Inflation peaking amid slow growth in global economy causes challenges also for Azerbaijan, which is a part of the world economy. Nevertheless, as a result of the successful economic policy of President Ilham Aliyev, the non-oil sector of Azerbaijan is growing rapidly and the country's financial indicators are improving.

On July 15, Prime Minister Ali Asadov signed the order on the establishment of working group tasked to keep inflation at an acceptable level for economic growth in the country, further improve the analysis and monitoring system that allows quantitative and qualitative assessment of inflation processes and its causes, as well as to strengthen inter-agency coordination in this area.

The Executive Director of the Center for Analysis of Economic Reforms and Communication, doctor of economic sciences, Professor Vusal Gasimli explained the anti-inflation policy of the government in his exclusive interview to "Report", as follows.

How to group the main causes of inflation in Azerbaijan?

- Under the leadership of the President of Azerbaijan, Ilham Aliyev, the national economy has grown more than three times which served as material basis of our Great Victory in 2020. Government of Azerbaijan set targets for continuous growth with high trajectory in order to achieve greater results in the new era. In this sense, starting from 2023, tasks in the field of economic growth and inflation control will be executed in the country. At the meeting dedicated to the socio-economic results of the first half of 2023 President Ilham Aliyev stated that double-digit level of inflation urges for timely response. In this regard, the head of the state instructed the government to make proposals on the steps to be taken by the end of the year.

To construct a "decision tree” on this issue by applying "the Hausmann-Rodrik-Velasco" diagnostic tool, we identify two factors as main challenge for economic growth: i) level of profitability of private investment and ii) the cost of financing. The analysis shows that the reasons for double-digit inflation can be grouped into three blocks - real economic conditions, fiscal policy and monetary policy. First, it is possible to make competitive supply cheaper by increasing productivity in the real sector of the economy. Secondly, we have to think of mechanisms to make public spending more supportive of economic growth. Thirdly, it is possible to achieve further soften financing conditions of the economy.

The budget envelope of “State Program of the Great Return”, increased spending on defense and national security, social direction, stimulates aggregate demand, and aggregate supply must be stimulated accordingly, so that equilibrium is established and inflation is hurdled. Attracting private investment in the non-oil sector can provide stability, in line with government incentives (taxes, customs, credit concessions, subsidies and public procurement) that are 1/3 of the non-oil sector. Monetary policy curbs inflation through exchange rate and interest channels.

- How does the inflation dynamics look in Azerbaijan in global and regional comparison?

- According to the International Monetary Fund (IMF) forecast that world inflation will drop from 8.7% in 2022 to 7% in 2023. Inflation rate in Azerbaijan decreased from 13.9% recorded last year to 12% in the first six months of this year. The relative reduction of weighted average inflation in the partner countries and the decrease in prices in the world commodity markets are the main factors that suppress inflation in Azerbaijan.

According to the latest report of the World Bank on commodity markets, in May of this year commodity prices decreased by 8.6%, including energy prices by 11.3%, and non-energy prices by 3.6%. Compared to the countries of the South Caucasus and Central Asia region, inflation in Azerbaijan is close to the average level. Thus, inflation is higher in Kazakhstan and lower in Georgia in compare with Azerbaijan.

- What is the underlying macroeconomic implication of inflation?

- Inflation is a symptom, a manifestation of the processes going on in the depths of the economy. At the moment, the actual non-oil GDP in Azerbaijan is higher than the potential GDP, in other words, the economy "heated up" and the output gap of the non-oil GDP is in the positive zone. A positive non-oil GDP output gap indicates that there is a higher demand for goods and services than the economy can produce at its maximum sustainable level. Aggregate demand expands with state support, and the aggregate supply we create in the national economy must respond to this, so that the inflation rate is balanced.

According to the calculations of the Organization for Economic Cooperation and Development, the weakening of competition in the world causes the acceleration of inflation. Currently, the main issue of the economy is increasing productivity, which is possible through serious structural reforms. For example, according to the IMF's calculations, Azerbaijan is the country with the greatest potential in this direction among the countries of the Caucasus and Central Asia.

According to the estimates of the "Growth Lab" at Harvard University, Azerbaijan has the potential to accelerate the Economic Complexity Index (ECI). We need to ensure that Azerbaijan has a more complex (and therefore competitive) economy than expected based on its income level. In this way, we can accelerate economic growth according to the Harvard methodology.

According to the estimates of the European Bank for Reconstruction and Development (EBRD), economic growth in Azerbaijan was driven by privatization at 3.7%, corporate governance at 0.9%, price liberalization at 0.2%, trade and forex at 0.5% and reforms in the area of competition at 0.4%. According to World Bank estimates, governance reforms could have an impact of 1.1%. The complex reforms in these areas have the potential to accelerate economic growth by 6.8%, which can ensure the goal set by President Ilham Aliyev to obtain high trajectory in economic growth. "Strategy of Socio-Economic Development of the Republic of Azerbaijan in 2022─2026" envisage reforms in abovementioned directions which are being successfully implemented. As Former US President Ronald Reagan said: " A rising tide lifts all boats", in other words, economic growth is the key to all problems.

- How do you assess the impact of import prices on inflation in Azerbaijan?

- In the first four months of 2023, the import price index in Azerbaijan was 120.5%, that is, import prices increased by 20.5%. However, Azerbaijan's export price index did not only increase in January-April of this year, but decreased to 82.9%. For most product groups, the import price index of the same product exceeds the export price index.

In the current case, the integration of tax and customs systems within the framework of transparency and whitewashing processes creates an opportunity to monitor the process of price formation of goods imported to Azerbaijan until they are sold in the domestic market. This also allows to explore the possibilities of reducing the tax burden in the domestic market through applying financial "engineering" by entrepreneurs and higher import price clearance.

- What about the food inflation and its implications?

- In terms of food prices, livestock products are traditionally more expensive than crop products. The main reason is the lack of industrial production and modern logistics, as well as natural conditions. As it is known, in 2019-2021, when the global food prices were sharply increasing, the government implemented a number of measures to minimize price increases in the domestic market. For example, these include measures such as strengthening administrative control over consumer markets, exempting imported raw materials from VAT and customs duties, providing cheap loans to entrepreneurs for stocking up reserves of basic food products, and restricting exports of some food and feed products.

It is possible to get detailed information about the difference between the sale price of fresh fruits and vegetables from the field and the retail price in Azerbaijan from the Price Information Portal of the Ministry of Agriculture. According to the database of the portal, there is a difference between the sale price of fresh fruits and vegetables from the field and the retail price, and this indicator is not more than that in the European Union and the United States.

The difference between field sales prices and retail prices of fresh fruits and vegetables varies depending on the season, product variety, place of production and logistics costs. This is the case in all countries of the world, mainly due to the specific characteristics of fruit and vegetable products such as perishability, storage and transportation conditions.

As one of the important measures implemented in the direction of reducing the differences between sale prices in the field and the retail of agricultural products in Azerbaijan, it is possible to mention the amendment made to the Tax Code regarding the calculation of the VAT applied from 2022 only from the trade surcharge and not from the total wholesale turnover. This tax adjustment serves to reduce the trade surcharge of agricultural products by stimulating the development of supply and sale logistics for agricultural products, reducing the costs of suppliers and retailers. Most importantly, this policy stimulates investment in the development of market infrastructure for agricultural products and the creation of modern market institutions.

- What mechanisms are used by state to curb inflation in Azerbaijan?

- The government of Azerbaijan implements complex measures in this direction. From one hand, government triggers overall economic growth via fiscal expansion tagged with reforms on increasing the efficiency and targeting of the public sector and public spending. On the other hand, government implements measures on inflation optimization.

President Ilham Aliyev recently signed orders assigning tasks to ensure financing sources and execution of monitoring and evaluation during approval stage of state programs. Significant reforms are also being carried out in the area of implementation of medium-term expenditure framework which indicates that Azerbaijan is transitioning into program management model. Results-based program management and more efficient use of public assets increase the competitiveness of the economy and have the potential to keep the inflation at he the optimal target corridor in the longer term.

- What is the role of monetary policy in controlling the inflation?

- The Central Bank of Azerbaijan (CBA) has the ability to regulate inflation by influencing aggregate demand rather than aggregate supply. For example, the main inflationary factor of the aggregate supply is imports, which increased by more than 20% in the first five months of 2023, and the ability of the Central Bank to directly influence inflationary imports is limited. Aggregate demand factors mainly include private consumption and private investments, as well as government spending.

Central Bank possess significant power in all chains of transmission operations. CBA is trying to form interest rates in the interbank money market within the corridor with the tools at its disposal. This process constitutes the first chain of transmission of monetary policy decisions. The average interest rate for 1-3-day operations in the interbank unsecured money market has risen by 2.67 percentage points since September of last year, and by 1.72 percentage points since the beginning of this year, reacting to the change in the interest rate corridor. At the same time, AZIR (Azerbaijan Interbank Rate) - the index reflecting the average interest rate of transactions between banks concluded in national currency on the "Bloomberg" trading platform, has also increased by 0.68 percentage points since the beginning of the year.

In the second chain of transmission, when short-term interest rates change in the interbank market, then other interest rates, including deposit and loan rates, also change. This process constitutes the second chain of transmission of monetary policy decisions. In accordance with the tightening of the conditions of the monetary policy in Azerbaijan, deposit and loan interest rates also increase, so the second chain of transmission is also effective.

Although monetary policy alone cannot return inflation to the target range, it shows its transmission power both in the interbank market and in lending rates. In Azerbaijan, institutional and structural reforms are being continued in the financial and banking areas to optimize the spread between the Central Bank's discount rate and market credit interest rates. Providing financial availability under favorable conditions serves to reduce inflation.

Azerbaijan has great potential in terms of institutional development of monetary and exchange rate policy. The improvement of the monetary policy is carried out in accordance with the Action Plan of the "Socio-Economic Development Strategy of the Republic of Azerbaijan in 2022-2026" within the framework of "Formulation of the basic conditions for the transition to the inflation targeting regime". Diversification of supply channels in the country's foreign exchange market, increasing the depth of the financial sector, limiting the cash-shadow economy and strengthening the effectiveness of macroeconomic coordination will create conditions for the transition to the inflation targeting regime.

- What are the next steps of the government's anti-inflation policy?

- The analysis shows that high inflation is the result and indicates that there are some faults in the economy. Therefore, on the basis of a deeper analysis, the main causes of inflation should be identified and solved. Failure to respond timely to the challenge of high inflation might led to deepening of the economic problem and loss of opportunities. In Azerbaijan, the issue of inflation has always been in the center of attention as an essential component of macroeconomic stability, and we have an institutional memory of successful fight against inflation. The Decree of the Cabinet of Ministers dated July 15, 2023 "On additional measures to strengthen monitoring of inflation and prices" will also help to solve this issue and the government will reduce inflation to an optimal level. According to the order, the relevant working group will take measures to further strengthen the work on the analysis of inflation processes in the country and improve price monitoring, and will submit a report on its findings to the Cabinet of Ministers once a month.

At the same time, the issues related to the foreign exchange market, the new operating framework of monetary policy, the current situation and development of the banking and insurance sector, as well as the medium-term framework for public debt management, new goals and changes in the Borrowing Strategy, proposals for creating a mechanism for compensation of investors in the capital markets were widely discussed at the meeting of the Economic Council.