FOR NOW AND THEN

It is posited that the state of happiness is not contingent on the possession of wealth, but rather on the extent of one's financial resources. However, it is not uncommon for a substantial influx of capital to become a source of significant distress for the individual in question. Such occurrences can be observed at the level of both the individual and the state.

Azerbaijan was immediately confronted with the significant responsibility associated with substantial financial resources following the initial revenue generation from the sale of oil produced at the Azeri-Chirag-Guneshli fields. Despite the challenging economic circumstances and the urgent need for investment to stimulate recovery from the post-Soviet period of economic decline, the previous government made a prudent decision in favour of fostering long-term stability over pursuing immediate economic growth. In 1999, the State Oil Fund of the Republic of Azerbaijan (SOFAZ) was established with the objective of accumulating, managing and disbursing the proceeds derived from the sale of energy resources in a prudent and responsible manner. It became the primary mechanism for achieving macroeconomic balance in the country, supporting the implementation of the most crucial infrastructure and social projects, as well as undertaking intricate activities to augment and safeguard savings for future generations.

Mission Accomplished

It should be noted that Azerbaijan was not required to devise a novel approach in establishing the SOFAZ. Sovereign funds with varying objectives have existed since the mid-twentieth century. Following the emergence of the concept of "Dutch disease" in the economy, their existence became particularly pertinent for resource-rich countries. This phenomenon, also known as the "Dutch disease," refers to a situation in which an economy is unable to effectively absorb a significant influx of capital from a single sector. Consequently, all other sectors experience a decline in performance, and the country is susceptible to hyperinflation and other characteristics associated with an overvalued currency. In order to circumvent this predicament and in consideration of the finite nature of natural resources such as oil and gas, which are prone to periodic price fluctuations, the governments of numerous resource-rich countries have recognised the necessity to invest a portion of their petrodollars in the economy, while simultaneously accumulating the surplus in a dedicated reserve fund. The latest data indicates that there are over 150 such funds globally, with a combined asset value of $8.1 trillion. Concurrently, the income of these institutions is distinguished by accelerated growth rates, which enables them to become active participants in the global investment market and, in general, to exert influence over global economic processes.

The funds' differing purposes and areas of expenditure result in a variety of missions. The most notable of these are accumulation-stabilisation (as exemplified by the Norwegian fund), accumulation-pension (as seen in the Australian fund) and the accumulation of resources with the dual objective of stabilisation and development (as observed in the Kazakh fund).

Azerbaijan elected to pursue the initial option, particularly given that the Norwegian fund, with assets amounting to $1.4 trillion, is regarded as the largest sovereign fund globally and the most exemplary model for learning from experience. For the past 25 years, the SOFAZ has been successfully fulfilling both of its assigned missions. The fund serves as an impressive source of replenishment for the country's gold and foreign currency reserves. As of April 1, 2024, 83.1% of Azerbaijan's $69.272bn gold and foreign currency reserves were accounted for by the SOFAZ. Additionally, the fund plays a pivotal role in maintaining macroeconomic stability through transfers to the state budget and financing of projects deemed crucial for the country's economic and social development. At the present time, the fund is accumulating revenues derived from the fulfilment of oil contracts. Concurrently, as a consequence of a meticulously devised management strategy, the SOFAZ replenishes its assets on an annual basis with the profits derived from its investment activities.

Most Significant Projects

In the period preceding the decline in oil production and revenue in the country, there was considerable debate about the merits of distributing the funds generated by oil sales. The opinions ranged from the impractical, such as the suggestion of distributing the funds directly to the population, to the seemingly more pragmatic, such as the proposal of investing in small and medium-sized business projects. In light of the decline in oil production, the resilience demonstrated in the face of a precipitous decline in oil prices and global economic stagnation during the Coronavirus pandemic, it has become evident that the selected course of action is the optimal decision for both the present and future generations of Azerbaijanis.

Consequently, at the time of the Fund's establishment, its assets were valued at $271 million. By 1 April 2024, this figure had reached $57.3728bn. It is noteworthy that despite the fact that the Fund's resources are not preserved, some of them have been actively involved in the country's economy over the course of many years. This has been achieved through both transfers to the state budget and the financing of major projects. These include the financing of SOCAR's share in the ACG project, the construction of oil and gas pipelines of regional and global scale, the construction of the first floating semi-submersible drilling rig of the 6th generation in Azerbaijan, the STAR refinery in Türkiye, the Baku-Tbilisi-Kars railway, the Oghuz-Gabala-Baku water pipeline, the reconstruction of the Samur-Absheron irrigation system, and so forth. Additionally, social objectives have been financed, including the improvement of housing conditions for refugees and the implementation of state programmes for the education of Azerbaijani youth abroad.

A review of the growth trajectory of SOFAZ's assets reveals that these expenditures not only did not impede the fund's accumulation function but also enabled the country to undertake significant investments without incurring an undue debt burden. Such initiatives have a long-term impact on the country’s economic development. The invested projects are self-sustaining and profitable, and are already contributing to the state budget of the country. Investments in social projects facilitate the creation of valuable human capital, which will also ensure the reliable management of economic processes in the future.

                                       SOFAZ's Asset Growth Dynamics, in billion USD

                                                      Source: SOFAZ Report 2023

Necessary Support

It should be noted that the largest share of the fund's expenditures is accounted for by transfers to the state budget. By the end of 2023, the total volume of these transfers since the creation of SOFAZ was $125.1 billion, representing 91.1% of all expenditures of the fund. Indeed, the figure is considerable. Both foreign and local experts have indicated that this threshold should be reduced. Nevertheless, it is unfeasible to do so at the present time, given that the country has significant objectives to restore territories liberated from occupation and reintegrate them into the economy, which necessitates substantial financial investments. Furthermore, as highlighted by Finance Minister Samir Sharifov, the state budget is already experiencing adverse effects due to the decline in oil revenues, and the non-oil sector is yet to fully offset the resulting deficit. "A modest increase in the transfer from SOFAZ is warranted, without compromising macroeconomic stability," the minister concluded.

In the absence of these transfers, the state will be compelled to borrow extensively from external sources, which will significantly exacerbate the vulnerability of its economy and render it dependent on creditors. Furthermore, as President Ilham Aliyev has repeatedly asserted, economic independence is the foundation of political independence. "We are responsible for our own sustenance." It is evident that external assistance is not forthcoming, has never been forthcoming, and is unlikely to be forthcoming in the future. It is therefore incumbent upon us to construct our own lives. "We refrain from interfering in the affairs of others, yet we similarly prohibit others from interfering in our affairs," the Azerbaijani leader observed.

Undoubtedly, SOFAZ's savings play a significant role in achieving this economic independence.

A report published in July by Moody's stated that the sovereign wealth assets held by SOFAZ cover approximately five times the government's direct debt. The report's compilers based their affirmation of Azerbaijan's Ba1 rating on the country's strong government balance sheet, which is characterised by a low debt burden and a net asset position.

Similarly, Fitch Ratings issued a statement affirming Azerbaijan's long-term foreign currency issuer default rating at 'BB+' with a positive outlook. The rating is supported by Azerbaijan's robust external balance sheet, the lowest level of sovereign debt in a comparable group of countries, and the flexibility of financing through the country's substantial sovereign wealth fund assets.

Investment Policy

As previously stated, over the course of its operations, SOFAZ has successfully diversified its assets, including through a meticulously devised asset management strategy. Presently, the fund serves as a global investor in the debt, equity, real estate, and gold markets. From its inception until the end of 2023, these activities have generated a total of $11.5 billion for SOFAZ, representing an annualised return of 2.5%. In 2023, the fund's return of 7.1% represents the highest return achieved in all years of its operation.

                                               SOFAZ Rate of Return since inception

                                                          Source: SOFAZ Report 2023

Therefore, by the end of 2023, 57.7% of the investment portfolio was comprised of fixed income and money market securities, 24.3% was allocated to equities (including private equity funds and mutual funds investing in unrated debt), 12% was invested in gold, and 6% was directed towards real estate.

SOFAZ's investment in the fixed income securities are primarily comprised of investments in sovereign, government agency, international organisation, and corporate bonds. The aforementioned investments are allocated among sub-portfolios denominated in US dollars, euros, British pounds, Chinese yuan, Turkish lira and Australian dollars.

It is evident that the fund's investment policy is characterised by a preference for a conservative approach, eschewing the use of high-risk instruments. The policy of "less is better" has been vindicated by repeated crises in recent years, particularly given the 5.1% rate of return on this category last year, which is a commendable indicator.

                      Top 5 largest investments with fixed income by end-2023, in million USD

In recent years, SOFAZ has also become noticeably active in the private equity segment. Its decisions are formed on an annual basis, based on the current situation and forecasts for financial and other markets. This process is overseen by a large group of qualified analysts. In consideration of the favourable dynamics, the fund initiated an increase in its equity portfolio in 2022, investing in the MSCI World Index (Morgan Stanley Capital International), which provides diversification across various global markets and sectors. This resulted in a portfolio value of 20.5% or $11.5 billion by the end of last year. Consequently, the yield of this segment, excluding the impact of exchange rates, was 23%.

Despite the fund's efforts to diversify its equity portfolio across sectors, its investment focus remains on large companies with sustainable development practices. To illustrate, the fund has augmented its holdings in technology companies to a value approaching half a billion dollars in the current fiscal year. This encompasses securities from such prominent market entities as Microsoft, Apple, NVIDIA, Alphabet (Google), META, and Amazon.

A further significant source of revenue for SOFAZ is derived from property investments. Currently, there are 54 such investments in locations spanning more than 30 countries, with a notably diverse portfolio in terms of region, sector and risk profile. The acquisition of commercial real estate in major global cities, including London, Paris, Milan, Seoul, and Tokyo, has already yielded profits amounting to $1.1 billion.

Indeed, there are instances when the return on a specific investment segment is less than anticipated. This is, in principle, a normal practice within the financial market. It is not feasible to predict all potential fluctuations with absolute certainty. Nevertheless, the sustained growth of the fund's assets demonstrates that the selected ratio of diversification within the total portfolio enables the offset of losses in one segment through the enhancement of profitability in another. In other words, the potential for loss is reduced, which is the primary objective. In other words, the probability of financial loss is reduced, which is the primary objective of the management of financial institutions of this magnitude. The most crucial aspect of SOFAZ's operations is to guarantee that the accumulated savings can be leveraged to sustain the long-term economic growth of Azerbaijan, maintaining its role as a crucial financial institution.