The Ministry of Finance of Azerbaijan recently announced the proposal for the amendments to the 2020 state budget. The move comes as no surprise, given the current economic climate. However, there is much to discuss in amendments, particularly concerning the State Oil Fund and the Budget Rule…

BRIEF OVERVIEW OF THE AMENDMENTS

The numerical changes in the state budget are not necessarily controversial. Certain revenues from sources such as taxation of non-oil entities are reduced whilst expenditures towards healthcare, as well as social welfare has naturally increased due to the pandemic. Just to give you an idea, here is a short overview of the main changes:

Table 1: Main changes in proposed state budget amendments
Source: Ministry of Finance of Azerbaijan

The report shared by the Ministry of Finance mentions that they are expecting the revenues of the budget to be 927.5 million AZN less than what they have forecasted back in November when the budget was prepared. On the contrary, the measures against the coronavirus epidemic will enlarge the expenditures of the budget by 1.4 billion AZN. Thus, there arises a need to cover the difference of 2.3 billion AZN that occurs due to the diminished revenues and heightened expenditures. I constructed a simple illustration to showcase how the Ministry proposes to cover this additional difference:

Illustration 1: The proposed financing mechanism to cover additional expenses
Source: Ministry of Finance of Azerbaijan

An extra 850 million AZN worth of funds will be transferred from SOFAZ to the budget, bringing the total amount of transfers to 12.2 billion AZN, which is approximately 51% of the whole revenues of the state budget. Another 30 million will come from “other revenues”, as the Ministry puts it[1]. Expenditures of 774 million AZN that were previously included in the state budget have been scrapped off or delayed to a further date and thus been re-directed to other, relatively more pressing issues. Lastly, the Ministry plans to integrate the surplus of the state budget from the previous year, and also issue new bonds to the public. With that, the deficit of the state budget would equal 3.4 billion AZN, which is 12.3% of total expenditures.

The Ministry also notes that the Budget Rule of Azerbaijan, which came into force in 2019, will be “temporarily suspended” for 2020 and the upcoming year. The suspension could have been somewhat tolerable if the argument was even a little bit adequate. Yet the Ministry’s justification of this suspension is so absurd that I feel it is my natural right and duty to rant about it.

SUSPENSION OF THE BUDGET RULE

Firstly, lets have a look at how the Ministry of Finance justifies the move:

“The budget rule is temporarily suspended in order to ensure that the newly formed challenges are met, the revenues and the expenses of the state budget are balanced, and a soft counter-cyclical budget policy can be pursued…[2]”

So, there are three stated reasons: (a) meeting the new financial obligations due to the epidemic, (b) balancing the budget and (c) conducting counter-cyclical budget policy.

The arguments of (a) and (b) are somewhat understandable. After all, one of the primary functions of Azerbaijan’s budget rule was to curtail the non-oil primary deficit, as well as limit the transfers from the State Oil Fund. The contemporary economic climate, on the other hand, requires (at least that’s how Ministry of Finance sees it) running a significant non-oil primary deficit with the help of transfers from SOFAZ. I do not wholly agree with these arguments, but they are partially understandable.

The elephant in the room is the argument (c), because the fundamental idea behind budget rules, particularly in resource rich countries like Azerbaijan, is that they make governments more financially responsible whilst allowing them to pursue a counter-cyclical fiscal policy. That means, budget rules are usually designed in such ways that when the economy grows, the government shrinks its share in the national GDP and allows the private sector to take the lead. But when the economy heads toward recession (as it is now), the government steps in, boosts its expenditures and (on theory) helps the economy to get back on track. Azerbaijan’s budget rule is also designed in such way, as I have explored that topic before. Theoretically speaking, although not ideal, Azerbaijan’s budget rule is designed relatively well and is suitable for conducting counter-cyclical fiscal policy. The Ministry of Finance, on the other hand, argues that they are suspending the budget rule of Azerbaijan because they plan to pursue counter-cyclical budget policy…

The reason why Ministry of Finance had put forth such justification is that if the budget rule was to be followed this year, then the transfers from the State Oil Fund to the state budget must have been cut from the previous 11.3 billion to 8.9 billion AZN, a difference of 2.46 billion AZN. Add to that the additional transfer of 850 million AZN that the current amendments envision, then the difference comes to 3.31 billion AZN. Thus, long story short, if we did not suspend the budget rule, then the revenues (and hence the expenditures, ceteris paribus) of the state budget must have been reduced by 3.3 billion AZN. That surely does not sound like a counter-cyclical fiscal policy, so the Ministry is correct with the arguments, right? Not really.

At first glance it looks like the budget rule is the problem here, but it is not. The problem is how the original 2020 state budget was designed. Its faulty composition has put the economy and state budget in such a rough situation that the suspension of the fiscal rule has become unavoidable. Its flawed design is bound to cost State Oil Fund billions of AZNs and will be the prime cause behind the Fund’s largest ever deficit. What I mean is quite simple: according to the fiscal rule, the maximum amount of transfers from SOFAZ to state budget was calculated as 11.3 billion AZN, if the price of oil per barrel averaged 55 USD in 2020. Putting the coronavirus epidemic aside, even if the average price was indeed 55 USD, then the state budget was going to run a deficit of 2.8 billion AZN, equal to the 10.2% of the total budget.

I want you to take a moment and think about this: the budget rule said the maximum amount of oil transfers that we could spend, if everything goes well, is 11.3 billion AZN. Not only did the Ministry of Finance (designers of the budget) and the Members of the Parliament (all but 2 MEPs voted in favor of the proposal, adopted by 101 to 2 votes) included all 11.3 billion AZN in the expenditures right away, they even went as far as running an additional 10.2% budget deficit! They failed to recognize the simple but colossal error in their design: when the things go bad, revenues of the state budget will be less than expected, hence the budget will have even a larger deficit, yet the logic of counter-cyclical fiscal policy dictates to raise expenditures in such a scenario. How can you increase your expenditures when are already spending more than you earn and you will be earning even less than you anticipated before?

Even a freshman student of Economics can point out that this is an appalling idea, because if the things go even slightly bad, all of a sudden, your hands are tied as you left no room for any kind of additional expenses. And by no means that is a newly formed practice, similar cases also existed in the previous budget proposals. It is just that in the previous years, the actual price of oil was tended to be higher than the estimate, hence we did not feel any serious disturbance with the state budget. But this year is a whole different story…

The question is, why were the expenditures of the original 2020 budget that much higher than the revenues? Back in November, when the budget was drafted, State Statistical Committee reported GDP growth of 2.1%. The relative figure for the non-oil GDP stood at 3.5%. Inflation was at 2.6% and official sources cited unemployment rate at 5%. And most importantly, one barrel of BRENT crude oil was traded at around 60 USD. So why did the Ministry of Finance, as well as the MEPs decided on running such a large deficit? There was no apparent pressure on the economy, nor any observed deflationary movement. The non-oil sector was doing just fine, and official unemployment was at its ever-stable “5%”. If the government was even a little fiscally responsible, then there would have been a surplus in the budget legislation, not a deficit. If the upper limit of transfers from the Oil Fund was calculated at 11.3 billion AZN, then they should have included no more than 9 billion AZN in the expenditures and leave the remaining 2.3 billion as a cushion against economic slowdown. If that was done so, then there would have been no need for abandoning the budget rule this year and in 2021.

One can say that I am putting too much emphasis on the budget rule in this distressing times. It can be argued that the epidemic is a more immediate problem and suspending the budget rule for 2 years should be our last concern right now. I agree, for the time being, the epidemic is a much imperative problem, but it is not here to stay forever. Sooner or later, coronavirus will be gone from our lives, but the adverse effects of the suspension of the budget rule, as well as the mere habit of suspending it at the first “obstacle” is a more severe problem for us in the long-term. I also rant about this because it is clear that certain officials took multiple missteps (not for the first time either) but it goes unnoticed. They put much of the blame on the “extra-ordinary” situation caused by the pandemic, but nobody takes a moment to mention about the fundamental blunders that they have made while preparing the state budget. It is their miscalculations, misjudgment and overestimation, not the pandemic, that makes the suspension of the budget rule unavoidable today. If we cannot recognize that reality now, then we shall do the same mistake(s) again in the future.

STATE OIL FUND OF AZERBAIJAN

Lastly, before I wrap up this post, I wanted to briefly touch upon the implications of these amendments for the State Oil Fund of Azerbaijan. As you can see from the table below, the revenues of the Fund are expected to take a 41% plunge whilst the expenditures are inflated by 7%. That leaves the Fund with a deficit of 5 billion AZN, the largest so far.

Table 2: Main changes in proposed amendments for SOFAZ
Source: Ministry of Finance of Azerbaijan

I have constructed a timeline of the budget balance of SOFAZ in order to showcase the sheer magnitude of this year’s deficit. In fact, since 2005 (there are no statistics on pre-2005 period) the fund had deficit only once, back in 2015 when the oil market crashed. Even back then the deficit was only 1.5 billion AZN, equal to 19% of the revenues of 2015. This year’s deficit, on the other hand, is equal to 70% of the revenues…

Graph 1: Timeline of budget surplus/deficit of SOFAZ
Source: Ministry of Finance of Azerbaijan

The Budget Rule is also important for State Oil Fund and ensuring that it can at least deliver on its fundamental promise of safeguarding the oil wealth to the future generations of Azerbaijan. But how can we attain that promise if we suspend the rule whenever we wish, and spend 70% more than what SOFAZ actually earns?

It is not only about the future generations either, such large wealth funds are an easy way-out for governments and without an adequate political checks & balances system, it would only serve to exacerbate the political/economic situation of the country and lag its development.

CONCLUSION

The amendments to the state budget of Azerbaijan were expected, due to the contemporary economic climate. The numerical changes themselves are not much contentious, but two points stand out. Firstly, the budget rule, which came into force in January 2019, is suspended for 2020 and 2021. Secondly, the State Oil Fund is going to run a colossal deficit.

The justification for the suspension of the budget rule, provided by the Ministry of Finance, is rather absurd. As we have already discussed in one of my previous posts, budget rules (or fiscal rules) are instituted with the primary purpose of making the governments more financially responsible while allowing them to pursue counter-cyclical fiscal policy. The Ministry, on the other hand, argues that one of the leading causes of the suspension is that they are planning to conduct counter-cyclical fiscal policy.

Upon further inspection it is evidently revealed that the problem does not necessarily lie with the budget rule, but rather with the 2020 state budget itself. The budget rule envisioned that the maximum amount of transfers from SOFAZ to state budget in 2020 is 11.3 billion AZN. Not only did the Ministry of Finance and the MEPs included all of that amount in the expenditures, they went as far as running an additional deficit of 2.8 billion AZN. Considering that the economic outlook for Azerbaijan was satisfactory back in November (when the budget was drafted), this deficit, as well as the total inclusion of spendable oil revenues makes absolutely no sense. If there is one single reason behind the unavoidable suspension of the budget rule today, it is not coronavirus, it is the incompetency of the policymakers.

Collapse of the global energy demand following the epidemic was surely going to have a negative effect on State Oil Fund of Azerbaijan too. Yet, the unsound design of the 2020 state budget added insult to the injury. The Fund, already taken a substantial hit from far less-than-expected revenues from oil sales, is also going to carry part of the additional burden of the state budget. Thus, the Fund is going to run its largest ever deficit of 5.1 billion AZN, 3 times higher than the last deficit. That is 7%, in terms of the Fund’s assets as of January 2020. 7% loss in a single year, for a Fund that is merely 20 years old and is tasked with safeguarding the oil wealth for future generations.

At the end, although Azerbaijan’s budget rule has much to improve, its suspension is unjustified. The only adequate argument for its suspension can be recognizing the fact that the Ministry of Finance and the MEPs have designed an unhealthy, inefficient and objectionable state budget, which not only rendered the suspension of the budget rule inescapable, but also put a colossal burden on the State Oil Fund.

FOOTNOTES

[1] Certain sources that are included in the “other revenues” category, such as paid services provided by the state institutions, as well as interest payments on loans have decreased. Meanwhile other sources saw an increase, such as fines collected from the population, and expropriation of assets/wealth of public servants that were recently jailed due to revealed cases of corruption. The net effect of these changes is 30 million AZN.

[2] http://maliyye.gov.az/scripts/pdfjs/web/viewer.html?file=/uploads/news_files/5f2486962c071.pdf