As a Caspian littoral state, Azerbaijan is capitalizing upon the Seas sizeable, but still mostly untapped, hydrocarbon resources. Azerbaijans real gross domestic product (GDP) grew by an impressive 26 percent to $13 billion in 2005 as foreign investors pushed ahead with major projects in Azerbaijan. Foreign direct investment in the country contracted from $2.3 billion in 2004 to just under $500 million in 2005 largely due to the completion of construction on the BTC pipeline in Azerbaijan. In the next couple years favorable real GDP growth is expected, but maintaining low inflation rates as energy and transit revenues flow into the country represents a major challenge. In the meantime, Azerbaijan is struggling to overcome the economic collapse that followed independence from the former Soviet Union, as the countrys GDP contracted by almost 60 percent from 1990 to 1995. By 2000 and 2001 wages were increasing around 20 percent each year, and by the end of 2005 the average monthly wage was around $125. Still, according to the International Monetary Fund (IMF), almost 45 percent of the population lives below the poverty line. Azerbaijan has drawn over $120 million (as of April 2006) from an IMF-run Poverty Reduction and Growth Facility program in Azerbaijan that has helped re-structure the countrys economy and alleviate economic hardships. Azerbaijans hope for future economic growth rests in large part with successful development of its oil and natural gas resources in the Caspian Sea region and through effective management of the resulting revenue stream. After the first commercial oil flows through BTC during Summer 2006, oil revenues will contribute to a doubling of Azerbaijans GDP by 2008. Azerbaijan will have drastically higher oil revenues than ever before, and although the country has effectively managed a $1 billion oil fund, bankers and investors question whether Azerbaijan can manage an oil fund that could eventually be worth $100-200 billion (depending on the oil price).To manage the revenues, former president President Heydar Aliyev created a State Oil Fund in 1999, which is designed to use money obtained from oil-related foreign investment for education, poverty reduction, and efforts aimed at raising rural living standards. As of the end of 2005, the State Oil Fund reported assets of $1.3 billion, but the funds assets are expected to almost double during 2006. Please see a recent paper in Geopolitics of Energy for more information on the effects of energy revenues on Azerbaijan.

Economists at the IMF warn Azerbaijan that institutional reform and economic liberalization are necessary for the country to sustain its upcoming oil wealth. Some of the slow-paced reform has been due to the transfer of power to Ilham Aliyev, who was elected president in October 2003. He succeeded his father, Heydar Aliyev, the longstanding president during the 1970s and much of the 1990s. However, the shift in power from father to son was reportedly tainted and accompanied by violence. Ilham Aliyev has a background in his countrys energy sector, was educated in Russia and the United States, and has maintained a good working relationship with foreign investors and the U.S. Regardless of the policy direction that Azerbaijan takes, the establishment of the oil fund and Azerbaijans leadership in the Extractive Industries Transparency Initiative (EITI), which urges data transparency and hopes to reduce corruption, show positive signs that Azerbaijan is aware of the challenges it faces. The Organization for Security and Cooperation in Europe (OSCE) noted some improvements in the election process during the November 2005 elections, but observed deteriorating conditions during the tabulation of votes and the interference of local executive authorities in the campaign process. Results for 10 seats in last Novembers national election were annulled because of these violations, and concerned authorities scheduled a re-vote in May of 2006. Following the re-vote, a statement issued May 15 by the OSCEs Office for Democratic Institutions and Human Rights called the vote a welcome step toward increased transparency. The ODIHR assessment lauded authorities for inclusive candidate registration and a largely unimpeded campaign. It also stressed a need for further electoral reforms, and cited several issues of concern, including the composition of election commissions, instances of interference by local authorities in the election process and the handling of complaints and appeals by election commissions and courts. Opposition figures again said the balloting was marred by official abuse. One of the most significant challenges to Ilham Aliyevs government is maintaining good relations with Azerbaijans neighboring states. One source of conflict is the dispute over Nagorno-Karabakh. The conflict, which started over the Armenian claims to the area, grew into a full-scale war that led to the death of over 30,000 people on both sides. As a result of Azerbaijans armed conflict with Armenia from 1988-1994, around 12 percent of Azerbaijans 8.3 million people became refugees and internally displaced persons (IDPs). While Baku and its environs have been the recipient of high levels of foreign direct investment (FDI) in recent years, the Western regions have the lowest levels of income and the highest incidence of poverty. As a result of a 1994 cease-fire, Azerbaijan lost approximately 16 percent of its territory. Lingering tensions between the two countries remain, which raises concerns for stability and energy security in the area. Fueled in part by new oil revenues, Azerbaijans military expenditures have also risen from $135 million (2.7 percent of non-oil GDP) in 2001 to $300 million (4 percent of non-oil GDP) by 2005. The Minsk Group of the OSCE, co-chaired by France, Russia and the U.S., has been facilitating negotiations since 1994, but has not been successful in brokering an agreement between the parties. Currently, Azerbaijans relations with Russia are also tense, and disputes over Caspian Sea borders hinder relations with Iran and Turkmenistan.