1990, the between 1990 and 2015. Azerbaijan's baseline for the MDG goals, the U5MR progress has beenat only about 0.9 percent and IMR were 106 and 84 per 1,000 live annually during 1990-2000. Thus births, dropping to 96 and 76, respectively Azerbaijan is at risk o f not meeting this in 2002. However, for the pilot districts MDG without a concerted effort to covered by the Health Reform Project, strengthen primary health care and make it UNICEF reports a 13 percent decline accessible to the poor. from 73.2 per 1,000 births (2002) to 63.7 per 1000 (2004) ininfant mortality, which if sustained and generalized to the rest of the country, would put Azerbaijan back on track to meet the goal of 213 reduction by 2015. Reduce maternal M I C Survey (UNICEF) estimates place Unlikely. There has been a disconcerting mortalityby three maternal mortality at 79 deaths per rise in maternal mortality according to quarters 100,000 births in 1990, and 94 in 2000. independent surveys, but a reduction in According to the State Statistical MMR according to official data. In the Committee, the MMR was 19.9 deaths per absence o f comprehensive health sector 100,000 births in 2002, a 52 percent reform to improve access and quality in reduction compared with 37.6 in2000. primary healthcare delivery, it is unlikely that Azerbaijan will meet this goal. For health-related MDGs, problems o f data collection and definitions have to be resolved to enable realistic targets and monitoring. 95 Millennium Current status Prospectsfor achieving Goal by 2015 Development Goal Reverse the spread o f The prevalence rate o f Azerbaijani Likely. Although the prevalence rate is HIV/AIDS citizens infected with HIV i s believed to considered to be very low, there are an be l o w by regional standards, although estimated 600,000 IDUs in the country newly reported cases doubled between who account for 63 percent o f the cases. 1999 and 2000. The actual extent is not There is a need for both sero and known because o f limited coverage o f behavioral surveillance and greater seroprevalence surveys and lack o f attention to HIV/AIDS prevention and behavioral surveys. care. A s o f December 1, 2004 Ministry of Health has launched the HIV/AIDS project funded by the Global Fund to fight AIDS, - Tuberculosis and Malaria. Reverse the spread o f In 2003 tuberculosis prevalence and Likely. According to WHO Global tuberculosis mortality rates were 50 cases and 12 Tuberculosis Control Program, DOTS deaths per 100,000 population, population coverage was 48 percent in respectively. Case fatality rate stands at a 2003. Political commitment and additional high 14 percent. Case detection rate resources are needed to expand coverage remains at around 25 percent, much lower from the current to 100percent in order to than the international standard o f 70 meet the MDG goal of reversing the percent, with only a small fraction o f spread. cases detected through DOTS. The cure rate was 84 percent, close to the target o f 85 percent. Ensure environmental According to available estimates, around Unlikely. Achieving this MDG is feasible sustainability (including 76 percent o f all households have access only if the government gives sufficient halving the proportion to an improved drinkingwater source - 93 priority to rural water in its public o fpeople without percent in urban areas and 58 percent in investment program, consistent with the access to safe water). rural areas. SPPRED. calculate the MDG target o n a pro rata basis and the 2015 target was determined in relation to the available base year. 96 Annex 5 CPS Consultationswith CivilSociety andNon-GovernmentalOrganizations CPS priorities were discussed with a large and diversified set o f representatives o f the civil society during two rounds o f public consultations. Participants were invited to share their views and visions on the perspectives o f development processes in the country as well as ask questions ifany. Participants expressed their great interest in the meetings and raised questions and concerns regarding Bank activities in Azerbaijan, as well as provided information on their own activities. Comments and feedback received duringthe meetings covered both general andspecific areaso fthe Bank's current andpotential involvement inthis country. Inview of all participants, the World Bank plays an important role inhelping the development process move and its presence in Azerbaijan adds credibility to the reforms carried out by the government. It was also mentioned that at this point, where the country is at a crossroads given the rapidly rising oil revenues, Bank should continue to provide its expertise and technical assistance on the management o f revenues and expenditures since cooperation with the Bank i s critical to ensure good practices in governance are put inplace. At the same time, the Bank should think o f a more effective way to work with NGOs. Participants reiterated the importance o f increased involvement o f NGOs indesign and implementation o fBank-funded projects as well as inassessment o ftheir results. A general concern is that projects should be well monitored in order to ensure effective and efficient use o f funds. A general wish expressed was that the Bank improve the quality and availability o f socio-economic data and information on project results and their assessment inthe Azerbaijani language. The representative o f the National NGO Coalition dealing with EITI raised the fundamental question o f how to engage the civil society as an essential party to policy making. Representatives o f the civil society organizations generally expressed appreciation o f their involvement in the preparation o f SPPRED but complained about little involvement o f NGOs during its implementation. They also feel that the Civil Society Organizations are not adequately involved in the implementation as well as impact monitoring o f the Bank-fundedprojects inAzerbaijan. As meeting participants particularly underlined, it would be a valuable instrument for the development and capacity buildingo f civil society in the country. They were also wondering if there i s any independent review o f the Bank funded projects inAzerbaijan to ensure the transparency and accountability for the proper usage o fthe credit funds. 97 Among the areas, which need attention o f the international organizations and should be prioritized for their involvement, several participants particularly indicated the health sector o f the country, which was identified as problematic, as health outcomes are raising increased concern. The education sector was also mentioned as not very successful and requiring additional attention. The participants recognized the difficulties o f working with the relevantministries andpersuadingthemto involve NGOsmore intheir sectors. Several participants also underlined the importance o f municipal development and increasing cooperation between NGOs/municipalities and government structures to fight poverty and ensure economic growth o f the country One o f the NGOs working in ecological sector expressed concern with the lands deterioration at the areas where BTC is constructed and requested to forward their concern to the IFC. Participants suggested that the Bank should put a stronger emphasis on addressing governance issues by encouraging the government to put in place structural reforms such as separation o f commercial and regulatory functions o f ministries, setting better monitoring mechanisms, and promoting participatory approaches to decision making. The latter would be facilitated by institutionalizing and including adequate budget allocations for the government's support to NGOs. Domestic trade should be an area o f the Bank's attention. Development o f rural infrastructure, especially inremote and mountainous areas is vital for stimulating economic activity o f communities. Alternative sources o f energy, such as windmills and bio-energy can be a solution when addressing energy efficiency. Access to clean water and irrigation i s another area emphasized duringthe meeting. Participants suggested that the Bank continues assistance to the financial sector by promoting banking in rural areas, in particular by supporting those banks that have branches inremote areas. Other areas that were emphasized as deserving the Bank assistance were small and medium-size enterprises. Local entrepreneurs see the Bank's role as a supporter o f the institutional development including legal framework, improved corporate governance and promoter o f better business and economic education and R&D. The Bank is expected to advocate for a business environment free o f harassment, corruption and monopolies. Notwithstanding the energy resources, Azerbaijan is an agrarian country and therefore, participants said, it i s crucial to invest inthis sector. The Bank could concentrate on supporting agro-processing and also provide assistance to Azerbaijani entrepreneurs in their efforts to integrate with internationalmarkets 98 With large government spending and the Bank's investments inthe non-oil sector, it is vital that the Bank helps improve institutional management and build capacity, two important elements o f a successhl change. Qualified professionals in the key sectors and good management skills are already in high demand both by the public and the private sector. Several participants mentioned the importance o f a comprehensive approach to the development o fparticular sectors andthe Bank's investment operations. The last but not the least comment was that all operations should be gender sensitive andtarget women as important beneficiaries o f Bank-funded projects. 99 Annex 6 Collaboration with Development Partners The Bank is collaborating closely with other development partners, particularly in structural reform areas. On the overall reform program there has been close coordination betweenthe Bank's support through the SAC-I1 and PRSC and the IMF-supported Poverty Reduction and Growth Facility (PRGF). The fourth review o f the PRGF was completed satisfactorily in December 2004 and the program has come to conclusion in 2005. The ADB, the European Union, and the IsDB for capacity building provided critical support. The EUTACIS also helped on modernizing the taxation system. The Bank worked as one team with USAID on Treasury Systems, PIP and utility regulatory reform and teamed up withUS Treasury on budgetaryreform. The Bank worked closely with EBRDandUSTDA on SOCAR restructuring. The Bank has also joined with ADB, Switzerland, and UNDP to support the formulation and implementation o f the SPPRED. The latter has been particularly helpful in integrating the monitoring o f the MDGs into the recent SPPRED progress report. An intensive three-way dialogue between the Bank, IMF and the government, and close cooperation supported achievements in the macro/financial management/governance environment with other donors, especially the European Union andUSAID. Highlights o fthis collaborationover the CAS periodinclude the following: Macroeconomic management and public expenditure. The Bank will continue to work closely together with the IMF. On Treasury modernization, the Bank i s financing computerization together with USAID. The Bank is also coordinating with USAID on its Public Investment Policy and Efficiency (PIPE) project, which is supporting improvements o f capital budget formulation, investment project preparation, and long- term budget planning at the Ministry o f Economic Development and selected line ministries. The U.S. Treasury i s supporting a long-term engagement with the Ministry o f Finance on improving the budget preparation process and moving toward program budgeting. Financial sector. IDA and the IMF collaborated closely on the preparation of the 2005 Financial Sector Assessment Report; this collaboration will continue with implementation support o f the FSAP recommendations. U SAID i s providing support for banking supervision. KfW is playing an important role in supporting the Credit Guarantee Fund and Deposit Insurance. It is expected that the European Union will support the strengtheningo f anti-money laundering legislation andinstitution building. Accounting. The Bank and IFC have cooperated closely with the ADB and the EuropeanUnion inthe context o f the recent Accounting and Auditing ROSC, which is being finalized. The European Union, the Bank (including the IFC), the IsDB, and USAID are working very closely in supporting accounting reforms and the implementation of the new accounting law. The Bank used Consultant Trust Funds made available by Canada and Switzerland to extend assistance to policymakers, regulators, and private sector stakeholders inenhancing financial reporting and internal control systems inAzerbaijan. 100 3+Anticorruption. The Bank will work closely with the European Commission on corruption as its ENP Action Plan crystallizes. It is expected that the European Commission will include specific actions to strengthen enforcement and assess the impact and progress o f the Anticorruption Law in force since January 2005 and the state program on fighting corruption, which is closely related to the policy framework supported by the CPS. The European Union is expected to play a leading role in simplifying and streamlining customs and tax legislation and procedures in line with EUandinternational standards. > Judicial reform. Several donors are working with the Ministry o f Justice and the courts inthe areasoflaw drafting, proceduralreforms, andtraining ofjudges. The Council of Europe and European Union are working on law drafting, the selection and hiring o f 100 additional judges, and development o f supervision systems. USAID and GTZ are working on training. The American Bar Association Central European and Eurasian Law Institute (ABA CEELI) is working on legal education and information, judicial training on ethics and commercial law, and alternative dispute resolution (ADR). Preliminary consultations indicate that donors are not fully satisfied with the institutional capabilities or infrastructure o fjudicial institutions to actually implement many o f the law and human rights reforms that have been initiated and approved in recent years with their assistance. IDA will collaborate closely with donors (including the Netherlands, the International Committee o f the Red Cross, OSCE, the Eurasia Foundation, and Soros Foundation) on the implementation o f judicial reform and training activities. > Agriculture. IDA is coordinating its agricultural program with USAID, the ADB, the International Fund for Agricultural Development (IFAD), and GTZ, which are providing credit to agricultural producers, supporting small and medium-size enterprises, and working to increase the competitiveness o f rural enterprises. USAID is supporting three programs that provide support to small and medium-size enterprises and farmers to improve linkages to markets. It is launching a program to strengthen microfinance institutions inrural areas. The ADB i s planninga new project to support micro-finance institutions (MFIs) in nonurban areas through the provision o f a credit line. IDA is working with the European Union Food Security program and TACIS on coordinating activities in the agricultural sector. The development o f rural areas and collaboration, especially in the areas o f food safety, have been discussed. IDA is coordinating activities related to real estate and cadastre development with the ADB, KfW, and SDC. The second phase o f the ADCP will coordinate closely with all stakeholders on their areas o f involvement. P Health. IDA is coordinating with UNDP and UNICEF on establishing family clinics and district health programs. GTZ i s enhancing the national health monitoring system. USAID/Caucasus-Azerbaijan has started a new $5 million project that focuses on redefiningand restructuring primaryhealth care with improved financing and resource allocations inorder to improve service quality. Other USAID-funded programs include the Child Survival Program (Mercy Corps) and the Reproductive Health and Family Planning (ACQUIRE). USDA is supporting primary health care (via ADRA) and a 101 HIV /AID program (via IRD). UNICEF is planning to continue its activities in safe motherhood, neonatal care, nutrition, and HIV/AIDS prevention and care. It is also supporting overall health sector reform within the SPPRSD framework. A UnitedAid for Azerbaijan project i s supporting early intervention services, and the UnitedNations Population Fund(UNFPA) is implementinga reproductivehealth program. The Global Fund to Fight AIDS, Malaria and Tuberculosis has granted the Ministry o f Health $6 million for a HIV/AIDS project, and further fhnding is being considered for malaria and tuberculosis. GOPAKfW has been involved in implementing DOTS for tuberculosis treatment in Azerbaijan. Further tuberculosis screening and follow-up is needed to strengthen integrated primary health care services and epidemiology and sanitary control. The World Health Organization will be providing technical assistance to the Ministry o f Health on primary health care, health policies and strategies, health financing, tobacco, HIV/AIDS, tuberculosis programs, andimmunization. P Education. The ADB has launchedan early childhood development project. The Soros Foundation is complementing the IDA program in providing support for early childhood development. The Open Society Institute and BTC/SCP are implementing a rural inclusive education program to integrate children with special needs into mainstreamkindergarten andprimaryclasses. The Japanese government has provided a grant for building and rehabilitating primary schools. JBIC is preparing a project on secondary vocational education development. The Saudi Fund has financed the construction o f five secondary schools in Baku. USAID is considering a grant project in secondary and tertiary education. UNICEF, USAID and SDC are involved in the sector through civic education, voter education, and youth projects. P Social protection. Inclose coordination with IDA, UNDP will maintain its support to the Social Protection Fund for establishing the system o f individual accounts until the end of 2006. The EU TACIS and Food Security programs are planning to continue their support to the ministry o f labor and social protection in implementing targeted social assistance. These projects are still being developed. P Internally displaced people. IDA and the ADB are working together to help improve the economic opportunities o f internally displaced people and integrate them into society. Their efforts partially complement the more immediate humanitarian support provided by UNHCR (shelter) and the World FoodProgram (food security). P Infrastructure. Several donors are currently supporting different parts of the North- South and East-West road corridor modernization including ADB, EBRD, IDB, Kuwait Fund, OPEC Fund, and the Saudi Fund. Inview o f its substantial involvement inthe sector, the Bank will provide overall leadership andcoordination inthe transport area as recently agreed with ADB. EBRD and ADB technical assistance i s coordinated with andcontinues the Bank's technical assistance program started with the Azerbaijan Highway Project. The Bank's support for the water sector is complemented by support provided by ADB and KfW on water supply in secondary towns and rural areas. ADB i s working on an integrated and comprehensive urban planning approach in three provincial cities. With regard to the energy sector the Bank i s working closely with 102 EBRD on SOCAR restructuring and major upstream and pipeline investments. The Bankistakingthe leadondonor coordinationinthis sector. 103 Annex 7 Country Financing Parameters for Azerbaijan Table A5.1. Country Financing P rameters for A erbaijan [tern Parameters ExplanatiodResult Cost-sharing upto 100 Itis expected that 100percentBank financing Limit onthe proportiono f individual percent would be applied selectively. This would most project costs that the Bank may finance likely be needed for community-driven development projects and for IDFgrants. Recurrent costfinancing N o country-level Recurrent cost financing i s expected to remain Any limits that would apply to the overall limitonrecurrent limited. The Bank will continue to monitor the amount o f recurrent expenditures that the cost financing aggregate fiscal position andprospects, and its Bank may finance. implications for recurrent cost financing. In determining Bank financing o frecurrent costs inindividualprojects, the Bank will take into account sustainability issues at the sector and project levels, including impliedfuture budgetary outlays. Local costfinancing Yes The criteria for Bank financing o f local costs Are the requirements for Bank financing: are met. The Bank may finance local costs in financing requirementsfor the country's the proportions needed inindividual projects. development program would exceed the public sector's own resources (for example, from taxation and other revenues) and ex- pected domestic borrowing; and the financing o f foreign expenditures alone would not enable the Bank to assist inthe financing o f individual projects. Taxesand duties None There are no taxes and duties that arejudged ~~ Are there any taxes and duties that the Bank to be unreasonable. At the project-level, the would not finance? Bank would consider whether taxes and duties constitute an excessively high share o f projects costs. 104 Annex 8 StandardCPS Tables Table A2: Azerbaijan at a Glance Table B2: SelectedPortfolio Indicators Table B3: IBRD/IDA Program Summary Table B3: IFC andMIGA program Summary Table B4: Summary o fNon-Lending Services Table B5: Social Development Indicators Table B6: KeyEconomic Indicators Table B7: KeyExposure Indicators Table B8: OperationsPortfolio Table B8b IFC's Held& DisbursedPortfolio 105 CPSAnnex Tables - Page I of 13 Azerbaijan at a glance 10/2/06 Europe& Lower Key Development Indicators Central middle Azerbaijan Asia income Age distribution, 2005 (2005) Female Population,mid-year(millions) 8.4 473 2,475 7&74 Surfacearea (thousandsq km) 87 24,238 39,946 6084 Populationgrowth (Oh) 1.1 0.1 1.o Urban population(YOof total populabon) 52 64 50 5054 4oM GNI (Atlas method. US$ billions) 10.4 1,945 4,746 5054 GNI per capita (Atlas method. US$) 1,240 4,113 1.918 M 2 4 GNI per capita (PPP international$) 4,890 9,142 6,313 1C-14 0-4 GDP growth (%) 26.2 6.0 6.9 15 10 5 0 5 10 15 GDP per capita growth(Oh) 25.0 5.9 5.9 percent (most recent estimate, 2000-2005) Povertyheadcountratioat $1 a day (PPP, YO) 4 2 Povertyheadcountratioat $2 a day (PPP, Yo) 33 16 Under-5 mortality rate (per 1,000) Life expectancyat birth (years) 72 69 70 Infant mortality(per 1,000 live births) 75 28 33 Child malnutrition(YOof childrenunder 5) 7 5 12 Adult literacy,male (% of ages 15and older) 99 99 93 Adult literacy,female (% of ages 15and older) 98 96 85 Gross pnmaryenrollment.male (Ohof age group) 98 105 115 Gross pnmaryenrollment.female (% of age group) 96 102 113 Access to an improvedwater source (YOof population) 77 92 82 Access to improvedsanitationfacilities (Ohof population) 54 85 57 1893 1885 2003 m :Azerbaijan tEumpe&CentralAsia N e t Aid Flows 1980 1990 2000 2005 a (US$ mihons) Net ODA and official aid 0 139 176 jrowth of GDP and GDP per capita (X) Top 3 donors (in 2004) UnitedStates 19 48 Germany 1 9 17 Japan 0 36 10 Aid ( O hof GNI) 2.1 2.8 2 2 Aid per capita (US$) 0 17 21 Long-Term Economic Trends 65 85 w 0 Consumerprices (annual 56 change) 912.3 1 8 9 7 GDP implicit deflator (annual Oh change) 83.5 12.5 103 --O-GDP - GDP per capita Exchangerate (annualaverage,local per US$) 0.0003 0.895 0 931 Terms of trade index (2000= 100) 100 145 1980-90 1990-2000 200045 (averageannualgrowth %) Population,mid-year(millions) 6 2 7.2 8.0 8 4 1.5 0.8 GDP (US$ millions) 8,858 5,273 12561 41.2 2 132 (% of GDP) Agnculture 29 0 17 1 100 -1 8 7 9 Industry 32 9 45 3 62 3 -1 8 163 Manufacturing 19 3 5 6 7 8 -10 9 106 Services 38 1 37 5 27 7 -2 5 9 2 Householdfinal consumptionexpenditure 51 2 63 5 47 6 2 0 115 Generalgov't final consumotionexoenditure 176 152 109 -2 3 4 2 Gross capitalformation 26 5 20 7 37 8 186 342 Exportsof goods and services 43 9 39 0 57 4 7 2 21 0 Importsof goods and services 39 2 38 4 53 8 157 20 9 Gross national savings 4 9 17 1 32 6 Note: Figuresin italics are for years other than those specified. 2005 data are preliminaryestimates. ..indicatesdata are not available a. Aid data are for 2004. DevelopmentEconomics.DevelopmentData Group(DECDG). 106 CPSAnnex Tables -Page 2 of 13 -- Azerbaijan at a glance (cont.) Azerbaijan Balance of Paymentsand Trade 2000 2005 GovernanceIndicators. 2000 and 2005 (US$ m'lfions) Total merchandiseexports (fob) 1,799 7,649 Total merchandiseimports(cif) 1,539 4,350 Voiceand accuuntability Netbade in goods and services 36 1,329 Politicalstability Workers' remittancesand compensationof employees(receipts) 57 363 I Regulatoryquality Current acwunt balance -187 167 Ruleof law as a % of GDP -3.6 1.3 Controlof corruption Reserves,includinggold 680 1.178 0 25 50 75 iw Consolidated GovernmentFinance 32005 Country'spercentilerank (0.100) 32000 h@er velues im#y belle, re!!- (% of GDP) Revenue 21.2 26.5 Some Kaufmann-Kraay-MastNz?l WoM Bank Tax revenue 14.5 16.0 Expense 21.8 23.8 Technology and Infrastructure 2000 2004 Cash surplus/defidt -0.6 2.7 Pavedroads(% of total) 92.3 47.0 Highestmarginaltax rate ( O h ) Fixedlineand mobilephone Individual 35 35 subscribers(per 1,OW people) 152 333 Corporate 27 22 Hightechnology exports (% of manufacturedexports) 4.5 2.1 External Debt and ResourceFlows Environment (US$ millions) Total debtoutstandingand disbursed 1,352 1,881 Agriculturalland (% of land area) 55 57 Total debtservice 130 235 Forestarea (% of land area, 2000 and 2005) 11.3 11.3 HiPC and MDRidebt relief(expected:flow) - - Nationallyprotectedareas (% of land area) 6.4 Total debt (% of GDP) 25.6 15.0 Freshwaterresources per capita (cu. meters) 977 Total debt service(%of exports) 6.0 3.0 Freshwaterwithdrawal (% of internal resources) 212.6 Foreigndirectinvestment(net inflows) 149 459 CO2 emissionsper capita (mt) 3.7 3.4 Portfolioequity(net inflows) 0 31 GDP per unit of energy use (2000 PPP $per kg of oil equivalent) 1.8 2.3 omposition of total external debt, 2005 Energyuse per capita (kg of oil equivalent) 1,430 1,493 IBRD,0 W (US$ millions) iBRD Total debt outstandingand disbursed 0 0 Disbursements 0 0 Principalrepayments 0 0 Interestpayments 0 0 IDA Total debt outstandingand disbursed 216 501 Disbursements 27 48 Private Sector Development 2000 2005 Total debt service 2 6 Time requiredto start a business(days) - 115 IFC (fiscalyear) Cost to starta business(% of GNIper capita) 12.5 Total disbursedand outstandingportfolio 163 61 Time requiredto registerproperty(days) -- 61 of which IFCown account 124 37 Disbursementsfor IFC own account 46 26 Rankedas a major constraintto business Portfoiiosales,prepaymentsand (% of managerssurveyedwho agreed) repaymentsfor IFC own account 6 58 Tax administration 24.9 Tax rates .... 22.9 MlGA Grossexposure 65 1 Stock marketcapitalization(% of GDP) 0.1 Newguarantees 30 0 Bank branches (per 100,000people) .. 4.1 Note: Figures in italicsarefor years otherthan those specified. 2005 data are preliminaryestimates. ..indicatesdata 10/23/06 are not available. -indicates ObSeNatlOnis not applicable. DevelopmentEconomics,Development Data Group(DECDG). 107 CPSAnnex Tables-Page 3 of 13 Azerbaijan at a glance(cont.) Millennium Development Goals Azerbaijan With selected targets to achieve between 7990and 2075 (estimateclosesf to date shown, +/- 2 yeant Goal 1: halvethe rates for $1a day poverty and malnutrltlon 1990 1995 2000 2004 Povertyheadcountratioat $1 a day (PPP. % of population) 10.9 3.7 Povertyheadcountratioat nationalpovertyline(Ohof population) 68.1 49.0 27.5 Shareof incomeor consumptionto the poorestqunitile(%) 12.2 Prevalenceof malnutrition(Ichildrenunder 5) of 10 17 Goal 2: ensure that children are able to complete primaryschooling Primaryschoolenrollment(net.%) 89 86 84 Primarycompletionrate(% of relevantage group) 81 89 96 Secondaryschool enrollment(gross,%) 88 75 83 Youth literacyrate(YOof peopleages 15-24) 100 Goal 3: eliminate gender disparity ineducation and empower women Ratioof girls to boys in primaryandsecondaryeducation(%) 100 100 97 Women employedin the nonagriculturalsector(% of nonagriculturalemployment) 34 39 44 49 Proportionof seats heldbywomen in nationalparliament(%) 12 12 11 Goal 4: reduce under-5 mortality bytwo-thirds Under-5mortalityrate (per 1,000) 105 98 93 90 Infantmortalityrate (per 1,000livebirths) 84 80 77 75 Measlesimmunization (proportionof one-year olds immunized,%) 66 97 99 98 Goal 5: reduce maternalmortality bythree-fourths Maternalmortalityratio(modeledestimate,per 100,000live births) 94 Birthsattended byskilledhealthstaff (% of total) 84 Goal 6: halt and beginto reversethe spread of HIVIAIDSand other major diseases Prevalenceof HIV (YOof populationages 1549) 0.1 Contraceptiveprevalence(% of women ages 15-49) 55 Incidenceof tuberculosis (per 100,000people) 35 75 Tuberculosiscases detected under DOTS (%) 5 6 47 Goal 7: halve the proportionof people without sustalnable access to basic needs Access to an improvedwater source(% of population) 68 77 Access to improvedsanitationfacilities (%of population) 54 Forestarea (% of total landarea) 11.3 11.3 Nationallyprotectedareas (% of total landarea) 6.4 C02 emissions(metrictons per capita) 7.5 4.2 3.7 3.4 GDP per unitof energyuse (constant2000 PPP$per kgof oilequivalent) 1.1 1.8 2.3 Fixedlineand mobile phonesubscribers(per 1,000people) 87 84 152 333 Internetusers (per 1,000people) 0 0 1 49 Personalcomputers(per 1,000people) 18 Youth unemployment(%of total laborforce ages 15-24) Education indicators (Oh) Gafies immunization(%of lyear olds) CT indicators (per 1,000 people) 4w -, 1880 1995 2wo 2 c a xxx) 2om 2 w +Primary netenrolimntratio ckerbaijan 0Europe8 CentralAsiaI 3 Fixed+ mobilesubscnbers 3 Internetusers Note: Figuresin italicsarefor years otherManthose specified...indicatesdataare notavailable. 10/2/06 DevelopmentEconomics, DevelopmentDataGroup (DECDG). 108 CPSAnnex Tables -Page 4 of 13 CAS Annex B2 Azerbaijan - Selected Indicators* of Bank Portfolio Performance and Management As Of Date 10123/2006 Indicator 2004 2005 2006 2007 PottfolioAssessment Numberof Projects Under Implementationa 14 18 18 16 Average ImplementationPeriod(years) 3.5 3.2 2.7 2.8 Percentof Problem Projectsby Numbera, 14.3 5.6 0.0 0.0 Percentof ProblemProjectsbyAmount 30.5 3.5 0.0 0.0 Percentof Projectsat Risk by Numbera* 14.3 5.6 0.0 0.0 Percentof Projectsat Risk byAmount 30.5 3.5 0.0 0.0 DisbursementRatio (YO)e 18.0 26.6 16.2 2.8 Pottfolio Management CPPR during the year (yedno) SupervisionResources(total US$) AverageSupervision(US$/project) Memorandum Item Since FY 80 Last Five FYs Proj Eva1by OED by Number 11 8 Proj Eva1by OED byAmt (US$millions) 340.8 192.3 % of OED ProjectsRated U or HU by Number 45.5 37.5 % of OED ProjectsRated U or HU by Amt 37.2 20.7 a. As shown in the Annual Reporton PortfolioPerformance(exceptfor current FY). b. Averageage of projects in the Bank's country portfolio. c. Percentof projectsratedU or HU on developmentobjectives(DO)andlor implementationprogress(IP). d. As definedunderthe Portfolio ImprovementProgram. e. Ratioof disbursementsduringthe year to the undisbursedbalanceof the Bank's portfolioat the beginningof the year: Investmentprojects only. * All indicatorsare for projects active in the Portfolio,with the exceptionof DisbursementRatio, which includesall active projectsas well as projectswhich exitedduringthe fiscal year. 109 CPSAnnex Tables - Page5 of 13 CAS Annex 8 3 IBRDllDA Program Summary - Azerbaijan As Of Date 0711112006 Proposed IBRDllDA Base-Case Lending Program a Strategic Implementation Fiscalyear Proj ID US$(M) Rewards Risks (H/M/L) (H/M/L) ~~ 2007 Corporate& PublicSector Accounting 20 H H NationalLandTitle & Registry 30 M M RailwaysTTF 80 M M NationalWater Supply and Sanitation 220 H H Gas Flaring Carbon Financing M L Result 350 2008 FinancialSector Modernization 10 M M Transit Corridor and Traffic Management II 200 M M Education APL II 40 H M Social ProtectionII 10 H M Absheron Env. Cleanup 50 H M Result 310 2009 10 - e-Government& Pub. Sect. Reforms 30 H H Irrigation& Drainage II 75 M M Transit Corridor and Traffic Management111 200 M M WSS and Urban Rehabilitation 200 H H Other InfrastructureTBD 50 M M Higher Education 45 H M Other Global Partnerships Carbon Financing L L Result 600 Overall Result 1,260 110 CPSAnnex Tables - Page 6 of 13 CAS Annex B3 (IFC & MIGA) for Azerbaijan Azerbaijan IFC andMIGA Program, FY 2002-2006 - 2002 2003 2004 2005 2006 IFC Commitments (US$m) 0.00 4.15 61.40 0.4 10.3 Sector (%) Finance& Insurance 100 100 100 Oil, Gas andMining 100 Total 0 100 100 100 100 Investmentinstrument(%) Loans 58 100 78 Equity 42 100 22 Total 0 100 100 100 100 MIGA guarantees (US$m) 38.06 3.23 3.56 111 CPSAnnex Tables - Page 7of 13 CAS Annex B4 Summary of Nonlending Services - As Of Date 7/11/2006 Product Completion FY Cost (US$OOO) Audiencea Objectiveb Recentcompletions Business Env. Survey (BEEPS) FY05 23.8 Energy Sector Review FY05 78.9 Health Sector Review FY05 199.3 PSlA on the Impact of Utility Sector Reform FY05 114.8 PSlA on Labor Markets FY05 108.5 Education Spending on the Poor FY06 53.1 Corporate and Accounting ROSCs FY06 85.8 Statistical Capacity Bldg FY06 18.4 Prog. PER FY06 95.1 Agro-processing Study FY06 144.6 Prog. Poverty Assessment FY06 126.8 Underway PER Core with PEFA Assessment FY07 150 Business Env. TA FY07 50 Structural Reform TA FY07 250 Water Sector Review FY07 20 Prog. Poverty Assessment Program. 125 p.a. Planned Prog. PER with PlFC Assessment FY08 150 CEM FY08 250 Structural Reform TA FY08 250 BEEPS FY08 Transport Sector Review (with ADB) FY08 Prog. Poverty Assessment Program. 125 p.a. Education Review FY08 200 Environmental Review FY08 125 Prog. PER with CFMCPAR updates FYO9 100 Private and Financial Sector TA (inc. FSAP in 08) Program. 50 p.a. Regional Development Strategy FYO9 100 Social Sector Review FYO9 125 Natural Disaster Management FYO9 250 a. Government, donor, Bank, public dissemination b. Knowledgegeneration, public debate, problem-solving. c. Maybe integratedinto a Public FinancialManagementReport d. The timingand financingofthis activity are still to be determined e. May be integratedintothe Programmatic Public ExpenditureReview 112 CPSAnnex Tables - Page 8 of 13 CPSAnnex B5 Azerbaijan Social Indicators Latestsingle year Same regiodincomegroup Europe& Lower- Central middle- 1980-85 1990-95 1999-05 Asia income POPULATION Total population, mid-year (millions) 6.7 7.7 8.4 472.9 2,474.7 Growth rate (?Aannual averagefor period) 1.6 1.4 0.8 0.0 1.o Urbanpopulation (% ofpopulation) 53.5 52.4 51.5 63.7 49.5 Total fertility rate (births per woman) 2.9 2.3 2.0 1.6 2.2 POVERTY (?Aofpopulation) Nationalheadcount index 68.1 27.5 Urban headcount index 26.3 Rural headcountindex 29.0 INCOME GNI per capita(US$) 400 1,240 4,113 1,918 Consumer price index (2000=100) 87 125 130 130 Foodprice index (2000=100) INCOMEKONSUMPTIONDISTRIBUTION Gini index 36.0 Lowest quintile (?Aof income or consumption) Highest quintile (% ofincome or consumption) SOCIAL INDICATORS Publicexpenditure Health(% of GDP) 2.1 1.O Education (?Aof GDP) 4.5 3.1 4.4 4.3 Net primary school enrollment rate (?Aof age group) Total 89 84 90 Male 89 85 91 Female 89 83 90 Accessto an improvedwater source (% ofpopulation) Total 68 77 92 82 Urban 82 95 99 94 Rural 51 59 80 71 Immunizationrate (% of children ages 12-23 months) Measles 97 98 93 85 DPT 96 96 93 88 Child malnutrition (% under 5years) 7 5 12 Lifeexpectancy at birth bears) Total 69 69 72 69 70 Male 66 65 70 64 68 Female 73 73 75 73 73 Mortality Infant (per I,000 live births) 89 80 75 28 33 Under 5 (per 1,000) 114 98 90 34 42 Adult (15-59) Male (per I,000population) 262 216 230 316 184 Female (per I,000population) 127 96 107 134 117 Maternal (per 100,000live births) 94 58 163 Birthsattended by skilled healthstaff (?A) 84 94 86 CAS Annex BS. This table was produced from the CMU LDB system. 10102106 Note: 0 or 0.0 meanszero or less than halfthe unit shown. Net enrollmentrate: break in series between 1997 and 1998due to change from ISCED76 to ISCED97. Immunization: refers to children ages 12-23 months who received vaccinations before one year of age or at any time beforethe survey. 113 CPSAnnex Tables - Page 9 of 13 Azerbaijan Key Economic Indicators -CPSAnnex B6 Actual Estimate Projected Indicator 2002 2003 2004 2005 2006 2007 2008 2009 2010 Nationalaccounts(as % of GDP) Grossdomestic producta 100 100 100 100 100 100 100 100 100 Agriculture 15 13 12 I O 9 8 9 9 10 Indusby 50 53 55 62 67 67 66 63 60 Services 35 34 33 28 24 24 26 28 30 Total Consumption 73 70 66 45 36 36 36 38 41 Gross domestic fixed investment 34 53 58 44 40 37 36 36 37 Government investmnt 5 4 4 4 10 12 15 14 13 Private investment 29 49 54 40 30 24 22 22 24 ~ x p o r t s(GNFS)~ 43 42 49 66 76 77 74 70 63 Imports (GNFS) 50 66 73 56 52 50 46 44 41 Grossdomestic savings 27 30 34 55 64 64 64 62 59 Gross national savings' 22 25 28 46 54 58 61 60 59 Memorandum items Grossdomestic product 6,236 7,276 8,682 12,561 19,139 25,628 32,855 38,728 42,754 (US$ million at current prices) GNIper capita (US$,Atlas method) 720 820 950 1,240 1,650 2,400 3,330 3,940 4,450 Real annual growth rates (%, calculated from 2005 prices) Gross Domestic Product at marketprices 10.6 11.2 10.2 26.4 24.6 27.1 19.9 11.6 5.7 Real annual per capita growth rates (%, calculated from 2005 prices) Gross Domestic Product at marketprices 9.8 10.4 9.3 25.1 23.6 26.1 19.0 10.7 4.8 Balanceof Payments(US%millions) EXPOITS (GNFS)~ 2,667 3,057 4,235 8,332 14,584 19,652 24,283 27,063 26,790 MerchandiseFOB 2,305, 2,625 3,743 7,649 13,733 18,595 23,100 25,749 25,343 ~mports(GNFS)~ 3,121 4,770 6,312 7,003 9,954 12,727 15,133 16,897 17,604 Merchandise FOB 1,823 2,723 3,582 4,350 6,993 9.190 11,283 12,545 12,814 Resource balance -454 -1,713 -2,077 1,329 4,630 6,926 9,150 10,166 9,186 Net current transfers 70 134 189 484 1,088 1,866 1,993 2,494 2,612 Current account balance -768 -2,021 -2,589 167 2,749 5,452 8,217 9,464 9,109 Net private foreign direct investment 1,067 2,352 2,351 459 -1,539 4,120 -1,456 -667 81 Long-term loans (net) 167 115 17 218 163 311 339 337 418 Official 175 149 62 70 114 193 254 303 337 Private -8 -34 -45 148 49 118 85 34 80 Other capital (net, incl.errors& ommissions) -230 -199 665 -208 457 1,409 2,l I O 2,012 1,714 Change inreservesd -236 -247 -444 -636 -1,830 -3,051 -9,210 -1 1,146 -1 1,322 Memorandum items Resourcebalance (YOo f GDP) -7.3 -23.5 -23.9 10.6 24.2 27.0 27.9 26.2 21.5 Real annual growth rates Merchandise exports (FOB) 8.7 -4.2 12.9 46.6 47.8 45.8 32.0 19.6 5.1 Merchandise imports (CIF) 23.2 34.3 22.4 21.4 55.8 26.6 22.3 10.5 1.5 114 CPSAnnex Tables - Page I O of 13 Azerbaijan- Key EconomicIndicators (Continued) Actual Estimate Projected Indicator 2002 2003 2004 2005 2006 2007 2008 2009 2010 Public finance (as % of GDP at market prices)' Currentrevenues 27.3 26.8 26.8 26.5 40.8 45.3 63.9 64.7 61.4 Currentexpenditures 21.2 21.5 21.7 19.1 22.6 23.9 24.0 22.9 22.9 Current accountsurplus (+) or deficit (-) 6.1 5.2 5.1 7.4 18.2 21.3 39.9 41.8 38.6 Capital expenditure 5.6 6.0 4.1 4.7 10.7 12.8 15.4 14.9 13.9 Overallbudgetbalance 0.5 -0.8 1.0 2.7 7.5 8.5 24.5 27.0 24.7 Monetary indicators M2/GDP 13.0 14.3 17.6 15.4 21.1 26.3 27.8 31.3 35.7 Growthof M2 (%) 14.4 29.8 47.5 22.1 93.6 59.0 28.6 26.0 22.4 Private sector credit growth/ 77.4 120.3 136.8 108.8 114.2 106.9 103.8 101.8 100.3 total credit growth(YO) Price indices (ZOOS = 100) Merchandiseexport price index 47.8 56.8 71.8 100.0 121.5 112.9 106.2 99.0 92.7 Merchandiseimport price index 83.7 93.1 100.0 100.0 103.2 107.1 107.6 108.2 108.8 Merchandiseterms of trade index 57.1 61.0 71.8 100.0 117.7 105.4 98.8 91.5 85.2 Realexchange rate (US$/LCU)' 88.4 86.3 87.4 100.0 117.4 139.4 170.9 202.1 227.8 Consumr priceindex (% change) 2.8 2.2 6.7 9.7 13.0 17.0 17.0 13.0 10.0 GDP deflator (YOchange) 3.1 6.0 8.3 10.1 14.0 0.0 1.5 0.3 1.3 a. GDP at factor cost b. "GNFS" denotes "goods andnonfactorservices." c. Includesnet unrequitedtransfers excludingofficial capital grants. d. Includesuse of IMF resourcesand changes inOil Fund assets. "-I'denotesan increaseinreservedoil Fundassets. e. Consolidatedgovernment,including Oil Fund. f. "LCU denotes "local currencyunits." An increaseinUSULCUdenotes appreciation. 115 CPSAnnex Tables- Page 1I of 13 CPS Annex B7 Azerbaijan Key Exposure Indicators - Actual Estimate Projected Indicator 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Total debt outstandingand 1,299 1,499 1,746 1,982 1,881 2,009 2,284 2,604 2,924 3,328 disbursed(TDO) (US$m)* Net disbursements (US$m)a -4 102 101 154 98 127 276 320 320 404 Total debt service (TDS; US$m)a 132 171 216 240 235 140 195 211 243 262 Debt anddebt service indicators(%) TDO/XGSb 51.7 52.3 53.5 44.1 21.1 12.9 10.8 10.0 9.9 11.2 TDO/GDP 22.8 24.0 24.0 22.8 15.0 10.5 8.9 7.9 7.5 7.8 TDSiXGS 5.3 5.9 6.6 5.3 2.6 0.9 0.9 0.8 0.8 0.9 ConcessionaliTDO 35.4 46.1 53.8 57.7 60.3 IBRD exposure indicators("A) IBRD DSipublic DS 0.0 0.0 0.0 0.0 0.0 0.6 2.9 7.0 11.2 18.1 PreferredcreditorDS/public DS ("h)' 59.7 54.8 64.5 62.3 62.1 53.6 52.3 49.0 50.4 58.3 IBRD DS/XGS 0.00 0.00 0.00 0.00 0.00 0.00 0.02 0.04 0.07 0.11 IBRD TDO (US$m)d 0 0 0 0 0 39 126 257 442 659 Ofwhich present value of 0 0 0 0 0 0 0 0 0 0 guarantees (US$m) Share of IBRDportfolio (%) 0 0 0 0 0 0 0 0 0 1 IDA TDO (US$m)d 23.5 314 422 493 SO1 557 613 683 754 804 IFC (US$m) Loans 101 73 43 64 53 40 Equity andquasi-equity' 3 3 3 3 3 4 MIGA MIGA guarantees (US$m) 0 0 0 0 0 0 0 0 0 0 a. Includespublic andpubliclyguaranteeddebt, privatenonguaranteed, use of IMF creditsandnet short- term capital. b. "XGS" denotes exportsofgoods and services, includingworkers' remittances. c. Preferredcreditors are definedas IBRD, IDA, the regionalmultilateral developmentbanks, the IMF, andthe Bankfor InternationalSettlements. d. Includespresent value ofguarantees. e. Includesequity and quasi-equitytypes ofboth loanandequity instruments. 116 0 m m N 0 d N CPSAnnex Tables - Page 13 of 13 Statement of IFC's Held and Disbursed Portfolio As of06/18/2006 (InUSDollarsMillions) Held Disbursed FY Approval Company Loan Equity Quasi Partic Loan Equity Quasi Partic 1998/2003/2006 Azerigazbank 0.9 2.30 0 0 0.9 0 0 0 1999 BakuHotel 1.46 0 0 0 1.46 0 0 0 2002/2006 MFB Azerbaijan 3.0 1.6 0 0 3.0 1.6 0 0 1998/2003 Rabitabank 0.9 0 0 0 0.9 0 0 0 2005 Unibank 5.0 0 0 0 2.39 0 0 0 2004 BTC 31.0 0 0 31.0 31.0 0 0 31.0 TotalPortfolio: 42.26 3.9 0 31.0 39.65 1.6 0 31.0 Approvals PendingCommitment Loan Equity Quasi Partic 2001 Azer JVIncrease 0 0.06 0 0 2005 AG Leasing 3 0 0 0 TotalPendingCommitment: 3 0.06 0 0 118 . . .* MAP SECTION 45°E 46°E 47°E 48°E 49°E To RUSSIAN Makhachkala GEORGIA Balaken G FEDERATION To To BALAKEN Zagatala r e Tbilisi Tbilisi a ZAGATALA ter KHACHMAZ C GUSAR a Gusar Khachmaz Gakh u AZERBAIJAN To GAKH c Vanadzor AGSTAFA a s Guba Devechi GAZAKH u To Sheki s GUBA Vanadzor Agstafa SHEKI M DEVECHI TOVUZ Oghuz o Gazakh u Siyazan 41°N 41°N Tovuz Kura Mingechevir n SIYAZAN L SAMUKH Reservoir OGHUZ Gabala t e a s i s SHEMKIR n Khizi e Shemkir GABALA s r Nabiagaly MINGECHEVIR Ismailli SHAMAKHY C Mingechevir ISMAILLI KHIZI To a Ganja Agdash SUMGAYIT Vanadzor u GANJA Yevlach Goychay Shamakhy Caspian Sea c Gedabay Geranboy a Sumgayit Khanlar AGDASH YEVLACH GOYCHAY Akhsu Maraza GEDABAY su KHANLAR Udjar GERANBOY AKHSU Khyrdalan s Dashkesan Barda GOBUSTAN UDJAR Lake DASHKESAN M Tartar ar Kyurdamir ABSHERON BAKU BAKU ARMENIA BARDA K Sevan TTARTAR AR AR ZARDAB u Zardab KYURDAMIR r To a HAGIKABUL Sevan AGDZHEBEDI Kelbadzhar AGDAM L Kura SABIRABAD Gazi-Mammad 40°N To Agdzhebedi o 40°N Yerevan KELBADZHAR o u n t a i n s Sabirabad KHODZHALY Agdam w IMISHLI l Ali Bayramli Khodzhaly a n Saatly This map was produced by the Map Design Unit of The World Bank. Imishli d ALI BAYRAMLI The boundaries, colors, denominations and any other information LACHIN Khodzhaveno BEILAGAN SAATLY shown on this map do not imply, on the part of The World Bank TURKEY Shusha SALYAN AN Group, any judgment on the legal status of any territory, or any SADARAKSadarak SHUSHA VENO Beilagan Araz endorsement or acceptance of such boundaries. Lachin Fizuli 50°E 51°E Sharur KHODZHA FIZULI BILASUVAR Salyan SHARUR SHAKHBUZ Bilasuvar Araz Gubadly BABEKShakhbuz Dzebrail Neftchala AZERBAIJAN GUBADLY DZEBRAIL NEFTCHALA JALILABAD NAKHCHIVAN Jalilabad DZHULFA Babek Zangilan Masally 39°N ORDUBAD ZANGILAN To Dzhulfa 39°N RAYON CAPITALS Salmas MASALLY Ordubad Lenkaran CAPITAL OF AUTONOMOUS REPUBLIC Yardymly YARDYMLY NATIONAL CAPITAL ISLAMIC REPUBLIC Lerik LowlLENKORAN LERIK Lenkoran RIVERS To and To Tabriz OF IRAN Tabriz MAIN ROADS 0 10 20 30 40 50 Kilometers SEPTEMBER ASTARA RAILROADS To Astara IBRD Tabriz 0 10 20 30 40 50 Miles RAYON BOUNDARIES 33365 2004 INTERNATIONAL BOUNDARIES To 45°E 46°E 47°E 48°E Rasht 49°E