100 year development path of central banking in Azerbaijan

Baku, 30 September, AZƏRTAC

The President Ilham Aliyev gave full marks to the establishment of the first democratic republic in the Muslim East on 28 May 1918 as one of the glorious pages of the Azerbaijani statehood chronicle and declared 2018 the Year of the Republic. The anniversary of the Republic that left indelible imprints in the history of national statehood with its rich state-building experience and laid a solid foundation for today's independence, was celebrated with numerous events both inside and outside the country. The 100 year anniversary of central banking was a follow-up of the series of events. AZƏRTAC casts a glance at a century-old way of development of central banking in Azerbaijan.

The Republic that functioned for only 23 months managed to create majority of state attributes. As the President Ilham Aliyev noted with pride: "the national flag of Azerbaijan, Azerbaijani citizenship was established and our national army was created." A Parliament and a Cabinet of Ministers consisting of 15 ministries were established under a modern republican governance model. The Government of the Republic implemented a comprehensive reform package covering tax, budget, cash circulation, property relations, especially land reform, employment and other areas to address the severe political and socio-economic crisis inherited from the First World War. In total, about 200 bills were developed and submitted to the Parliament, a significant number of which were approved.

One of the attributes of statehood created by the Government of the Azerbaijan Democratic Republic (ADR) was the national currency and an independent central bank. The government approved a proposal on establishing the State Bank of Azerbaijan with its decision of 7 March 1919. The Parliament approved the Charter on 16 September 1919, grand opening celebration of the bank was on September 30 and the State Bank of Azerbaijan (SBA) started to function. Establishment of central banking in Azerbaijan coincided with such a difficult historical condition.

The ADR collapsed seven months after the establishment of the SBA. However, over such a short period of time, the SBA managed to create key elements of central banking. First of all, the national currency, one of the main attributes of independent statehood, was put into circulation. First banknotes were 10, 25, 50, 100, 250 and 500 manat denominations. The Bank also set exchange rates against other currencies to make the national currency convertible.

The Bank also discharged other functions of central banking. One of these functions was to issue loans to trade, industry, and agriculture. The SBA, a ‘bank of banks’, also supervised existing credit institutions in the country.

Following collapse of the ADR, the SBA was renamed the People's Bank, all banks and credit institutions were nationalized and incorporated to it and the banking sector was under exclusive state monopoly at the resolution of the USSR Finance Commission of 31 May 1920. In 1922, the Transcaucasia moved into a single monetary system. But over early years of the Soviet Union a deep crisis resulted from the inadequate economic policy, high inflation sharply devalued the currency.

The Baku branch of the USSR State Bank was established in 1923. According to the Constitution of the USSR adopted in December 1936, Azerbaijan joined the USSR as a ‘sovereign’ republic. Subsequently, the Azerbaijani Office of the USSR State Bank was established and operated until the end of 1991. However, the Office was far from the modern and independent central banking model, and as a satellite, was only engaged in realizing instructions from the center.

Shortly after Azerbaijan gained its independence for the second time in the 20th century, in February 1992, a Central Bank was established under the name of the National Bank of Azerbaijan. The launch of the bank coincided with difficult processes in our republic, occupation of our lands, conflicts of power, threat of the country's fragmentation and a deep socio-economic crisis. On the backdrop of existence of remnants of the old economic system and lack of the national monetary system in particular, the Central Bank could not implement a sovereign monetary policy. State budget deficit reached 13-14% of GDP. The main role of the bank was to issue money printing for fiscal purposes.

The banking sector experienced a deep crisis too. Hundreds of new banks were established in 1988-1995 to carry out fraudulent operations. Money supply grew at a rate that did not meet operational requirements of the economy. There were apparent financial pyramids, and the poor were rapidly reduced to poverty.

As a result of hyperinflation population’s income rapidly devaluated and the size of the economy shrank by double digits every year. Although the national currency, the main attribute of independence, was put into circulation in 1992, manat was not the only legal tender in the country. Lack of foreign exchange reserves disallowed to regulate the exchange rate, resulting in a rapid decline of its external and internal cost. Inflation and devaluation were measured by four-digit indicators.

As in all areas of public life, socio-economic stability was maintained after return of the National Leader Heydar Aliyev to political leadership at the request and demand of the Azerbaijani people in 1993. The Great Leader, first and foremost, maintained socio-political stability, effectively neutralized the forces that weakened foundations of statehood followed by radical reforms to take the country out of the severe crisis.

In this regard, the Decree of 15 June 1994 ‘On measures to strengthen social protection of the population and stabilize financial standing of the economy’ was of historical importance. This Decree was a turning point in activities of the Central Bank too. Radical measures were initiated to safeguard macroeconomic stability. Unjustified monetary expansion was averted, and the legislation put an end to coverage of budget deficit with emission. Manat was declared the only legal tender and the Central Bank got a chance to pursue an independent monetary policy. As part of implementation of the measures arising from the decree with the support of international financial institutions foreign exchange reserves totaling $ 12 million initially reached $ 250 million by the end of 1995. The reserves maintained stability in the FX market from early 1995 onward.

As a result of the measures taken, inflation dropped from a four-digit rate of 1993-1994 to 19.9% in 1996 and 3.7% in 1997. The following years also confirmed that price stability had been achieved. As a result of comprehensive reforms, the economy entered a positive growth phase in 1996. A successful oil strategy, laid by the National Leader, also played an important role in this regard. Owing to stability Azerbaijan left the 1997-98 financial crisis behind with minimal losses.

Over the post-2003 period, the Central Bank managed to create an optimal balance between strengthening the exchange rate and inflation in the context of active use of oil revenues for country's socio-economic development. By sterilizing excess currency supply, the Bank covered economy's demand for liquidity meanwhile protecting manat from sharp appreciation. To reduce inflation related to expansion of aggregate demand, the Bank created a condition for strengthening the manat to a certain extent, and monetary policy instruments were adequately used to regulate growing money supply as a result of currency interventions.

Due to financial resources and flexible management Azerbaijan recovered from the 2008-2009 global financial and economic crisis with minimal losses. In a short time, the country maintained macroeconomic stability.

The country lived through another crisis episode in 2014-2015. Oil price slump in the global market led to deterioration of foreign exchange revenues and the balance of payments. In this regard, the Central Bank implemented adequate maneuvering in the fiscal and monetary policies. These measures yielded positive results in a short time. From 2017 onward macroeconomic stability was safeguarded, inflation stabilized at a single-digit rate, economic growth resumed, and foreign exchange reserves began to increase again. The balance of payments surplus and rebalancing in the FX market stabilized inflation expectations as well.

Return of the National Leader to power was a turning point in formation of the financial and banking system. The banking system was rehabilitated on the basis of the programs adopted under his well-known ‘A bank of any country is the most influential part of its economy and finance’ motto, accompanied by strict consolidation and restructuring, the number of private banks was optimized.

The banking legislation was tailored to international standards. A two-tier banking system was established in the country. In mid-1990s, three state-owned banks were restructured, a single state bank was created and subsequently privatized on the basis of their healthy assets. Classical financial intermediation was shaped, and the share of private banks in bank assets increased significantly. All restrictions on foreign capital participation were lifted. A network of non-bank credit institutions was established. With its extensive branch network covering the country, Azerpost started to supply financial services. For the first time in the country, international financial reporting standards were applied in the banking sector. A banking supervision framework was established in line with modern requirements and Basel standards. A third generation banking legislation was adopted under European standards. Consumer finance protection was institutionalized, in parallel with large-scale efforts on raising financial literacy of the population. The capital flow regime was liberalized. The Central Bank's policy and measures it had taken in good time contributed to financial stability of the banking system, boosting financial depth of the sector, and expanding access to financial services.

Amid macroeconomic and financial stability the population's confidence in the banking system began to recover. Licenses of more than 250 unhealthy banks were revoked. As a result, their number was reduced to 59 in 2001, and to 42 in 2013 and the role of financial intermediation in the economy strengthened.

The institutional architecture of central banking has undergone fundamental changes and modern central banks have become important macroeconomic stability institutions over recent decades. The most important anchor of macroeconomic stability is price stability. Low and less volatile prices allow businesses to better plan their investment decisions and the population to optimize their savings and consumption costs. Price stability is also an important social indicator. Price swings have direct impact on budgets of 2.1 million families in Azerbaijan.

The Central Bank has been able to adequately manage inflation since 1997 with direct support of the country leadership. Over the past 22 years, the average annual rate of price growth has been only 5.3%. Empirical literature considers it an optimal level. For comparison, developing countries experienced a 7% inflation on average over the same period. We can proudly note that Azerbaijan is the country that has managed the lowest rate of inflation in the long run among the CIS partners. At the same time, it should be noted that Azerbaijan has achieved this low inflation rate on the backdrop of high enough economic overheating – 5.7 times growth of the economy (only 2.3 times in the CIS). In the long run, the exchange rate of the national currency in Azerbaijan has also remained relatively stable. While AZN has depreciated against USD for about 2 times since 1995, there are countries among partners where the national currency devalued 7, 16, 86, even 300 times.

The Central Bank flexibly uses its tool arsenal to achieve price stability, its main mandate. Over the past period of the year the Bank took 6 monetary policy decisions, and reduced interest rates on a stepwise basis. The Bank has changed interest rates 24 times over past 10 years as part of counter cyclic monetary policy.

Optimal regulation of money supply is also a prerequisite for ensuring price stability. To regulate liquidity in circulation, the Central Bank conducts open market operations, maintains economic cycle driven sterilizations or emissions.

One of the important conditions for price stability is exchange rate stability. Especially in small open economies like Azerbaijan, the exchange rate has a significant impact on inflation via the import price channel of end and intermediate consumer goods. In this regard, the exchange rate is used as an active anchor in price stability. To ensure stability of supply in the FX market, the Central Bank conducts regular currency auctions with the funds of the State Oil Fund. Results of currency auctions show that the FX market is completely stable, even supply prevails over demand. At the same time, there has been no significant change in foreign exchange reserves of the Central Bank over the past two years. All this shows that the FX market is close to natural balance and there is no depreciation pressure on the exchange rate and no need for Central Bank interventions.

The Central Bank has made significant progress in the banking over the past period with the support of political leadership. Following exclusion of banks that fail to meet regulatory requirements as well as setting additional capital requirements, the role of banks in financial intermediation began to strengthen, and the banking and financial sectors are actively involved in financing economic growth. Banks' lending portfolio increased by 30 times, financial depth (loans / non-oil GDP) reached 51%. In 2008-2015, the banking sector (excluding the International Bank) issued AZN75B worth of loans. Bank loans have become one of the main sources of capital investment, along with budget expenses.

The banking sector supported improvement of social welfare (housing conditions, purchase of long-term consumer goods, lending for current needs, etc.) by financing ‘deferred’ consumption and paying more than AZN5B on deposits only in 2009-2015. In the years of the oil boom, a part of rapidly growing income of the population became a source of savings and banks' resources. Since 2003, per capita deposits have grown 21 times, and the number of depositors has increased 13 times. Growth of financial resources led to lending boom. Financial depth of the banking sector increased by over 3 times to 77% of GDP. Azerbaijan rose to the 56th place in the world among 162 countries in 2003 in terms of this indicator. Assets of the sector increased by 33 times, average annual growth rates of assets (36%) surpassed economic growth by 3 times.

To strengthen financial intermediation, the Central Bank managed to establish many new financial institutions. One of them was the Deposit Insurance Fund, established in 2007. This fund was instrumental in stimulating savings to and boosting public confidence in the banking sector. At the same time, the Azerbaijan Mortgage Fund was established under the Central Bank of Azerbaijan to improve housing conditions of the population, create an efficient housing financing mechanism, and ensure that related supply meets real demand with purchasing power. In total, in 2006-2018, the Fund issued AZN1.2B worth of 25,000 mortgage loans. One of the important institutions was the Financial Monitoring Service established under the Central Bank to combat money laundering and financing terrorism.

The Central Bank also actively supported other institutions to strengthen financial intermediation. To increase access of the population to banking services in regions, the Azerpost LLC with extensive regional branches and offices was reorganized and licensed to provide financial services in addition to traditional postal services.

The banking-financial sectors has not lost its balance, demonstrating sufficient resilience to the global crisis begun in 2008 as a result of a successful strategy of development and modernization, as well as preventive crisis management. Global uncertainties in the second half of 2014 and adverse effects of the slump in oil prices left imprints on the banking system.

However, in February of this year, successful and humanistic steps were taken by President Ilham Aliyev to address these impacts and successful implementation of measures to address problem loans was successfully completed. On 28 February 2019 the President signed a relevant Decree to provide state support for the solution of financial losses of individuals on foreign currency denominated as well as problem loans as a result of the depreciation of the national currency in 2015. The Decree entrusted the Central Bank to provide a state-guaranteed loan at the request of the Financial Markets Supervisory Authority (FMSA) to restructure overdue credit debt of individuals up to $10000 and AZN17000. Currently, a guarantee agreement is under way with the Ministry of Finance and the FMSA.

Expanding cashless payments and limiting cash circulation to combat the shadow economy are in the spotlight of the head of the state. The Central Bank is actively working in this direction with other related agencies, in particular the Ministry of Taxes and the FMSA. The Bank is tasked to create a modern payment infrastructure and radically increase its accessibility. Currently, total number of payment cards in the country has exceeded 7.1 million – 71 cards per 100 citizens, Azerbaijan is the leader in the South Caucasus in terms of this indicator. Over the past 10 years, the number of ATMs has increased by 62 percent, POS-terminals by 7.5 times. It is no coincidence that the share of cashless card payments has risen by 4% over the past 5 years to 20% (5 times).

The Bank's constant focus is to modernize the national payment system, reduce dependence on international organizations, and maintain stability and reliability of payment systems to increase cashless payments. The created modern and reliable infrastructure, as well as tax incentives and effective tax administration allow rapid expansion of non-cash payments. Total volume of transactions via national payment systems reached AZN252B in 2018 (3.4 times of GDP).

However, the tasks set by President Ilham Aliyev are more than the work done. Cash withdrawals still prevail in card payments, businesses operating in the shadow economy prefer cash payments. Taking into account all these challenges and current global trends, the Central Bank implemented a ‘Cashless Azerbaijan’ project in 2017 jointly with MasterCard Worldwide with extensive experience and resources. Successful outcome of this project is the ‘State Program on expansion of digital payments in the Republic of Azerbaijan for 2018-2020’, approved by the Presidential Decree of 26 September 2018. At present, appropriate measures are being implemented by relevant state authorities according to the State Program.

The Central Bank has always focused on organization of cash circulation, full, adequate and timely coverage of demand of the economy for cash, as well as creation of strategic cash reserves. One of the biggest reforms in this area was the 2006 denomination initiated by the President. With the denomination, our country managed to bring the value of the national currency closer to the world's most advanced currencies by reducing zeroes inherited from the economic transformation crisis. As a result, confidence in the manat as a means of collecting and settling began to rise significantly followed by long term and sustainable de-dollarization.

At the same time, last year the Central Bank issued a 200 manat banknote into circulation, taking into account cash trends, the share of large denominations in circulation and global practice, which increased adequacy of currency to payments.

Currently, the Central Bank constantly improves the design and security elements of currency in light of the latest technologies and global innovations. For the past 14 years since its issue to circulation, the national currency has fulfilled its function in terms of the ‘Independent Azerbaijan’ concept, aesthetic appearance and security. The Bank used the hi-tech and security systems in the development of AZN200 and updated AZN10 banknotes, taking into account challenges in application of innovations, Nano and micro technologies in security systems.

Moreover, a special laboratory supplied with high-tech systems and equipment has been established in the Central Bank HQ to effectively combat money counterfeiting, and a counterfeit money monitoring system has been established to coordinate with credit institutions and law enforcement agencies. The Bank currently actively works with relevant agencies, especially the Ministry of Internal Affairs, to combat counterfeiting.

New challenges and values ​​are being formed before the society in young and independent Azerbaijan. The Central Bank adopted a policy on issuing commemorative coins by selecting the topics that are most welcomed and considered more important by the public and various denomination 41 thousand modern design commemorative coins of 47 types dedicated to prominent persons, socio-political and historical developments were issued into circulation up to now. The Bank issued to circulation commemorative coins dedicated to the 80th, 85th, 90th and 95th anniversary of the National Leader Heydar Aliyev, the 100th anniversary of establishment of the Azerbaijan Democratic Republic, the memory of the great Azerbaijani poet Nizami Ganjavi, the great opera singer Uzeyir Hajibeyli, the 20 year anniversary of restoration of state independence of Azerbaijan, the 135 year anniversary of the National Press, the 20th Anniversary of the Central Bank, the 90 year anniversary of the Nakhichevan Autonomous Republic, the Contract of the Century, one of the biggest achievements of our contemporary history, TANAP, “’Azerspace-1’, Bakı-Tbilisi-Kars projects and the first European Games.

One of the important directions of the successful development strategy of the President of Azerbaijan is constant increase of human capital. In addition to its mission, the Central Bank also supports this policy by implementing corporate social projects. One of such social projects is the Educational Complex in Bilasuvar named after the National Hero Mubariz Ibrahimov. The complex consists of a high school-lyceum and a kindergarten. With the financial support of the Central Bank advanced school infrastructure was established at the high school, highly qualified teachers were recruited and curriculum modernized.

The Central Bank has developed into an institution with extensive experience in solving complex tasks at all times. For the first time among public institutions the Central Bank transited to the strategic planning system, with dozens of projects being successfully implemented. Modern organizational structure and decision-making procedures, necessary business processes across all areas of activity, corporate governance standards have been applied for effective implementation of the mission of the Bank. Internal business processes and information systems have been automated and a platform for integration into e-government has been created. Technological development uses modern equipment and software.

Young, dynamic and talented staff has the potential to actively participate in the bank's renewal process. Analytical research and modeling capabilities have been created in the Central Bank in line with the challenges of the new era. The formed analytical capacity allows to quickly evaluate and predict potential macro and microeconomic processes, make optimal decisions. It is no coincidence that the Central Bank has become an important think tank in the country.

Central Bank transparency constantly increases thanks to effective communication. At the time of deepening integration of the national economy into the world economic system, it is important to establish mutually beneficial cooperation with international financial institutions and countries with international central banking reputation. Related measures will ensure fulfillment of the tasks set for the Central Bank, benefit from the experience of foreign central banks with extensive banking experience in ongoing reforms and modernization activities, as well as proper representation of the bank on an international arena. Effective cooperation with international financial institutions, leading central banks, and implemented technical assistance projects allow the establishment and operation of modern central banking. Today, the Central Bank of Azerbaijan has turned from the organization attracting technical assistance to a donor organization. Thus, the Bank extends its cooperation with partner foreign central banks to share its experience in different central banking areas.

The centenary of the Central Bank coincides with the period of rapid new generation economic reforms in the country by President Ilham Aliyev. These reforms cover all areas and serve as a transition to a new growth model.

One of the most serious social problems, full compensation of losses for foreign currency denominated loans of the population as a result of correction to the exchange rate of the national currency and deep restructuring of overdue consumer loans in national currency up to a certain amount should be emphasized among recent decisions. This decision, with no international analogue in terms of scale and character, has played an important role in improving family budgets.

Macroeconomic stabilization measures implemented in the country, including macroeconomic stability since 2017, low inflation and balancing in the FX market also contribute to growth of real income of citizens. In this context, the Central Bank, which already has 100 year history, has set ambitious goals, taking into account the new strategic era challenges. The main task is to further safeguard macroeconomic stability, in particular, to expand the capacity to influence inflation, its main indicator.

The Central Bank aims to move to inflation targeting in the medium term. An appropriate strategy has been developed and a road map defined. The Bank prefers a gradual and conditional transition to the framework, in light of the specifics of the economy and world practice. Monetary reforms have been kicked-off to that end.

Another important task is to realize a new and faster phase of transformation into a cashless economy. In this regard, the project on digitalization and establishment of 7/24/365 instant payment system is under way. Measures on transition to cashless society are also being implemented rapidly on the ‘State Program on expansion of digital payments in 2018-2020’ approved by decree of the country leadership.

Digitalization and transformation into a cashless society is also important in terms of transforming country's financial resources into development goals, expanding financial intermediation and strengthening the financial sector.

In line with current trends in Fintex, various blockchain projects are expected to be implemented. The Bank has initiated a project on creation of digital identification system. Opportunities for formation of national cryptocurrencies are also under consideration. All this should allow efficient flow of financial resources beyond traditional banking as well.

Large-scale reforms in development of cashless payments do not necessarily exclude cash transactions. Cash operations grow at a certain rate along with development of cashless payments. Therefore, in the next strategic period the Bank will continue development of modern cash management, creation of new generation currency in exemplary design, and adjust cash services to advanced standards.

Challenges faced by the Central Bank require adequate internal management and capacity building. In the upcoming period, the Bank prioritizes automation of corporate governance, HR, technological development, various risks and internal communication management. The focus will be on developing HR, upgrading knowledge and skills of the staff, Bank's technological infrastructure and ensuring its security. At the same time, the Central Bank has the potential to become an intellectual partner of the government in formulation of the economic policy by using economic research, expertise and discussion. The main vision is to be among the leading central banks of the 21st century.