Tapped Out: Azerbaijan Must Diversify Its Economy Away From Oil

February 5, 2016 5:00 PM

Azerbaijan's economy is reeling, after years of extraordinary growth fueled by oil revenues. The latest World Bank figures suggest the economy is going to contract in 2016, and the budget deficit may reach over 5 percent of GDP. The way out is diversification of exports.

Hard times have come to Baku. In the last week of January 2016, Azerbaijan closed four of its commercial banks (a tenth of the total); requested a $4 billion loan from the World Bank and the International Monetary Fund; and saw its sovereign bonds downgraded to junk by Standard & Poor's.

A decade earlier, Azerbaijan was enjoying a bonanza from the opening of the Baku-Tbilisi-Ceyhan pipeline, which carries oil and gas condensate across Azerbaijan, Georgia, and Turkey. Economic growth shot up to 35.4 percent in 2006, the highest rate in the world for that year. In 2007, the Azeri economy grew by another 25 percent. Cumulatively, Azerbaijan has grown faster than any other economy in the postcommunist region in the past 10 years, bar Turkmenistan.

In the process of expanding its oil fields and pipeline capacity, by 2015 over 95 percent of Azeri exports and 75 percent of government revenues came directly from oil (see my blog here). After the global financial crisis in 2008–11, the Azeri government pledged diversification of the economy to be less dependent on commodity markets. Instead, money has been spent on hosting the Eurovision song contest, the Women's Under-17 World Cup in 2012, the first European Olympic Games in 2014, and on attracting the Formula One Grand Prix in 2016 and the group stages of the Euro 2020 soccer competition. Similar to Russian president Putin's drive to host the 2014 Winter Olympic Games in Sochi, such events were meant to bring Azerbaijan to the world stage.

Baku's skyline has changed dramatically too. Buildings by world-known architects like Zaha Hadid have sprung up. One of them—the Crystal Hall—has since opening in 2012 hosted Jennifer Lopez, Shakira, Rihanna, and Beyoncé, for the enjoyment of Azerbaijan's wealthier music aficionados. Another addition to the skyline hosts the largest carpet museum in the world.

Yet the returns on such investments are meagre, and costs tend to swell with corruption. The overall estimated cost of Baku's facelift is $18 billion, or about half of the national reserve at the end of 2015. The government may wish to have this money back, as remaining reserves would last for less than two years with current commodity prices and government expenditures.

Talk about the need for diversification, not surprisingly, is back in force. There are several possibilities for expansion into new sectors. The Azeri economy can develop the chemical industry, based on gas and oil. The agricultural sector is burdened by the lack of reliable irrigation. Government investment may alleviate this obstacle to growth. Tourism can also develop, on the shores of the Caspian Sea and in the nearby mountains. More generally, the weakened national currency—the manat lost nearly 60 percent of its value in the past year—may encourage the development of manufacturing exports, as the price of local labor becomes more competitive internationally.

Whatever path the country takes, stubborn reliance on the energy sector is clearly no longer an option.