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3. Caucasus and Central Asia: Reforms Needed to Weather Shocks from Commodity Prices and Russia

International Monetary Fund. Middle East and Central Asia Dept.
Published Date:
October 2015
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A wave of large external shocks, particularly lower commodity prices and the slowdown in Russia, has weakened growth prospects and raised vulnerabilities in the region. Increases in public spending have helped soften the immediate impact on economic activity, but fiscal consolidation remains a priority for the medium term. Exchange rate depreciations have supported competitiveness and helped preserve fiscal space, but they have also increased pressure on inflation and created challenges for the heavily dollarized financial sectors. Greater exchange rate flexibility will help protect external buffers, but needs to be accompanied by strengthened supervision to safeguard financial stability. Accelerating the pace of structural reforms remains key to improving the medium-term outlook for economic growth and job creation.

Economies Hit by External Shocks

Since late 2014 the CCA region has been hit by a series of adverse external shocks—a sharp drop in commodity prices, particularly for oil and metals, a significant slowdown in major trading partners, especially Russia, and a loss in competitiveness (owing to an increase in the value of the U.S. dollar, against which many countries manage their currencies, and a decline in the value of the Russian ruble). These shocks are expected to be persistent, unwinding only partially in the coming years and presenting policymakers with difficult choices.

Economic activity has slowed in response to these shocks, given the region’s heavy reliance on commodity exports, its close trade and remittance linkages with Russia, and increased intraregional trade links between CCA oil exporters and importers. This year, growth is expected to reach only 3¾ percent, one of the lowest rates since independence, and 1½ percentage points lower than in 2014 (Figure 3.1). Stronger growth in Russia, Europe, and regional trading partners is expected to provide greater support to external demand and push growth to about 4 percent in 2016. However, medium-term growth projections are well below growth rates from 2000–07 (Figure 3.1). The slowdown in medium-term growth reflects a decline in productivity growth, inadequate physical infrastructure investment, overreliance on commodities whose prices have fallen, and a weakened outlook for Russia and, to a lesser extent, China and Europe (Mitra and others forthcoming).

Figure 3.1CCA Growth Rates

(Percent change)

Sources: National authorities; and IMF staff estimates.

For CCA oil exporters, growth is projected at 3¾ percent for 2015, down from nearly 5½ percent in the previous year, despite a sizable fiscal stimulus in some countries (3 percent of GDP in Kazakhstan and 1 percent of GDP in Uzbekistan). Slower growth in oil production (Azerbaijan, Kazakhstan), fewer remittances from Russia (Uzbekistan), and less public investment (Turkmenistan), as well as weaker confidence resulting from currency depreciations, have contributed to the slowdown. Growth is expected to pick up in 2016 to 4 percent, as growth strengthens in important trading partners, such as Russia and the euro area, and as domestic confidence improves (Figure 3.2).

Figure 3.2Trade Partner Growth Rates

(Percent change, weighted by export share)

Sources: National authorities; and IMF staff estimates.

Note: CIS = Commonwealth of Independent States.

For CCA oil importers, growth is expected to slow to 2¼ percent in 2015 from 4¾ percent in 2014, despite a sharp increase in real fiscal expenditure in the Kyrgyz Republic and Armenia. The oil importers have strong economic links with Russia through trade, investment, and, particularly, remittances. Consequently, the contraction in Russia of 3¾ percent in 2015 has had a strong impact on these economies. Lower prices of aluminum, cotton (Tajikistan), and copper (Armenia), and lower gold production (Kyrgyz Republic), together with tighter monetary policy to mitigate inflation and exchange rate pressures, have also weighed on economic activity in 2015. Growth is expected to recover partially to 3 percent in 2016, as external demand from Russia, and from within the region, recovers (Figure 3.2).

Risks Tilted to the Downside

Downside risks related to a possible further deterioration in the external environment are on the rise. A further decline in oil prices would adversely affect not only oil exporters but oil importers as well, because of lower imports and remittances from Russia, an oil exporter whose currency has been following oil price movements in recent months. Links with China have become increasingly important (Box 3.1; see Figure 1.4 in Chapter 1); hence, a sharper-than-expected slowdown in China could weaken demand for CCA exports (particularly gas and other commodities from Armenia, Kazakhstan, Turkmenistan, and Uzbekistan) and reduce foreign direct investment (FDI). In addition, China’s slowdown could put further downward pressure on global commodity prices (especially oil and metals), given its large share of global commodity consumption. This would hurt exporters of these commodities, including in the CCA region. Commodity importers will also be affected through their linkages with Russia and CCA commodity exporters.

Another downside risk is that the normalization of U.S. monetary policy would raise borrowing costs for countries with access to international markets (Armenia, Azerbaijan, Georgia, Kazakhstan) by more than is currently expected. A further strengthening of the U.S. dollar, reflecting asymmetric monetary policy in major advanced economies, together with a weakening of emerging market currencies, could put CCA currencies under pressure, adversely affecting intermediation through the CCA countries’ highly dollarized financial systems. Upside risks include a stronger recovery in Russia, faster-than-expected growth in China and Europe, and a larger-than-expected improvement in commodity prices.

Exchange Rates under Pressure

Many CCA countries tightly manage their currencies against the U.S. dollar, either as outright pegged arrangements (Azerbaijan, Turkmenistan), within narrow ranges (Armenia, Tajikistan), or using a predetermined path (Uzbekistan). Prior to moving to a floating exchange rate regime in August 2015, Kazakhstan also tightly managed its currency within a narrow band.

Appreciation of the U.S. dollar and the sharp drop in the value of the Russian ruble, together with declining foreign currency inflows (remittances, FDI, exports), created pressure on the CCA currencies to adjust.1 Many CCA countries intervened in the foreign exchange market and, consequently, suffered losses in international reserves.

Box 3.1Strengthening Linkages between China and the CCA

The rising role of China in the CCA region provides an opportunity for enhancing growth, employment, and diversification. It also poses policy challenges, namely rapidly rising external debt obligations to China, which need supportive policies to ensure the region’s debt remains sustainable.

Trade and financial links between China and the CCA region have strengthened over the past decade and are expected to continue to expand in the coming years (Figures 3.1.1 and 3.1.2).

  • Trade between China and the CCA region grew almost tenfold in the past decade, to $48 billion at end-2014 from only $5 billion in 2005.1 China is the main trading partner for the Kyrgyz Republic, Tajikistan, and Turkmenistan, accounting for more than 25 percent of each country’s total trade. Exports to China are concentrated mostly in oil and gas, minerals, and metals, while imports consist mostly of manufactured goods.
  • Chinese official lending to the CCA region also soared, from $262 million in 2007 to $4,435 million in 2014.2 External debt obligations to China are rapidly rising, particularly in the Kyrgyz Republic, Tajikistan, and Turkmenistan. Cross-border bank exposures are low and exist in only two countries (Georgia, Kazakhstan), while other linkages, such as currency swaps and budget support, are sporadic.
  • Chinese foreign direct investment has also increased rapidly in recent years, reaching $5,555 million in 2012.3 Over the next three to five years, China is expected to invest an additional $30–$35 billion in the CCA, mainly in infrastructure and mining.

Figure 3.1.1CC’s Trade with China

(Percent total trade, 2014)

Sources: IMF, Direction of Trade Statistics database; and IMF staff estemates.

Note: Country abbrevations are International Organization for standardization (ISO) country codes.

1Data from TKM authorities.

Figure 3.1.2China’s Linkages with the CCA

Sources: IMF, Coordinated Direct Investment Survey (CDIS), Direction of Trade Statistics (DOTS), World Economic Outlook databases; national authorities; UN Conference on Trade and Development (UNCTAD); and IMF staff estimates.

Note: FDI = foreign direct investment; PPG = public and publicly guaranteed.

1DOTS data, referring to 2014.

2CDIS data, where available. UNCTAD data were used for Tajikistan and Uzbekistan. Data refer to 2013 (the latest available year), except for Georgia (2011), and Tajikistan and Uzbekistan (2012).

3UNCTAD data, where available. National sources were used for Tajikistan and Uzbekistan. Data refer to 2012 (the latest year available). FDI inflows are measured on gross basis.

4National authorities’ data on total external PPG debt and external PPG by creditor in 2014.

5National authorities’ data.

China’s economic interests in the region include accessing natural resources, building infrastructure to support resource extraction and other economic activity, and establishing new routes to European markets. To realize this vision, China launched the One Belt One Road initiative in 2013, involving 58 countries in South, East, and West Asia, as well as in Eastern Europe, Southern and Western Europe, and East Africa.4 The aim is to create the Silk Road Economic Belt connecting countries in the region, South Asia, Southeast Asia, the Middle East, and Europe in a transport-linked corridor via land roads, in tandem with the 21st Century Maritime Silk Route, which will connect China to Europe via sea routes through Asia (Figure 3.1.3). These initiatives will be supported by the $40 billion Silk Road Development Fund and the $100 billion Asian Infrastructure Investment Bank (AIIB).5 China’s involvement is expected to expand the region’s economic prospects, particularly through access to large loans for infrastructure. This will enhance the scope for addressing infrastructure gaps and economic diversification.

Figure 3.1.3China’s One Belt One Road Initiative and Future Investment Commitments

Sources: Fung Business Intelligence Centre; and IMF staff estimates.

To maximize the growth and employment effects of Chinese investment and trade, and to ensure external debt sustainability, supportive policies need to be put in place. Implementing a prudent debt management strategy and subjecting investment projects to rigorous appraisal would strengthen the capacity to manage the rapidly growing external debt. Streamlining tax incentives and strengthening the business climate would also help level the playing field for domestic and foreign investors.

Prepared by Eddy Gemayel and Ritu Basu.1 Direction of Trade Statistics (DOTS), IMF.2 This excludes Azerbaijan for which information is not available.3 This aggregate includes Georgia (with data referring to 2011), while data for Turkmenistan are not available.4 This includes all CCA countries: Armenia, Azerbaijan, Georgia, Kazakhstan, Kyrgyz Republic, Tajikistan, Turkmenistan, and Uzbekistan. Several MENAP countries are also members including Afghanistan, Bahrain, Egypt, Iran, Iraq, Jordan, Lebanon, Kuwait, Oman, Pakistan, Qatar, Syria, Saudi Arabia, and Yemen. Source: Fung Business Intelligence Centre (2015).5 Of the 57 member countries of the AIIB, five are from the CCA region (Azerbaijan, Kazakhstan, Kyrgyz Republic, Tajikistan, and Uzbekistan).

Between November 2014 and August 2015, all the CCA currencies weakened against the U.S. dollar (Figure 3.3). This in turn helped to moderate the sharp appreciation of real effective exchange rates (that is, the strengthening of their currencies against those of their trading partners in inflation-adjusted terms) at the end of 2014 (Figure 3.3).

Figure 3.3CCA Exchange Rates

Sources: National authorities; and IMF staff calculations.

Note: An appreciation is a positive movement. Country abbreviations are International Organization for Standardization (ISO) country codes.

Pressure to adjust the exchange rate persists in some countries. For example, in Uzbekistan the difference between the official and parallel market rate has increased substantially since the beginning of the year. Greater exchange rate flexibility, accompanied by clear communication to anchor market expectations, would help CCA economies adjust to external shocks and improve their competitiveness.2 However, policymakers also need to consider the impact of the exchange rate on their financial sector and take measures to ensure its health, especially given the sector’s substantial foreign currency lending to unhedged borrowers and short open foreign exchange positions (Box 3.2).

Fiscal Policy: Supporting Near-Term Growth, Rebuilding Buffers, and Keeping Debt Sustainable

Countercyclical fiscal policies have helped many CCA countries mitigate the slowdown in economic activity in 2015. Fiscal deficits were allowed to rise in most of them, as overall expenditure (particularly from public investment) increased or held steady, while revenue contracted from lower oil prices in oil exporters and weaker economic activity across the region (Figure 3.4). Azerbaijan and Turkmenistan are exceptions, with projected declines in public spending in 2015, as these countries have already started to consolidate their non-oil fiscal positions in response to lower oil prices. Revenue gains from exchange rate adjustments also helped these countries, along with Kazakhstan, to reduce the necessary fiscal adjustment (see Figure 4.10 in Chapter 4).3

Figure 3.4CCA’s Overall Fiscal Balance

(Percent of GDP)

Sources: National authorities; and IMF staff calculations.

1In percent of non-oil GDP.

Box 3.2Balancing Macroeconomic and Financial Stability Objectives in CCA Countries

Faced with a weakening economic environment and rising financial risks, CCA countries need to reconcile three competing policy objectives: supporting growth, reining in domestic and external imbalances, and ensuring that the financial sector remains stable and intermediates effectively between savers and investors. The external shocks are affecting banking system stability through an adverse impact on the economy. Therefore, reducing economic imbalances would support banking system stability.

Increased exchange rate flexibility can play an important role in improving competitiveness, reducing trade and fiscal imbalances, preserving reserves, and promoting growth. It may, however, erode the debt-servicing capacity of unhedged foreign currency borrowers and destabilize dollarized banking systems. Several dynamics are at play, illustrating the challenges of resolving policy trade-offs at the present juncture:

  • Expectations of currency depreciation have increased deposit dollarization, which is increasing short open foreign exchange positions and the risk of revaluation losses, thereby weakening banks’ capital and domestic liquidity.
  • Currency depreciation also erodes capital adequacy buffers for banks that have capital in local currency and risk-weighted assets in dollars. It also increases the debt burden of households and corporations that borrowed in dollars.
  • Protecting the exchange rate by selling official reserves would reduce external buffers, potentially undermining confidence and increasing the risk of a disorderly exchange rate adjustment.
  • Exchange rate pass-through to inflation is high because of countries’ high dependence on imports, but tighter monetary policy to dampen inflationary pressures and provide support to the exchange rate may also exacerbate the already tight liquidity conditions in banks.
  • Higher interest rates to dampen inflation pressures raise the debt service burden of borrowers with flexible-rate foreign currency loans, at a time when their loan burdens have already increased with the devaluation, while the weak interest rate transmission mechanism hampers their effectiveness for subduing inflation.
  • Rising risks to financial stability and weakening aggregate demand are curtailing private sector credit growth, which may further weaken banks’ balance sheets.

The external shocks that have hit the region are expected to persist, requiring a real effective exchange rate adjustment, of which the nominal depreciation is an important part. With high dollarization and low growth limiting the extent to which exchange rates can depreciate before financial system stability is threatened, near-term policies need to focus on measures to strengthen banks’ resilience to macro shocks. These include:

  • Risk monitoring of credit, concentration, exchange rate, and liquidity risks (silent deposit runs and systemic liquidity risks) through improved reporting and disclosure rules for banks and borrowers’ foreign exchange (FX) open positions, and stress testing.
  • Strengthening banking supervision, particularly oversight of banks’ risk management practices and risk pricing of FX risks, as well as reducing directed lending.
  • Prudential measures, including minimum capital and provisioning requirements to cover solvency risks arising from borrowers’ currency mismatches, and liquidity requirements in foreign currency to reduce liquidity risks.
  • Reducing leverage among borrowers through limits on debt-to-income ratios, loan-to-value ratios on mortgages, and capital surcharges on lending to unhedged borrowers.
  • In dollarized banking systems, matched FX positions do not protect banks from losses. A prudential approach designed to protect capital-asset ratios should be considered.

Medium- to long-term policy objectives should include addressing the root causes of dollarization. This can be achieved through the development of financial markets that provide alternative investment opportunities in local currencies and the development of hedging instruments (Ben Naceur, Hosny, and Hadjian 2015). These measures need to be supported by sound macroeconomic and financial policies to engender confidence in the domestic currency.

Prepared by Inutu Lukonga and Saad Quayyum.

Fiscal policies need to ensure that near-term accommodation is sustainable in the medium term. With external conditions expected to improve in 2016, mainly as growth in Russia and Europe starts to recover, most CCA countries are expected to return to a path of fiscal consolidation.

With oil prices expected to remain low during the coming years, concrete plans for medium-term fiscal consolidation are therefore imperative so that oil exporters can rebuild buffers and ensure intergenerational equity. Figure 3.5 shows the fiscal breakeven prices of two of the three oil exporters to be higher than the $52 projected for this year, suggesting they cannot balance their budgets if oil prices remain low.

Figure 3.5Fiscal Breakeven Oil Prices in the CCA

(U. S. dollars per barrel)

Sources: National authorities; and IMF staff estimates.

Note: WEO = IMF, World Economic Outlook database.

In the oil importers, improving the quality of public expenditure and consolidating the fiscal balance in the medium term, while preserving capital and social expenditure, will help to ensure that debt remains sustainable and, at the same time, safeguard growth and make it more inclusive. On average, public debt in the oil importers is projected to increase by about 7 percentage points of GDP from the previous year to above 45 percent of GDP, reaching nearly 60 percent in the Kyrgyz Republic and approaching 50 percent in Armenia.

Monetary Policy Faces Complex Trade-offs

Exchange rate depreciations are set to raise inflation in most countries in 2015, despite weakening demand and low global food prices. Inflation in the CCA is expected to edge up to 6¼ percent in 2015 from 5¾ percent in 2014, reaching double digits in Tajikistan. In 2016, inflation is projected to increase in Kazakhstan, the Kyrgyz Republic, and Georgia, in part from the exchange rate depreciations, while it is expected to moderate in all others mostly because of benign food and fuel prices and weak domestic demand.

Monetary policy in the CCA region faces complex trade-offs: inflation is picking up while economic activity remains weak and the highly dollarized financial sectors in many countries are under duress. Tighter monetary policy can help anchor inflation expectations, but excess tightening may weaken financial intermediation and inhibit economic activity. Monetary policy needs to be tightened in countries where inflation pressures are high (Tajikistan, Uzbekistan). In Georgia, inflation has risen and the central bank, consistent with its inflation-targeting regime, has increased its policy rate five times this year to reach 7 percent by end-September, from 4 percent in December 2014. In Armenia, where these trade-offs are particularly acute, and monetary conditions are tighter than they were a year ago, the pace of normalization should be tied to inflation prospects.

External Vulnerabilities Have Risen

External positions in the CCA region are projected to weaken sharply in 2015, mainly because of lower oil and metal prices, a sharp drop in remittances from Russia, and a loss of competitiveness of local goods against Russian goods due to a much weaker ruble. The current account balance in the CCA oil exporters is expected to turn from a surplus of 3¼ percent of GDP in 2014 to a deficit of 2¾ percent in 2015, reflecting large oil export revenue losses (Figure 3.6). Exports are projected to decline further in 2016 driven by lower oil receipts, pushing the current account deficit to 3¼ percent of GDP.

Figure 3.6CCA’s Current Account Decomposition

(Percent of GDP)

Sources: National authorities; and IMF staff estimates.

1Excludes employee compensation.

The current account deficit in the CCA oil importers is expected to remain high at about 10 percent of GDP in 2015. Weaker exports and a large drop in the dollar value of remittances—in part the effect of the weakening Russian ruble—are expected to offset gains from lower 011 prices and slowing import growth. Given the dependency on Russia’s economic prospects, remittance flows are expected to recover only gradually. The current account deficit is expected to improve modestly in 2016, but remain above 9 percent of GDP. External debt is projected to increase to 74 percent of GDP in 2015 from 63 percent of GDP last year, owing to exchange rate depreciations and increased public financing needs. Reserves are expected to remain at about one month of imports in Tajikistan but above three months of imports in other oil importers.

Spillovers from the Economy to the Financial Sector

Currency depreciations, declining remittances, and the economic slowdown are putting the financial sector in the CCA under strain. The effect of these shocks has been amplified by significant preexisting vulnerabilities: dollarized bank balance sheets, short open foreign exchange positions, lending to unhedged borrowers, directed lending, and concentrations in loan portfolios. These vulnerabilities imply that capital buffers may overstate the ability of banks to absorb shocks.

The balance sheets of banks, households, and corporations have already started to weaken, as revaluation losses and credit and liquidity risks have risen. Bank profitability and capital adequacy have declined, and nonperforming loans have edged upward (Armenia, Azerbaijan, Tajikistan—see Figure 6.3 in Chapter 6).4 Financial conditions have tightened (especially in Kazakhstan and Armenia). Rising balance sheet risks have increased risk aversion among banks, which, combined with declining aggregate demand, is curtailing private sector credit growth. Despite low financial depth and a weak link between credit and economic growth in the CCA, anemic credit growth is triggering feedback effects on economic activity and could affect asset prices, further weakening banks’ balance sheets.

To safeguard financial systems, policies should be geared toward enhancing surveillance of emerging macro-financial risks and strengthening supervision and macroprudential policies, as well as crisis management frameworks that can ensure orderly resolution in case of bank distress. Steps also need to be taken to reduce directed lending (particularly in Tajikistan and Turkmenistan), enforce prudential regulations related to large exposures and other loan concentrations, and address the causes of dollarization. Policymakers also need to carefully balance the trade-offs between macroeconomic and financial stability objectives (Box 3.2; see also Chapter 6).

Improving Medium-Term Prospects and Creating Jobs

Developing the private sector beyond the extractive industries and making growth more inclusive will help the CCA region reduce its reliance on commodities and remittances. The region has been lagging behind other emerging markets and developing countries in the quality of education, financial development, and export diversity, while control of corruption and the business environment are also weak in many countries (Figure 3.7). Addressing these shortcomings together with infrastructure bottlenecks, and pursuing market-based restructuring of state-owned enterprises, would help boost medium-term growth prospects, and create employment opportunities for returning migrants and new entrants to the labor market.

Figure 3.7Structural Reforms Needed in the CCA

(Global percent rank)

Sources: IMF World Economic Outlook database; IMF/DFID, Export Diversity Index; World Economic Forum, Global Competitiveness Report; World Bank, Doing Business Indicators; and World Bank, Worldwide Governance Indicators.

Productivity growth can be further enhanced by adopting more modern production methods through greater integration with global value chains (Mitra and others forthcoming). The CCA region can unleash its significant economic potential, provided it adjusts its policies to the “new normal” that is emerging from what are likely to be lasting external shocks.

CCA: Selected Economic Indicators
Real GDP Growth8.
(Annual change; percent)
Kyrgyz Republic4.3−0.910.
Consumer Price Inflation9.
(Year average; percent)
Kyrgyz Republic9.
General Government Overall Fiscal Balance2.−3.5−1.5
(Percent of GDP)
Kyrgyz Republic−3.1−4.7−5.1−3.9−5.9−6.7
Current Account Balance1.−3.4−3.8
(Percent of GDP)
Kyrgyz Republic−3.5−15.6−15.0−16.8−17.7−15.7
Sources: National authorities; and IMF staff estimates and projections.

Central government.

State government.

Sources: National authorities; and IMF staff estimates and projections.

Central government.

State government.

Prepared by Saad Quayyum with input from Inutu Lukonga and research assistance from Mark Fischer.


Between August 2014 and 2015, the U.S. dollar appreciated by 16 percent in nominal effective terms, and the Russian ruble depreciated by 45 percent against the U.S. dollar.


Measures to increase exchange rate flexibility include limiting exchange rate intervention in Armenia, the Kyrgyz Republic, and Tajikistan, introducing a band around the central parity or a currency basket in Turkmenistan, and increasing the pace of depreciation in Uzbekistan.


As fiscal revenue from oil exports is earned in U.S. dollars, exchange rate depreciation increases its value in local currency.


In Azerbaijan, disclosed nonperforming loans are underestimated as they include only the overdue portion of principal and interest.

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