Economic Outlook Business & Investment climate

ECONOMIC OUTLOOK

The prospect of developing enormous hydrocarbon reserves, and the beneficial impact for regional development, even in the non-oil producing countries of Armenia and Georgia, is part of the allure of the Caspian region. Most of the Caspian region’s oil and gas reserves have not yet been developed, and many areas of the region remain unexplored. According to the U.S. Department of Energy, proven oil reserves, at 32 billion barrels (bbls), exceed those of the United States (22 bbls), and the North Sea (17 bbls). And it is estimated that possible oil reserves could be nearly five times proven reserves. Proven gas reserves, estimated to range from 236 to 337 trillion cubic feet (tcf), are comparable to total proven North American reserves (300 tcf), and possible gas reserves could double this amount. As highlighted in the accompanying tables, the potential exports of oil and gas from the Caspian region are very large. But the Caspian region is located far from Western markets, in remote and landlocked countries whose pipeline transportation routes have linked them principally with other former Soviet republics. Of the 429,000 barrels per day in net exports of oil in 1997, for example, mostly from Kazakhstan, only about 150,000 were exported outside the former Soviet Union. Azerbaijan and Kazakhstan, in particular, stand to benefit from a pipeline infrastructure that improves direct access to Western countries. Georgia and Turkey will benefit from transit fee income as well.

Even though increased oil exports from the Caspian region will depend largely on further Greenfield exploration and development, there is a tremendous amount of natural gas currently available for production and export in the Caspian region.

Instead, the constraint to be overcome is to develop a pipeline infrastructure to gain access to Western markets, and to improve field gathering and processing facilities to take advantage of that access. Turkmenistan, in particular, would benefit from a pipeline that linked its enormous natural gas fields to Western markets.

The economic outlook for the Caspian region has shifted for the worse during the past year, because of soft international oil and commodity prices, the financial collapse of Russia, and other shocks, such as the failure of the cotton crop in some countries. These shocks have been magnified by poor economic management and legal and institutional structures that are unable to cope with such shocks. The immediate challenge will be to regain macroeconomic stability and re-invigorate systemic economic reform, while attempting to diversify export markets.

The recent consolidation that is engulfing the oil industry worldwide has tended to reduce the attractiveness of the Caspian region relative to other exploration and development sites around the world. This, combined with some disappointing early results of oil exploration in the South Caspian Sea, has caused some companies to pull up stakes, while those that intend to remain are re-evaluating the extent to which they can afford Greenfield exploration projects.

Despite these adverse developments, there are significant opportunities in the Caspian region in the near to medium-term. As described below in the sector overviews, increasing emphasis is being placed on upgrading the capacity to lift oil from already productive sites, while increasing the capacity to transport it along established routes. At the top of the list are projects to build the pipeline infrastructure necessary to transport natural gas to Western markets. There are also excellent opportunities in the power sector, infrastructure development, tourism, and agriculture. Over the longer term, with a firming of international oil

prices, the prospect of developing the potentially enormous hydrocarbon reserves in the Caspian region again becomes very attractive, providing the justification for expanded Greenfield exploration, production and oil pipeline carrying capacity.

There are significant opportunities for U.S. companies arising from economic development in the Caspian region. These are the kinds of projects that are highlighted in this Briefing Book, within the individual country profiles, as well as the regional and country-specific project profiles presented in subsequent sections.

BUSINESS AND INVESTMENT CLIMATE

All of the countries in the region have made great strides during the past seven years to create the institutional framework required for a market-oriented economy. Today, all have laws protecting the rights of foreign investors, and although much remains to be done to provide a stable and predictable investment climate, all are very motivated to attract foreign investment. All have established central banks, tax systems and customs systems, and have made progress in establishing ownership rights and the legal framework to support contracts and market transactions.

On a very broad scale, the countries in the Caspian region can be grouped by their commitment to create a market-oriented economy that is friendly to foreign investors. Armenia, Azerbaijan, Georgia and Kazakhstan tend to be more reform-oriented than Turkmenistan or Uzbekistan. The table below shows how the investment climate differs across the countries according to 8 key dimensions. The “Transparency” dimension ranks the countries relative to each other, rather than globally with respect to all economies in transition.

Banking Systems. All the countries of the region suffer from weak banking systems, but they have different strategies for building up their banking systems.

Armenia, Azerbaijan, Georgia, and to a lesser extent Kazakhstan, are pursuing bank reform policies that will ultimately lead to stronger systems, and now allow foreign banks to operate. Turkmenistan allows some banks with foreign capital to operate on a selective basis, although none of the foreign partners are from OECD countries other than Turkey. Uzbekistan’s banking policies are actually stifling business activity. Uzbekistan is attempting to require that all business transactions must be processed as interbank transfers, rather than cash, and delays of up to several months have created a two-tiered pricing system.

Currency Convertibility/Exchange Rates. There are also considerable disparities among the countries on currency convertibility and exchange rate policy. Armenia, Azerbaijan, Georgia, and Kazakhstan allow free convertibility of their currencies, and with the recent decision by Kazakh authorities to float the currency, the exchange rate in each country is determined by market forces. Each of these countries pursues a policy of exchange rate management, but there are no currency controls or problems exchanging local currencies for U.S. dollars or major European currencies. This is not the case in Turkmenistan and Uzbekistan, where businesses face increasingly stringent currency convertibility restrictions, in part because of large disparities between the official and the exchange rates on the

street.

Privatization. Almost all of the countries have made some progress in privatization, although Kazakhstan, Georgia, Armenia, and Azerbaijan are in general further along than Turkmenistan and Uzbekistan. All the countries have privatized most of their small enterprises; most have privatized or leased at least portions of their agricultural sectors; and some, notably Armenia, Kazakhstan, and now Georgia, use international tenders to privatize large state owned enterprises.

Indeed, some of the best investment and procurement opportunities will come from fairly transparent privatizations in the power sectors in Georgia (managed by Merrill Lynch) and in Kazakhstan. In many of the countries, the Governments encourage foreign participation in their mass privatization programs. However, these are often controlled by insiders, so foreign investors do best when they work with a local partner or get local legal advice at a minimum.

In general, foreign investors cannot own land, although in many of the countries, foreigners can directly, or through joint ventures, own buildings or manufacturing plants. Profit repatriation is not a problem in most countries, with the exceptions of Turkmenistan and Uzbekistan, provided all taxes and fees are paid.

Dispute Settlement. Adjudication of disputes is a serious issue in all these countries. While the nations have made progress in establishing court systems, courts are still generally not independent nor reliable for transparent adjudication.

In Armenia, Azerbaijan, Georgia, and Kazakhstan, investors are able to use international dispute settlement forums. At this time four major foreign investors in Kazakhstan are in international arbitration. Although Uzbek law allows for foreign arbitration, the extent to which this law is in conflict with other Uzbek laws is unclear. International arbitration decisions are generally not binding in Turkmenistan courts.

Transparency/Tax Systems. Tax systems and administration, as well as customs administration, are often in a state of transition and lack transparency. This is true in all of the Caspian nations. Investors and exporters are urged to complete due diligence investigations and if possible work with a known local partner. The old ways of doing business by relying on personal connections and relationships is very strong across the region. Foreign investors are urged to engage well-connected legal assistance before signing any binding agreements.