Oil Price Shocks and Monetary Policy in Azerbaijan: Challenges and Opportunities

Abstract

This article examines the transition from a fixed to a managed floating exchange regime in Azerbaijan and discusses the potentially stabilizing effects of monetary policy instruments on the Azerbaijani economy following oil price shocks. It argues that a proactive and credible fiscal policy and monetary expansion (albeit temporary) are indispensable measures to defend the domestic economy against external supply shocks. However, monetary expansion as a traditional approach to crisis management during recession has proven ineffective in the Azerbaijani case due to public panic over the possibility of further devaluation of the Azerbaijani currency (manat) and unofficial dollarization incentives. Faced with new challenges, the Central Bank of Azerbaijan adopted a tightening monetary policy to curb further devaluation of the manat, unofficial dollarization and inflation. However, establishing an effective monetary policy requires substantially enhancing credibility by creating a safer and sounder financial sector. In this regard, financial liberalization and greater ease of entry for foreign banks can lead to benefits connected with the development of the domestic financial system. The article also suggests that national currency devaluation has potential implications for the increase in exports and the inflow of import substituting foreign direct investment. However, a degree of uncertainty and turbulence surrounding the financial situation and weak institutional quality are barriers to external funding and can exacerbate the contraction of domestic credit for the time being.