TWENTY YEARS LATER

As the saying goes — money does not smell... Each bill has its own specific smell however. In Azerbaijan, for example, money 'smells' of oil, which is the main driver of its economy since the 19th century.

Back in those days, nobody could imagine how harmful the dependence on a single type of natural resource can be. It was in the 20th century when the world got to know about a dangerous disease, which has almost ruined the Dutch economy and later has become known as the Dutch syndrome.

To prevent the spread of this artificial syndrome in Azerbaijan, the government decided to take measures almost simultaneously when the first petrodollars began flowing into the country's economy. On December 29, 1999, it was decided to establish the State Oil Fund of the Republic of Azerbaijan (SOFAZ), which is responsible for control of any single petrodollar getting into the economy.

Stability buffer

Establishment of a sovereign oil fund in Azerbaijan is a result of a competent approach to income administration at government level. Such funds are needed primarily to enable the economy to 'digest' a huge inflow of income, directing it in such a way as to achieve not only immediate improvement of economic and social situation, but also to maintain stable development trend on a long run. After all, it is the effective management of financial resources from households to state level that determines the category of any country: a creditor or debtor country.

In fact, not all sovereign funds are established only by oil and gas producing countries. According to various estimates, there are approximately 80 sovereign funds operating in the world with an accumulated financial resources pool of more than $7 trillion. Most of them are resource funds, which account for 61% of all global assets of sovereign funds. As a rule, the objective of such funds is redistribution of funds acquired from highly profitable non-renewable resources into more diversified financial assets.

Assets managed by sovereign funds are characterized by rapid growth rates, which allows a country to become an active player in the global investment market. At the same time, the larger the sovereign fund, the more risks its leadership can take to obtain the highest dividends from its investment portfolio. For example, the investment structure of the Norwegian sovereign fund is formed of shares (61%), securities with stable income (27%) and real estate (2%).

The main assets portfolio of some sovereign funds, net savings, can be compared with the world's largest investment companies, pension funds and even central banks.

Sovereign funds are not only a significant source of replenishment of foreign exchange reserves, but also a kind of a firewall against all sorts of financial and economic disasters. As noted by Duncan Bonfield, Chairman of the Board of the International Forum of Sovereign Wealth Funds (IFSWF), these funds provide capital no one else can do: “We found that when the rating of government bonds falls, as well as the availability of capital in the financial market, there are still certain opportunities that we can use to replenish various sectors of economy with our capital.”

Historical decision

The decision of President Heydar Aliyev to establish SOFAZ can rightly be considered a historical one, which played a key role in the further economic development of Azerbaijan.

Even after twenty years since its inception, SOFAZ continues to improve its institutional structure, management mechanisms, and forms of development. Only the objective of the fund remains unchanged - the accumulation and, if possible, augmentation of income received from the export of Azerbaijani energy resources for future generations. With a starting capital of only $271 million, this figure now exceeds $40 billion, although, unlike some of its peers in the world, a role of 'a nationwide piggy bank' is not the only function of SOFAZ.

The fund also assists the government in preventing likely negative economic effects of external and internal crises, such as devaluation of the national currency and reduced competitiveness of local production, as well as the preservation of macroeconomic stability and protection of financial discipline.

Despite strong influence of external factors, the situation in the global economy and economies of neighbouring countries, SOFAZ's budget is growing each year thanks to conservative and competent asset management. Today the fund accumulates revenues from the sale of oil and gas contracts, in particular from the sale of profitable oil and gas, transportation of oil and gas across the country, leasing state property, etc.

Conservative and risk free

The fund is occasionally criticized for its conservatism. Some experts complain about its low level of profitability, particularly in 2018, and suggest that SOFAZ intensifies its investment activities. In fact, SOFAZ has to keep a significant part of its investment portfolio in government bonds, which yield not much but have high liquidity yet.

The key task of sovereign funds, including SOFAZ, is to preserve and then multiply the incoming petrodollars. Last year, for example, SOFAZ was not the only institution with low profit. Strong volatility in the stock market, decreased economic growth in the leading countries of the world, trade wars, etc. Even the largest resource funds of the world, including Norway (yield 6.1%), Alaska (-1.1%), New Zealand (-2.18%) were not spared. Therefore, the fact that SOFAZ managed to complete the year on a small but positive side (+ 0.35%) is already a fairly good indicator, meaning that it managed to avoid losses due to a strategic decision not to increase its share in stocks.

Moreover, last year SOFAZ entered the top ten most influential investors in the world, according to IFSWF. The ranking also includes large sovereign funds, pension and charitable funds, and central banks. SOFAZ was chosen the 10th best institution among hundred. The rating is based on such indicators as innovation and the implementation of special programs, financing mechanisms, profitability indicators, existing conditions, implemented initiatives.

SOFAZ has so far invested in 60 countries of the world, and most of its assets in 2018 was made up of debt obligations and currency - more than $29.5 billion (76.48%). In 2012, the fund began to diversify its portfolio of assets, adding gold, stocks and real estate. Regulatory changes last year allowed SOFAZ to increase its share in stocks up to 25%, but it kept this figure at the level of 13-14%, since any decision on investments is made only after a careful study of long-term prospects and possible risks.

Thus, purchases of commercial real estate in London, Paris, Milan, Moscow, Seoul and Tokyo brought a stable income for SOFAZ. Previously, the fund acquired property directly. Now it prefers doing this through intermediaries, since it requires less resources. At the same time, the share of real estate in the portfolio for the last year did not change significantly, while the share of gold increased by almost 2% compared to the same period of last year (5.43% of the investment portfolio).

According to the SOFAZ Executive Director Shahmar Movsumov, the fund plans to double its gold reserves in 2019 up to 100 tons. “We would like to have something that is not burdened with any credit risk. In a world with rapid changes in geopolitics, reserve currencies, relations between superpowers, which inevitably affects the financial sector, we want to be on the safe side,” Movsumov said.

Controlled expenses

Situation around the return on the assets of the fund strongly resembles disputes, actively supported by experts at the dawn of its inception. There were even those who offered to distribute the money of the fund to the population of the country or to allocate loans to local entrepreneurs. However, initially the statute of the fund stated that SOFAZ funds can be spent only with the permission of the head of state and only for projects of global and social importance. In particular, the fund participated in financing the share of Azerbaijan in the construction of oil and gas pipelines of regional and world scale, the Baku-Tbilisi-Kars railway, projects to improve the living conditions of refugees, reconstruction of the Samur-Absheron irrigation system, and the financing of the state program on training Azerbaijani youth abroad.

In other words, despite the disputes, time has shown that these were very timely and correct decisions, which not only did not damage the fund’s existing mechanisms, but also allowed Azerbaijan to make important investments without getting into unnecessary debt.

A lion's share of the funds expenses is the transfers to the state budget: almost ₼11 billion in 2018. Moreover, the total volume of transfers from 2003 to March 31, 2019 has already reached ₼91.2 billion - a rather impressive amount. Both foreign and local experts say that this bar should be lowered. The government agrees with this opinion, that is why it was decided that the transfers to the state budget would be reduced in the coming years. But at the same time, we note that this is not just an infusion into the state treasury. This money is intended for specific investment projects that are important for the country, especially in terms of the development of the non-oil sector. And it is much more expedient than to distribute oil revenues to the population, so to speak, directly, as is done in Alaska, as suggested by a number of experts.

Thanks to competent management of income from the sale of energy resources and their targeted spending, SOFAZ maintains stable economic growth to diversify and reduce oil dependence for many years to come.