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III. The Caucasus and Central Asia: A Bumpy Road Ahead?

International Monetary Fund. Middle East and Central Asia Dept.
Published Date:
May 2009
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The global downturn is taking a toll on the Caucasus and Central Asia (CCA) region. Growth is expected to almost come to a halt this year, and current account and fiscal balances are moving toward deficit. While linkages to international financial markets are weak in most countries, the global economic crisis is being transmitted to the region via falling commodity prices, declining export demand, and lower remittance inflows, particularly from Russia. Policies should focus on providing support to growth and safeguarding financial systems, while managing external adjustment.

Caucasus and Central Asia Countries

The CCA region consists of eight former Soviet Union republics. In the north, the region borders on Russia and in the east, on China. Both neighbors are key economic partners for the landlocked CCA region. There are four oil and gas exporters (Azerbaijan, Kazakhstan, Turkmenistan, and Uzbekistan) and four oil and gas importers (Armenia, Georgia, the Kyrgyz Republic, and Tajikistan). CCA countries differ substantially in terms of per capita GDP, which ranges from $800 in Tajikistan to $8,500 in Kazakhstan.

Note: The country names and borders on this map do not necessarily reflect the IMF’s official position.

Growth set to slow sharply as the global crisis bites

Economic developments in the CCA region have been very favorable in recent years. Real GDP growth averaged 12 percent during 2005–07, before slowing to a still-solid 6.3 percent in 2008. The regional average in 2008 reflects significant slowdowns in Armenia, Georgia, and Kazakhstan, but still-strong growth in other countries. For most hydrocarbon importers, remittance-driven demand was the main engine of growth. Inflation pressures had been building since 2004, peaking in mid-2008, but dissipating in the second half of the year with the decline in international commodity prices. CCA headline inflation had receded to about 12 percent year on year at end-2008. Driven by high energy prices and the coming onstream of new oil fields, fiscal and current account balances in hydrocarbon exporters improved until 2008. Fiscal developments in hydrocarbon importers were more mixed, while current account balances deteriorated.

The global downturn is affecting most CCA countries, with real GDP growth in the region expected to almost come to a halt in 2009 (Figure 14). High-frequency indicators, such as industrial production, point to a sharp slowing in activity starting in the fourth quarter of 2008 in a number of countries. In Kazakhstan and Georgia, spreads on externally issued bonds have also risen sharply and, in Kazakhstan, the stock market has plunged. In Armenia and Kazakhstan, the economy is expected to contract in 2009, while growth will be just barely positive in Georgia and the Kyrgyz Republic. Only Turkmenistan and Uzbekistan are expected to delink somewhat from the global recession and achieve real GDP growth of 7 percent on account of favorable developments in their hydrocarbon sectors and fiscal stimulus (Table 7). Assuming some recovery in the global economy, real GDP growth is expected to strengthen generally in 2010. The headline growth number of 5 percent for the region for 2010, however, is driven by exceptionally strong growth in Azerbaijan (from increased hydrocarbon production). Other countries are expected to see much more modest recoveries.

Figure 14.CCA: Real GDP Growth

(In percent)

Sources: Data provided by country authorities; and IMF staff estimates and projections.

Table 7.CCA: Real GDP Growth(In percent)
Kyrgyz Republic3.
Sources: Data provided by country authorities; and IMF staff estimates and projections.
Sources: Data provided by country authorities; and IMF staff estimates and projections.

While the factors driving the slowdown in individual countries vary, three common themes emerge.

  • The contraction in Russia is affecting CCA countries via trade, remittances, and financial linkages.
  • Several commodity exporters are being hit by declining demand and prices.
  • Capital inflows are drying up, putting pressure on credit, growth, and the external accounts.

Russia: Still important for the CCA region

Russia remains a key economic partner for the CCA region. Trade flows have declined in importance over the past decade, but remain significant for some countries (Figure 15). At the same time, financial linkages have increased. For example, the banking sector in Kazakhstan now has a large exposure to Russia. A number of CCA countries are also dependent on remittances from Russia, particularly the Kyrgyz Republic and Tajikistan, but also Armenia and Georgia (Figure 16). In Tajikistan, for example, remittances accounted for about 50 percent of GDP in 2008, with most Tajik migrants reportedly working in Russia.

Figure 15.Trade Patterns in the CCA, 2008

(In percent of GDP)

Source: IMF Direction of Trade Statistics.

Figure 16.Remittance Inflows

(In percent of GDP)

Sources: Data provided by country authorities; and IMF staff estimates.

The Russian economy is expected to contract sharply in 2009. Real GDP grew strongly until mid-2008, driven by large terms-of-trade gains and surging capital inflows, accompanied by accommodative monetary and fiscal policies. This strong growth provided ample employment opportunities for migrants, and remittance flows from Russia to the CCA region surged (Figure 17). However, the sharp fall in oil prices and the sudden reversal of capital flows, brought on by the global financial crisis, have hit the economy hard and have resulted in an abrupt economic slowdown. Real GDP is expected to contract by 6 percent in 2009 despite the large fiscal expansion under way. With falling oil exports, the current account surplus is expected to disappear.

Figure 17.Remittance Outflows from Russia

(In billions of U.S. dollars)

Source: IMF Balance of Payments Statistics.

Another factor affecting the region is the weakness of the Russian ruble, which has depreciated by about 30 percent against the U.S. dollar since July 2008. Most countries were initially reluctant to let their exchange rate move against the U.S. dollar, resulting in a sharp appreciation against the ruble both in nominal and real effective terms (the Kyrgyz Republic was an exception as it allowed greater exchange rate flexibility). This led to losses in competitiveness, particularly in import-competing industries, and has contributed to pressures on the external accounts. It has also reduced the dollar or local currency value of ruble remittances. In recent months, however, a number of countries have moved to adjust their exchange rates (Armenia, Georgia, Kazakhstan, while the Kyrgyz Republic has continued the gradual depreciation that started last year) as pressures mounted.

As such, developments in Russia are an important factor contributing to the economic slowdown in the CCA countries (Box 5). For countries such as the Kyrgyz Republic and Tajikistan, the main channel of transmission will be a slowdown in remittance inflows, which is already under way (Figure 18). As well as having an impact on growth and the external accounts, weaker remittance inflows will also lead to higher poverty rates in these countries. For Kazakhstan, financial and trade linkages are key. Further declines in real estate prices in Russia will erode the value of Kazakhstani bank assets in the country, putting pressure on balance sheets. Future movements of the ruble will also be important in influencing the competitiveness of domestic producers.

Figure 18.Remittance Receipts

(12-month growth, in percent)

Sources: Data provided by country authorities; and IMF staff estimates.

Despite its own difficulties, Russia continues to provide official assistance to CCA countries. For example, the Kyrgyz Republic could draw on $450 million in concessional financing from Russia in 2009 to mitigate the negative impact of declining remittances. In Armenia, a $500 million loan agreement for infrastructure projects and onlending to small and medium-sized enterprises is under negotiation. Support for other CCA countries has been offered, or is under negotiation, and Russian companies continue to explore investment opportunities in CCA countries.

China’s role in the region is also expanding. Trade with China has increased in recent years. For example, imports from China to Turkmenistan increased by 55 percent a year during 2004–07, and similar growth rates are being observed in Uzbekistan. Trade with China is expected to increase further in the coming years, in part helped by infrastructure projects that better link CCA countries and China. For example, a gas pipeline from Turkmenistan to China with a capacity of 30 billion cubic meters is expected to be completed by 2012, while China is investing in Uzbekistan’s hydrocarbon sector, with FDI worth $270 million being planned for 2009. Kazakhstan has also recently announced a $10 billion loan deal with China.

Weaker commodity markets: Good for some, not for others

Hydrocarbon exporters are, so far, mostly weathering declining prices reasonably well. Current account and fiscal surpluses are disappearing quickly as oil and gas revenues fall. Outside of Kazakhstan, however, current account balances are expected to remain in surplus in 2009 and 2010. Turkmenistan and Uzbekistan are seeing less of an effect on the external side as contracted gas prices have been increasing. Uzbekistan has also benefited from increasing gold prices. On the fiscal side, revenues are dropping as commodity prices decline, but all the hydrocarbon exporters have accumulated buffers during the boom years—partly in SWFs—on which they can now draw to provide fiscal stimulus and thus support nonhydrocarbon GDP growth (Figure 19). Nevertheless, the large deterioration in the terms of trade is negatively affecting domestic demand, and the fiscal stimulus envisaged will only partly cushion the extent of the downturn, most notably in Kazakhstan, where the impact of the global financial crisis is particularly severe.

Figure 19.CCA: Government Fiscal Balance

(In percent of GDP)

Sources: Data provided by country authorities; and IMF staff estimates and projections.

Hydrocarbon importers are benefiting from lower import prices, but this is not necessarily translating into better economic outcomes. The positive oil price effect on the current account is offset by falling remittances and exports, partly on account of declining commodity export prices (Armenia: copper; Georgia: ferroalloys and copper; Tajikistan: cotton and aluminum). Only in the Kyrgyz Republic, where gold is the main commodity exported, have export prices held up. As a result, current account deficits remain large and even increased in 2008 for the hydrocarbon importers (Figure 20). Food prices have come down from their 2008 peak, but remain above the levels seen earlier in this decade. As such, there is little relief to low-income households. Moreover, the decline in international prices is being offset by regional currencies depreciating against the U.S. dollar. As a result, headline inflation is expected to stabilize around current, still-elevated levels, or even increase in some cases (Figure 21).

Box 5.How Russia Affects the Neighborhood: Trade, Financial, and Remittance Channels

Although direct trade links with Russia have weakened in recent years, the current slump in the Russian economy will negatively affect growth in the CCA countries largely through financial and remittance channels.

The 1998 Russian crisis is said to have “de-linked” the CCA countries’ dependence on Russia. Indeed, trade data show that the declining trend in share of exports to Russia in CCA country exports, which had begun prior to 1998, accelerated further in the subsequent period (Figure B5.1). However, the recent boom in these countries at a time of high remittances and financial flows from Russia suggests otherwise.

A recent study by IMF staff tests the relationship between growth in the CCA countries and Russia, and explores trade, financial, and remittance channels.1 Estimation results show that after controlling for the impact of Europe, CCA countries continue to depend on Russia. But the links may have altered since the 1998 crisis, with financial and remittance channels playing a more important role.

CCA countries’ growth is positively associated with Russian GDP growth, but this is not explained by trade links (Figure B5.2). The growth spillover from Russia appears particularly large for Kazakhstan, the Kyrgyz Republic, and Georgia. Trade does not appear to be a channel, as Russian growth (weighted by the share of exports to Russia in total country exports) has little association with CCA growth.

The link with Russian prosperity appears to be explained by a strong and statistically significant association between proxies for financial flows from Russia and growth in CCA countries. As Russia accumulated vast oil-driven external savings earlier this decade, countries in this region appear to have benefited from the spillovers of these savings.

CCA countries’ growth is also strongly associated with remittances from Russia. The economic boom in Russia in the middle of the current decade appears to have strengthened its labor market links with the CCA. The resulting remittances were particularly large for Tajikistan and the Kyrgyz Republic, but also important for Georgia and Armenia. A slowdown in Russia will likely result in the return migration of CCA workers and add to unemployment pressures.

Figure B5.1.Share of Russia in CCA Countries’ Exports

(In percent)

Sources: Data provided by country authorities; and IMF staff estimates.

Figure B5.2.GDP growth

(In percent)

Sources: Data provided by country authorities; and IMF staff estimates.

Note: This box was prepared by Fahad Alturki and Nadeem Ilahi.1“How Russia Affects the Neighborhood: Trade Financial and Remittance Channels,” by Nadeem Ilahi, Fahad Alturki, and Jaime Espinosa, forthcoming IMF Working Paper. Owing to data limitations, Turkmenistan is excluded from the analysis.

Figure 20.CCA: Current Account Balance

(In percent of GDP)

Sources: Data provided by country authorities; and IMF staff estimates and projections.

Figure 21.Average Inflation, GDP-Weighted

(Annual percentage change)

Sources: Data provided by country authorities.

Global financial turmoil: Limited direct impact, bigger indirect effect

Banking systems in the CCA region are comparatively underdeveloped and have only limited direct linkages to global financial markets. As such, banks in most CCA countries have so far been relatively insulated from the global financial crisis. Kazakhstan is the exception. There, pressures in the non-oil private sector have increased, with banks in particular facing difficulties in meeting their external debt rollover needs. In 2009, about $10 billion out of a total of $40 billion in bank external debt is falling due. Azerbaijan, Georgia, and Tajikistan (for cotton financing) face more moderate external rollover needs (Figure 22). Countries in the region have also been affected by the drying up of trade credit and other credit lines. Most CCA countries are likely to see FDI decline substantially in 2009, in line with the global trend discussed in the April 2009 Global Financial Stability Report. Moreover, countries could also face private sector outflows as households and firms try to avoid the impact of depreciating local currencies by converting local currency into dollars.

Figure 22.Private External Debt, 2008

(In percent of GDP)

Sources: Data provided by country authorities; and IMF staff estimates.

Weaker capital inflows are affecting credit availability and growth. Across the CCA region, private sector credit growth is slowing dramatically, from the 2006 peak of 63 percent (Figure 23). In the past, episodes of slowing credit growth have been associated with a sharp drop in GDP growth and rising nonperforming loans (NPLs).3 This pattern is now showing in the region, with NPLs increasing since the second half of 2008 (although differences in methodologies mean that NPL levels should not be compared across countries, Figure 24). For now, capital adequacy ratios generally remain high, but capitalization may come under stress in some countries as the credit cycle evolves further (Figure 25). In Kazakhstan, significant problems in the banking sector are already evident. The government, through the Samruk-Kazyna Fund, took a majority stake in BTA, the largest bank, in early February following difficulties at the institution. Two banks—BTA and Alliance—have announced that they will stop making debt repayments while they negotiate with their creditors.

Figure 23.Credit Growth

(In percent)

Sources: Data provided by country authorities.

Figure 24.Nonperforming Loans

(In percent of total loans)

Sources: Data provided by country authorities.

Figure 25.Capital Adequacy Ratios

(In percent)

Source: Data provided by country authorities.

Regional financial spillovers will also take hold. Stress in the banking system in Kazakhstan will have repercussions for the Kyrgyz banking system, which is one-third owned by Kazakhstan banks. In addition, besides Russia, Kazakhstan is another destination for migrant workers from the region and the growth slowdown in Kazakhstan will contribute to the decline in remittance inflows in other CCA countries.

Risks to the outlook are on the downside

Risks to the outlook are largely on the downside and closely linked to the global economy. A continued deterioration in world growth—particularly in Russia, but also in China—or another drop in commodity prices would further reduce growth in the region. Likewise, renewed stresses in global financial markets would affect countries such as Kazakhstan. A more modest than expected global recovery in 2010 would also delay the expected rebound in the region. Even in countries not directly exposed to global financial markets, financial sector vulnerabilities are a key downside risk. In this regard, a sharp drop in real estate prices would undermine bank balance sheets in countries where real estate is widely used as collateral, and where past valuations were close to market prices (Figure 26).

Figure 26.Existing House Prices

(12-month percentage growth)

Source: Data provided by country authorities.

How should the authorities respond to the ongoing regional slowdown?

CCA countries have responded to the impact of the global crisis in a proactive way, but stepped-up policy efforts will be needed as the slowdown deepens. Most countries have already implemented fiscal stimulus, eased monetary policy, and allowed their exchange rate to depreciate (Table 8). On the financial sector side, the policy response has been more mixed, and so far largely determined by the timing and size of emerging vulnerabilities. Four countries (Armenia, Georgia, the Kyrgyz Republic, and Tajikistan) have IMF programs that are providing financing to help them cope with the current difficult economic situation.

Table 8.The Caucasus and Central Asia: Summary of Crisis Response Measures
CountryFiscal stimulusExchange rate depreciationMonetary easingLiquidity supportIncreased provisioningCapital injectionsDeposit guarantees
Kyrgyz Republic
Source: Data provided by country authorities.
Source: Data provided by country authorities.

Action is needed to identify financial sector risks at an early stage and put in place appropriate measures to manage vulnerabilities. While generally high capital adequacy ratios provide some comfort, these can be eroded quickly. In particular, countries need to step up supervision, ensure that banks are provisioning adequately for a deterioration of asset quality on their balance sheets, assess the impact of downside scenarios on banks, and (where needed) tighten prudential requirements. Countries should also ensure that their deposit insurance systems are well designed, that the central bank can provide liquidity to illiquid but solvent banks, that mechanisms exist for the government to effectively and quickly intervene in troubled institutions, and that they have contingency plans in place on how to deal with financial sector stress. A number of countries have made significant strides in these areas, but others have not. Kazakhstan is currently implementing a wide-ranging “anti-crisis” plan that is providing capital and liquidity support to the banks, has substantially increased the coverage of deposit insurance, and has established an asset management company to buy distressed assets from the banks. Azerbaijan and Georgia have also taken significant steps to strengthen their banking systems in recent months, while Uzbekistan has injected capital into banks and extended the coverage of deposit insurance. For countries that have yet to develop contingency plans on how they would handle problems in the financial sector, this is a priority.

Central banks in the region face a difficult dilemma on exchange rate policy. On the one hand, balance sheets in CCA countries are highly dollarized, and exchange rate depreciation would weaken balance sheets and adversely affect growth (Figure 27). On the other hand, CCA countries are losing competitiveness on account of the Russian ruble depreciation. Thus, exchange rate adjustment is likely to be needed and countries are generally moving in this direction (Box 6). Nonetheless, policies can differ across countries depending on the extent of international reserve buffers and on how governments weigh competitiveness concerns and financial sector stability issues.

Figure 27.Foreign Exchange Share of Loans and Deposits, End-2008

(In percent)

Source: IMF, Global Financial Stability Report, April 2009.

Monetary policy needs to strike the right balance between providing liquidity to the domestic financial system and ensuring that domestic currency assets remain attractive. The drying up of external financing and rising NPLs are contributing to liquidity shortages in many countries, and central banks have appropriately responded by providing liquidity to banks through a combination of reductions in reserve requirements (Azerbaijan, Georgia, Kazakhstan) and short-term liquidity operations (Armenia, Azerbaijan, Georgia, Kazakhstan, Tajikistan). These operations of course need to be carefully managed as there is a risk that such injections could lead to increased demand for foreign exchange, thus further contributing to pressures on the exchange rate.

Fiscal stimulus is desirable in the current environment, although for some countries increased donor financing is needed to achieve this. Almost all countries are seeing a drop in revenues as growth slows and export prices decline, and are appropriately accommodating this by allowing the fiscal balance to deteriorate (Figure 28). Debt levels are comparatively low, and the projected fiscal position in 2009 looks manageable (Figure 29). There should therefore be some room in most countries for a discretionary fiscal stimulus to bolster demand, with spending focused on protecting the poor, supporting returning migrants, and developing infrastructure where needed. In commodity exporters, governments are appropriately using their large fiscal reserves to finance such increases in spending. For other countries, there is a more limited ability to fund such policies. Where additional donor financing is not forthcoming, fiscal adjustment may be necessary to support external stability. In some cases, this may also imply reductions in social- and poverty-related spending at a time when needs are rising.

Box 6.Exchange Rate Policies: Coping with New Challenges in Caucasus and Central Asia Countries

Following a trend of real appreciation, CCA currencies have recently come under pressure. Policymakers initially resisted exchange rate adjustment, but by March 2009 most CCA countries had implemented one-step devaluations. Some are moving to greater exchange rate flexibility.

After years of strong inflows, all major sources of foreign exchange supply have dried up. Hydrocarbon exports have suffered from price reductions (Azerbaijan, Kazakhstan), remittances from the slowdown in the remitter country economies (Armenia, Georgia, the Kyrgyz Republic, Tajikistan), and capital inflows from the global recession (Georgia, Kazakhstan). Declining imports have reduced foreign exchange demand, but this has been more than offset by the conversion of deposits and cash to foreign currency, reflecting mounting expectations of a depreciation of the local currency.

Decreased foreign exchange inflows and the adverse impact on competitiveness of real appreciations suggest the need for nominal exchange rate adjustments. Regional currencies have appreciated particularly sharply against that of Russia, a key trading partner for the region (Figure B6.1). Policymakers are, however, understandably concerned about the adverse effect of depreciation on heavily dollarized bank, corporate, and household balance sheets. Exchange rate decisions therefore depend on the relative benefits of exchange rate depreciation in terms of increased competitiveness, weighed against the potential costs of adverse balance sheet effects. The response to exchange rate pressures also hinges critically on the expected duration of the current slumps in global growth and export prices, and on countries’ initial reserve levels.

The policy response to exchange rate pressures has in most cases involved depreciation, either through a step devaluation or a gradual adjustment (Figure B6.2). Kazakhstan, after maintaining a stable exchange rate for an extended period, devalued in February 2009 as reserve losses mounted (even though the country still has sizable reserves). Armenia, Georgia, and the Kyrgyz Republic, which experienced strong depreciation pressures and had more limited reserve buffers, also adjusted their exchange rates (the Kyrgyz Republic via a gradual depreciation). Uzbekistan continued with the crawling peg devaluations at a broadly unchanged pace. Supporting monetary and fiscal policies and measures to contain the impact of depreciation on dollarized balance sheets are needed to manage these depreciations. On the other hand, Azerbaijan, Turkmenistan, and Uzbekistan have ample reserves; have been subject to only limited exchange rate pressures; and have chosen to maintain broad exchange rate stability. Going forward, countries in the region should address remaining structural weaknesses to reduce external vulnerabilities, including by improving monetary frameworks, developing credible alternative monetary anchors, strengthening financial infrastructures, and fostering financial deepening.

Figure B6.1.Exchange Rate Developments

(Exchange rate change: end-June 2008–March 2009, in percent)

Sources: Data provided by country authorities; DataStream; and IMF staff estimates.

Figure B6.2.Gross International Reserves

Sources: Data provided by country authorities; DataStream; and IMF staff estimates.

1March 2009 gross international reserves include SBA purchases of $249 million (Armenia) and $250 million (Georgia).

Note: This box was prepared by Aidyn Bibolov and Holger Floerkemeier.

Figure 28.CCA: Government Fiscal Balance

(In percent of GDP)

Sources: Data provided by country authorities; and IMF staff estimates and projections.

Figure 29.Sovereign Wealth Fund Assets and Public Debt, 2008

(In percent of GDP)

Sources: Data provided by country authorities.

Note: This chapter was prepared by Tim Callen and Axel Schimmelpfennig, with research support from Jaime Espinosa.


See E. Mendoza and M. Terrones, 2008, “An Anatomy of Credit Booms: Evidence from Macro Aggregates and Micro Data” IMF Working Paper 08/226.

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