Samarkand, Uzbekistan: A women is sitting behind her fruit stand selling figs, a kind of tropical fruit in Siob Bazaar (photo: Tarzan/iStock by Getty Images)

Samarkand, Uzbekistan: A women is sitting behind her fruit stand selling figs, a kind of tropical fruit in Siob Bazaar (photo: Tarzan/iStock by Getty Images)

Navigating Fiscal Policy in Uncharted Waters: What's Next for the CCA region?

July 9, 2018

Following severe external shocks in 2014, countries in the Caucasus and Central Asia (CCA) implemented fiscal measures to reinvigorate their economies, which led to rising public debt and growing fiscal risk. In a new study, IMF staff assess policy options for the region moving forward, arguing that a more ambitious plan to balance the budget should be pursued, all the while focusing on policies that both spur economic growth and safeguard social spending.

Five years ago, the CCA region’s economic prospects were quite favorable. Buoyed by high commodity prices and rising remittances, growth was among the fastest in the world. Inflation was in line with central banks’ target ranges, and both external and fiscal positions were comfortable. In 2014–15, several adverse external shocks hit the region, notably a persistent slump in commodity prices, an abrupt decline in remittances, and lower import demand by key trading partners, especially China and Russia. This strong economic cocktail resulted in a sharp decline in growth and weakening current account balances (Figure 1)—two important indicators of an economy’s health.

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In response to the shocks, CCA countries implemented countercyclical fiscal policies to contain the impact on growth. In other words, during this downturn, they increased spending and cut taxes, among other measures, to boost growth. These policies, while appropriate in the short term, significantly eroded rainy-day funds and left countries vulnerable to further shocks. Governments now face the challenge of restoring fiscal sustainability over the medium term by enacting measures that reduce debt and deficits while also ensuring higher, sustainable and inclusive growth. This requires decisions on the size, pace, and composition of fiscal adjustment, or the process by which governments can best reduce their budget deficits:

  • Hydrocarbon-exporting countries need to decide whether to build up additional net financial assets – the difference between financial assets and gross debt – to ensure adequate savings for their citizens today and into the future. At a minimum, these countries need to stabilize net financial assets at present levels to ensure quality of life of future generations does not fall.
  • Hydrocarbon-importing countries need to decide not only on the pace of fiscal adjustment to ensure fiscal sustainability, but also on the scope of generating rainy-day funds to respond to future economic shocks.

Current medium-term fiscal plans suggest that hydrocarbon exporters and importers are aiming to stabilize their balance sheets over the coming years (Figure 2, blue dashed line). Given the recurrent nature of economic shocks and the risk of renewed headwinds, more ambitious medium-term fiscal targets would seem desirable (Figure 2, yellow solid line).

Oil-exporting countries in the region are at a low risk of debt distress given their natural resources and positive net assets. However, as previous episodes have shown, the rise in oil prices may prove temporary. Rebuilding net assets to pre-crisis levels would create greater room for counter-cyclical policies when needed, and would send a clear signal of fiscal responsibility to investors. For oil-importing countries, the rise in debt levels and a lack of rainy-day funds calls for more ambitious plans as well.

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Moving Forward

To support stronger, pro-growth fiscal policies, the new IMF study outlines the need for CCA countries to redouble their efforts in tax collection and productive, efficient public spending.

  • The tax system can play a key role in promoting growth. Smart policies can close loopholes, increase efficiency, reduce unnecessary exemptions and help broader efforts to lower debt. Particularly in oil exporting countries, tax collection has room to increase, but addressing tax policy and administrative bottlenecks are needed across the region.
  • Key priorities include broadening the tax base by reducing exemptions—for e.g. in agribusiness (Armenia, Kyrgyzstan) or Special Economic Zones (Azerbaijan, Kazakhstan). CCA countries need to simplify corporate and value-added taxes, and devise lower and fewer rates with less exemptions. In addition, higher net worth individuals need to be taxed more effectively. This will increase the efficiency and perceived fairness of the tax system, and would create a level playing field for all businesses and individuals. Finally, new laws and policies are not enough. Efforts should also be devoted to enforcing tax collection.
  • On the spending side, CCA countries need to reexamine non-priority spending, and hone in on policies that promote growth while, at the same time, safeguard social spending. This is a tough but critical balance to pursue. The study recommends governments focus on improving the salary structure of public servants through a comprehensive civil service reform, particularly in Uzbekistan and Kyrgyzstan. Another recommendation is to pursue energy subsidy reform in countries such as Turkmenistan by replacing generalized subsidies with targeted transfers to those in need. This would generate savings that could be used for productive investments and, more broadly, to support inclusive growth spending in areas such as education and health.

Finally, the study warns that policies aimed at tightening the fiscal belt—even if well designed and executed—could result in a significant slowdown. An ambitious reform agenda is needed to complement measures aimed at ensuring fiscal sustainability and building adequate buffers to deal with future shocks. In practice, this means strengthening the business climate, encouraging export diversification, enhancing competition, reforming labor markets and educational systems, and reducing red tape to increase efficiency, all the while strengthening social safety nets for the most vulnerable.

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