Dealing with Azerbaijan's Oil Boom

• Author: Christoph B. Rosenberg and Tapio O. Saavalainen
• Position: IMF's Resident Representative in Uzbekistan/Advisor in the IMF's European II Department

How can transition countries in the Caspian Sea region and Central Asia that are rich in natural resources manage them to maximum advantage, while limiting the risks they pose?

THE development of Azerbaijan's oil fields started in 1994, with the signing of the "Contract of the Century" with major Western oil companies. Today, Azerbaijan is experiencing an investment boom in the petroleum sector and the construction and service sectors. While the related balance of payments inflows currently appear quite beneficial to the country's economy, they could turn into a curse commonly known as the "Dutch disease." Why, one might ask, should a country suffer from the exploitation of its natural wealth? The following problems may be relevant to the case of Azerbaijan.

Macroeconomic stability may be affected through three channels. First, there is a risk to monetary stability, particularly if the central bank does not react appropriately to the balance of payments inflows associated with the petroleum boom. Often such inflows are related to an increase in money demand, and sterilization of the monetary impact of these flows by the central bank to contain inflation may be neither necessary nor desirable. If the credibility of the stabilization program is weak and inflows are particularly strong, however, partial sterilization may be called for in order to avoid an excessive increase in the money supply and inflation, and, consequently, a further push toward real exchange rate appreciation. On the other hand, if monetary policy overreacts and is too tight, this may lead to a strong nominal appreciation and to an overshooting of the real exchange rate, particularly if domestic goods prices are sticky but asset prices are flexible. The problem is to strike a balance between price stability and nominal appreciation. Second, uncertainties about the magnitude and timing of petroleum revenues pose risks to balance of payments sustainability. Azerbaijan's current account deficit rose from 11 percent of GDP in 1995 to 22 percent in 1997 (mainly owing to oil sector imports), and pressures to contract large amounts of nonconcessional foreign debt are mounting. Third, unpredictable revenue inflows may lead to "ratchet effects" on government spending and pose threats to the stability of the country's fiscal policy stance. In addition, the incoming petroleum revenues may promote rent-seeking behavior: resource-rich countries have often pursued protectionist policies that foster extensive bureaucracy and corruption, and have significant negative impacts on growth.

The classic Dutch disease argument focuses on unbalanced growth among the petroleum sector, the nonpetroleum traded goods sector, and the expanding nontraded goods sector. If the additional wealth created by oil production is spent on nontraded goods, their prices relative to those of tradable goods prices must rise, and the real exchange rate will appreciate. As a result, the international competitiveness of the traditional traded goods sector will diminish. Indeed, there are already indications in Azerbaijan that the share of the nontraded goods sector (which consists primarily of retail trade, restaurants and hotels, and construction) in GDP is expanding faster than in transition countries that are not oil producers.

The Dutch disease in a transition economy

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