Azerbaijan: Falling Economy, Rising Karabakh War Risk

Azerbaijan: Falling Economy, Rising Karabakh War Risk
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Azerbaijan: Falling Economy, Rising Karabakh War Risk by EurasiaNet

EurasiaNet Commentary

Azerbaijan is a major energy exporter. It is also one of the most oil-dependent economies in Eurasia and has been hit hard by lower oil prices. If the current fiscal trends persist, regional stability is likely to come under growing threat.

The country’s 2015 budget, which envisaged a high level of spending on infrastructure projects, was drawn up under the assumption that the average oil price would be $90 per barrel. Now the oil price is hovering around $60 per barrel and previously envisioned levels of state spending do not seem sustainable, at least in the near term. As a result, the government must confront austerity.

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Initially, the government insisted that the planned level of expenditure could be maintained despite the reduced oil revenue. However, oil and gas exports are simply too important for Azerbaijan: they account for 95 percent of the country’s exports and more than 70 percent of revenue. Budget cuts, then, seem unavoidable in the near future.

Already, the Azerbaijani government has had to react to lower energy prices. The first move came on February 21, when the Central Bank of Azerbaijan (CBA) devalued the local currency, the manat, by 33.5 percent against the US dollar and 30 percent against the euro. The regulator claimed this was necessary “in order to support diversification of Azerbaijan’s economy, strengthen its international competitiveness and export potential, as well as to provide balance of payments sustainability.”

The devaluation came as a shock to many Azeris. Retailers increased their prices shortly after the Bank’s move, and further price hikes are anticipated. Economists expect an increase in the cost of most food products, public transport and utilities, a development that would likely intensify discontent among the population. Several small protests have occurred in Baku and Lankaran, a city on the Caspian coast near the Iranian border.

The devaluation is forcing officials to revise state budget parameters. While the government is expected to maintain defense and social spending at existing levels, infrastructure expenditures may well take a hit. Private sector investments in infrastructure projects are also likely to decrease. Investors will now think twice before backing projects with unclear financial returns.

One of the first casualties is likely to be the Khazar Islands project, a $100 billion initiative to build 41 artificial islands in the Caspian Sea. Although the project is primarily being financed privately, it is far from completion and it will now be much harder for the developer to attract new financing.

Another project likely to suffer is Baku White City, an office and residential complex. Experts believe that government funding for this and similar projects will like dry up after the inaugural European Games, an Olympics-style extraveganza to be held in Baku in June.

In the absence of a sharp and sustained increase in the oil prices in the coming months, it is clear that the Azeri government will no longer be able to sustain a high level of economic growth. Living standards accordingly will decline.

Large-scale social protests are unlikely in the near future, but the recent shifts in global oil markets have highlighted a serious long-term problem for the Azeri economy – its lack of diversification and heavy dependence on energy revenue. Most experts agree that the best way Azerbaijan could address diversification challenges would be to improve its investment climate and attract foreign direct investments in sectors other than oil and gas: agriculture and food processing, alternative and renewable energy, tourism and construction offer the greatest potential.

The ability to achieve these targets will pose a major test for the country’s ruling elite. Pervasive corruption needs to be tamed, and the rule of law bolstered. The window of opportunity will not be open forever: the country’s oil reserves will be depleted in 15-20 years.

According to some estimates, Azerbaijan’s $37 billion rainy-day oil fund, SOFAZ, can help the government survive low oil prices for a year or two without serious risks to social stability. However, if the oil market does not recover within two to three years, quality-of-life standards in Azerbaijan are likely to fall sharply. In that case, the government could well have a social crisis on its hands.

Vladimir Putin has demonstrated that an authoritarian leader’s popularity can grow if a country goes to war against a weaker neighbor. The Crimea, given its history, means a lot to Russians, but Nagorno-Karabakh means even more to Azeris. Its loss to Armenia during the Karabakh war, fought amidst the collapse of the Soviet empire, remains a touchstone of bitterness for Azerbaijan.

Since a ceasefire went into effect in 1994, talks between Armenia and Azerbaijan on a permanent settlement for Karabakh have remained stalemated. Meanwhile, some of the deadliest clashes along the so-called Contact Line involving Azerbaijani and Armenian troops have occurred in recent months. The frontline remains highly militarized and there are no peacekeeping troops separating the sides. In other words, there is an increasing probability that a new “hot” phase could erupt in the near term.

Azerbaijan is, of course, smaller than Russia and it does not have nuclear weapons, but an attempt to take back Nagorno-Karabakh by force could be a way for Aliyev to remain in power if a deteriorating economic situation starts to threaten social and political stability.

Editor’s note: Youri Smakouz, Associate Director, The Risk Advisory Group

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