## Caucasus and Central Asia: Recovery Remains Fragile (cca0517)

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---

### Regional outlook and global drivers
- Global growth is projected to reach 3.5 percent in 2017 and 3.6 percent in 2018, up from 3.1 percent in 2016.
- Firmer growth in Russia and an upward revision to growth in China are key drivers for the CCA region through remittances, exports, investment, and trade links.
- Improved global outlook is consistent with somewhat higher commodity prices but implies higher interest rates, which could exacerbate debt vulnerabilities and tighten liquidity.
- Downside global risks:
  - potential inward shift toward protectionism;
  - faster-than-expected U.S. monetary policy normalization leading to tighter global financial conditions and further appreciation of the U.S. dollar.
- Oil market uncertainties: compliance with the OPEC+ agreement, production prospects of exempt/nonparticipating countries, and downside global growth risks.

### Regional growth prospects and drivers
- CCA growth:
  - 2.4 percent in 2016;
  - projected 3.1 percent in 2017;
  - projected 4.1 percent in 2018.
- CCA projected average growth: 4.3 percent in 2018–22, compared with 8.1 percent in 2000–14.
- Oil and gas exporters:
  - Growth slowed to 2.2 percent in 2016 (lowest since 1998).
  - Projected rebound to 3.1 percent in 2017 and 4.1 percent in 2018.
  - Country notes:
    - Azerbaijan—lower oil production and financial sector vulnerabilities;
    - Kazakhstan—supported by Kashagan output, fiscal stimulus, and expected bank credit resumption;
    - Turkmenistan and Uzbekistan—steady growth but Turkmenistan faces a large external deficit.
- Oil importers:
  - Growth of 3.3 percent in 2016 (lowest since the global financial crisis).
  - Projected 3.6 percent in 2017 and 3.9 percent in 2018.
  - Country notes:
    - Armenia—weak domestic demand and poor agricultural harvest;
    - Georgia—weak demand;
    - Kyrgyz Republic—stronger trade, construction, agriculture;
    - Tajikistan—investment-driven pickup.
- Main structural challenge: medium-term growth prospects remain relatively subdued; need to diversify away from commodities and reduce reliance on remittances.

### Fiscal developments and consolidation needs
- Overall fiscal balances deteriorated in 2016 in most countries; public expenditure increased in most countries.
- Consolidation expected mostly through reduced public investment; emphasis on preserving critical social expenditure and strengthening spending efficiency and project selection frameworks.
- Oil exporters (non-oil fiscal deficit):
  - Non-oil fiscal deficit amounted to 14.9 percent of non-oil GDP in 2016, an improvement of 3.6 percentage points relative to 2015.
  - Projected to increase to 20.6 percent of non-oil GDP in 2017 (due to one-time banking support in Kazakhstan and an extraordinary transfer from the Oil Fund to the Central Bank of Azerbaijan).
  - Projected to decline to 13.5 percent in 2018 as Azerbaijan reduces nonproductive public investment and Kazakhstan’s fiscal stimulus expires.
- Oil importers (overall fiscal deficit):
  - Overall fiscal deficit rose to 4.6 percent of GDP in 2016, 1.5 percentage points larger than in 2015.
  - Projected to decline to 3.4 percent in 2017 and 2.7 percent in 2018 (relying on consolidation plans such as lower public investment in Armenia and lower current expenditures in Georgia).
- Public debt trends and risks:
  - Public debt has increased rapidly in many CCA countries and further increases are anticipated over the next few years.
  - On average, almost half of the increase in public debt reflects valuation changes from local currency depreciations since 2014.
  - Concerns: high share of public debt denominated in foreign currency; some state-owned enterprise borrowing not recognized as contingent liabilities, potentially understating consolidated government obligations.
- Policy recommendations:
  - Develop credible multiyear fiscal frameworks to guide adjustment.
  - Identify new income sources and reduce dependence on commodity-related revenue.
  - Review asset-liability management frameworks for sovereign wealth funds and foreign exchange reserves to capture balance sheet risk.

### External sector and current accounts
- Current account deficits widened in most CCA countries in 2016 due to external shocks since 2014.
- Oil exporters:
  - Projected current account deficit of 3.2 percent of GDP in 2017 (an improvement of 2.7 percentage points relative to 2016), reverting to 2015 levels.
  - Projected current account deficit of 2.3 percent of GDP in 2018 due to sharper export acceleration from higher oil prices and improved external demand.
- Oil importers:
  - Current account deficit set to widen to 8.7 percent of GDP in 2017 from 7.9 percent in 2016; marginally improve to 8.4 percent in 2018.
  - Drivers: higher import prices from higher oil prices and currency depreciation, partially offset by pickup in remittances and increased value of commodity exports.

### Monetary policy and inflation outlook
- Inflation in oil exporters:
  - 11.5 percent in 2016 (double digits for the first time in eight years), reflecting past depreciations in Kazakhstan and Azerbaijan and administrated price increases and import duties in Azerbaijan.
  - Projected to decline to 8.3 percent in 2017 and 7.6 percent in 2018, reflecting tenge appreciation, lower government spending, fiscal consolidation in Azerbaijan, and tighter monetary policy as Azerbaijan moves toward a fully flexible exchange rate regime (Central Bank of Azerbaijan announced move to a free-floating exchange rate regime in early January 2017).
- Inflation in oil importers:
  - Average inflation of 1.9 percent in 2016, 3 percentage points lower than in 2015.
  - Country notes: Armenia—deflation; Kyrgyz Republic—near zero inflation; Georgia—declining inflation from weak demand and low global oil and food prices.
  - Projected to accelerate to 4.4 percent in 2017 and remain around 4 percent in 2018.
- Monetary policy focus and recommendations:
  - As exchange rate flexibility increases, monetary policy should continue to focus on inflation developments.
  - Further improvements needed in monetary policy frameworks: develop appropriate policy instruments; strengthen central bank independence, analytics, and communications to establish credibility for exchange rate flexibility and inflation targeting.
- Policy actions observed:
  - Policy rate reductions in Kazakhstan (oil exporters) and in Armenia, Georgia, and the Kyrgyz Republic (oil importers) where currency stabilization and easing inflation allowed cuts.
  - Monetary tightening in Azerbaijan (support exchange rate, address inflation) and in Tajikistan (stem inflation from currency depreciation and excess liquidity).

### Financial sector vulnerabilities
- Financial sector weaknesses continue to increase and urgent repair is needed.
- Across most countries: restructured and overdue loans have increased further; dollarization remains high; banks remain undercapitalized.
- Systemic risks and potential impacts on public finances underline the need to address dollarization and strengthen banking sector capital and soundness.

---

### Financial sector vulnerabilities and banking-system performance
- Credit growth continuing to decline in a number of countries.
- Lack of transparency and ownership issues inhibit operations and reduce confidence in the banking sectors of several countries.
- Governance issues and limited supervisory independence impede the resolution of deep-rooted problems in some cases.
- Country-specific actions:
  - Armenia: all banks have complied with the recent central bank-mandated increase in minimum capital; this has led to some mergers and a consolidation of the banking system.
  - Georgia: efforts underway to strengthen the regulatory framework and reduce dollarization.
  - Azerbaijan: capital injections and government purchases of bad loans continue; additional bank closures might be necessary as new capitalization plans are developed.
  - Kazakhstan: authorities engaged in the merger between the two largest banks, which will require significant public financial support.
  - Tajikistan: a recapitalization plan for two major banks and the liquidation of two smaller banks have been announced; regulatory forbearance and resolution of nonperforming loans remain a challenge.
- Ongoing weaknesses: regulatory forbearance, legacy and governance issues, and subdued economic growth continue to challenge containment of risks and enhancement of financial intermediation across the CCA.

### Policy guidance for the financial sector
- Diagnose and remedy bank balance-sheet weaknesses properly and effectively.
- Intervene timely in weak banks to avoid systemic risks.
- Provide support for bank resolution under strict conditions:
  - Public funds should support only viable systemic institutions.
  - Support should be provided with well-defined and fully collateralized guarantees.
  - Shareholders must not retain any claims on assets when support is provided.
- Liquidate bad assets and allow new investors to purchase these assets through a transparent and market-oriented approach that promotes competition in the banking system.
- Avoid forbearance.
- Improve corporate governance of state-owned enterprises, which are major debtors in many jurisdictions.
- Regulators should strengthen lending practices and crisis-management frameworks while enforcing prudential regulations.
- Rationale: Promptly addressing financial sector issues could accelerate financial intermediation and diminish potential pressures on public finances, with positive implications for growth.

### Risks to the outlook and urgency of structural reform
- Baseline assumptions point to a pickup in growth, but risks to the outlook for the CCA region remain tilted to the downside, including regional geopolitical tensions for some countries.
- A weaker-than-expected recovery could undermine prospects for credible fiscal consolidation plans.
- Failing to quickly address financial sector weaknesses could reduce growth prospects further and increase systemic risk, adding to fiscal pressures in a number of CCA countries.
- External shocks since 2014 have increased urgency of diversifying away from oil and other commodities and reducing reliance on remittances.
- Large uncertainty surrounding policy positions in the United States and other advanced economies could have significant global ramifications:
  - Trade and financial linkages with advanced economies are relatively limited for CCA countries, but an inward shift in policies (including toward protectionism) and subsequent disruption of trade and capital flows could significantly affect key trading partners and commodity prices, damping the regional outlook.
- Conversely, firming prices of oil and other commodities and a more favorable outlook in key trading partners risk leading to complacency and delay in implementing structural reforms needed to unleash the region’s growth potential.
- Ongoing reform initiatives cited:
  - Kazakhstan: 100 Concrete Steps.
  - Georgia: Four Point Reform Plan.
- Implementation of these initiatives will require a reduction in the role of the state, which may prove challenging; delays could further stall gains in living standards.

### Key regional indicators and projections (CCA Region: Selected Economic Indicators, 2000–18)
- Notes:
  - Sources: National authorities; and IMF staff calculations and projections.
  - CCA oil and gas exporters: Azerbaijan, Kazakhstan, Turkmenistan, and Uzbekistan.
  - CCA oil and gas importers: Armenia, Georgia, the Kyrgyz Republic, and Tajikistan.
  - Projections.

- CCA (Percent of GDP, unless otherwise indicated)
  - Real GDP (annual growth): 8.3; 5.3; 3.2; 2.4; 3.1; 4.1
  - Current Account Balance: 0.8; 2.3; -3.8; -6.2; -3.8; -3.0
  - Overall Fiscal Balance: 2.7; 1.9; -3.6; -2.4; -4.9; -0.8
  - Inflation, p.a. (annual growth): 9.3; 5.9; 6.4; 10.5; 7.9; 7.2

- CCA oil and gas exporters
  - Real GDP (annual growth): 8.6; 5.4; 3.1; 2.2; 3.1; 4.1
  - of which non-oil growth: 8.7; 6.7; 3.1; 1.5; 2.4; 2.9
  - Current Account Balance: 2.0; 3.5; -3.3; -5.9; -3.2; -2.3
  - Overall Fiscal Balance: 3.6; 2.3; -3.7; -2.1; -5.1; -0.6
  - Inflation, p.a. (annual growth): 9.5; 6.1; 6.6; 11.5; 8.3; 7.6

- CCA oil and gas importers
  - Real GDP (annual growth): 6.4; 4.7; 3.7; 3.3; 3.6; 3.9
  - Current Account Balance: -7.6; -9.1; -8.1; -7.9; -8.7; -8.4
  - Overall Fiscal Balance: -3.4; -1.3; -3.1; -4.6; -3.4; -2.7
  - Inflation, p.a. (annual growth): 7.4; 4.6; 4.8; 1.9; 4.4; 4.0

*Middle East and Central Asia Department — REO Update, May 2017*

### Section 1

### Caucasus and Central Asia: Recovery Remains Fragile

### Regional outlook and global drivers
- Global growth is projected to reach 3.5 percent in 2017 and 3.6 percent in 2018, up from 3.1 percent in 2016.
- Firmer growth in Russia and an upward revision to growth in China are key drivers for the CCA region through remittances, exports, investment, and trade links.
- Improved global outlook is consistent with somewhat higher commodity prices but implies higher interest rates, which could exacerbate debt vulnerabilities and tighten liquidity.
- Downside global risks highlighted: potential inward shift toward protectionism, and faster-than-expected U.S. monetary policy normalization leading to tighter global financial conditions and further appreciation of the U.S. dollar.
- Oil market uncertainties stem from compliance with the OPEC+ agreement, production prospects of exempt/nonparticipating countries, and downside global growth risks.

### Regional growth prospects and drivers
- CCA growth: 2.4 percent in 2016; projected 3.1 percent in 2017 and 4.1 percent in 2018.
- CCA projected average growth: 4.3 percent in 2018–22, compared with 8.1 percent in 2000–14.
- Oil and gas exporters:
  - Growth slowed to 2.2 percent in 2016 (lowest since 1998).
  - Projected rebound to 3.1 percent in 2017 and 4.1 percent in 2018.
  - Country notes: Azerbaijan—lower oil production and financial sector vulnerabilities; Kazakhstan—supported by Kashagan output, fiscal stimulus, and expected bank credit resumption; Turkmenistan and Uzbekistan—steady growth but Turkmenistan faces a large external deficit.
- Oil importers:
  - Growth of 3.3 percent in 2016 (lowest since the global financial crisis).
  - Projected 3.6 percent in 2017 and 3.9 percent in 2018.
  - Country notes: Armenia—weak domestic demand and poor agricultural harvest; Georgia—weak demand; Kyrgyz Republic—stronger trade, construction, agriculture; Tajikistan—investment-driven pickup.
- Main structural challenge: medium-term growth prospects remain relatively subdued; need to diversify away from commodities and reduce reliance on remittances.

### Fiscal developments and consolidation needs
- Overall fiscal balances deteriorated in 2016 in most countries; public expenditure increased in most countries.
- Consolidation expected mostly through reduced public investment; emphasis on preserving critical social expenditure and strengthening spending efficiency and project selection frameworks.
- Oil exporters (non-oil fiscal deficit):
  - Non-oil fiscal deficit amounted to 14.9 percent of non-oil GDP in 2016, an improvement of 3.6 percentage points relative to 2015.
  - Projected to increase to 20.6 percent of non-oil GDP in 2017 (due to one-time banking support in Kazakhstan and an extraordinary transfer from the Oil Fund to the Central Bank of Azerbaijan).
  - Projected to decline to 13.5 percent in 2018 as Azerbaijan reduces nonproductive public investment and Kazakhstan’s fiscal stimulus expires.
- Oil importers (overall fiscal deficit):
  - Overall fiscal deficit rose to 4.6 percent of GDP in 2016, 1.5 percentage points larger than in 2015.
  - Projected to decline to 3.4 percent in 2017 and 2.7 percent in 2018 (relying on consolidation plans such as lower public investment in Armenia and lower current expenditures in Georgia).
- Public debt trends and risks:
  - Public debt has increased rapidly in many CCA countries and further increases are anticipated over the next few years.
  - On average, almost half of the increase in public debt reflects valuation changes from local currency depreciations since 2014.
  - Concerns: high share of public debt denominated in foreign currency; some state-owned enterprise borrowing not recognized as contingent liabilities, potentially understating consolidated government obligations.
- Policy recommendations:
  - Develop credible multiyear fiscal frameworks to guide adjustment.
  - Identify new income sources and reduce dependence on commodity-related revenue.
  - Review asset-liability management frameworks for sovereign wealth funds and foreign exchange reserves to capture balance sheet risk.

### External sector and current accounts
- Current account deficits widened in most CCA countries in 2016 due to external shocks since 2014.
- Oil exporters:
  - Projected current account deficit of 3.2 percent of GDP in 2017 (an improvement of 2.7 percentage points relative to 2016), reverting to 2015 levels.
  - Projected current account deficit of 2.3 percent of GDP in 2018 due to sharper export acceleration from higher oil prices and improved external demand.
- Oil importers:
  - Current account deficit set to widen to 8.7 percent of GDP in 2017 from 7.9 percent in 2016; marginally improve to 8.4 percent in 2018.
  - Drivers: higher import prices from higher oil prices and currency depreciation, partially offset by pickup in remittances and increased value of commodity exports.

### Monetary policy and inflation outlook
- Inflation in oil exporters:
  - 11.5 percent in 2016 (double digits for the first time in eight years), reflecting past depreciations in Kazakhstan and Azerbaijan and administrated price increases and import duties in Azerbaijan.
  - Projected to decline to 8.3 percent in 2017 and 7.6 percent in 2018, reflecting tenge appreciation, lower government spending, fiscal consolidation in Azerbaijan, and tighter monetary policy as Azerbaijan moves toward a fully flexible exchange rate regime (Central Bank of Azerbaijan announced move to a free-floating exchange rate regime in early January 2017).
- Inflation in oil importers:
  - Average inflation of 1.9 percent in 2016, 3 percentage points lower than in 2015.
  - Country notes: Armenia—deflation; Kyrgyz Republic—near zero inflation; Georgia—declining inflation from weak demand and low global oil and food prices.
  - Projected to accelerate to 4.4 percent in 2017 and remain around 4 percent in 2018.
- Monetary policy focus and recommendations:
  - As exchange rate flexibility increases, monetary policy should continue to focus on inflation developments.
  - Further improvements needed in monetary policy frameworks: develop appropriate policy instruments; strengthen central bank independence, analytics, and communications to establish credibility for exchange rate flexibility and inflation targeting.
- Policy actions observed:
  - Policy rate reductions in Kazakhstan (oil exporters) and in Armenia, Georgia, and the Kyrgyz Republic (oil importers) where currency stabilization and easing inflation allowed cuts.
  - Monetary tightening in Azerbaijan (support exchange rate, address inflation) and in Tajikistan (stem inflation from currency depreciation and excess liquidity).

### Financial sector vulnerabilities
- Financial sector weaknesses continue to increase and urgent repair is needed.
- Across most countries: restructured and overdue loans have increased further; dollarization remains high; banks remain undercapitalized.
- Systemic risks and potential impacts on public finances underline the need to address dollarization and strengthen banking sector capital and soundness.

*Regional Economic Outlook Update, May 2017, Middle East and Central Asia Department*

### Section 2

### Section 2

### Financial sector vulnerabilities and banking-system performance
- Credit growth continuing to decline in a number of countries (Figure 5).
- Lack of transparency and ownership issues inhibit operations and reduce confidence in the banking sectors of several countries.
- Governance issues and limited supervisory independence impede the resolution of deep-rooted problems in some cases.
- Country-specific actions:
  - Armenia: all banks have complied with the recent central bank-mandated increase in minimum capital; this has led to some mergers and a consolidation of the banking system.
  - Georgia: efforts underway to strengthen the regulatory framework and reduce dollarization.
  - Azerbaijan: capital injections and government purchases of bad loans continue; additional bank closures might be necessary as new capitalization plans are developed.
  - Kazakhstan: authorities engaged in the merger between the two largest banks, which will require significant public financial support.
  - Tajikistan: a recapitalization plan for two major banks and the liquidation of two smaller banks have been announced; regulatory forbearance and resolution of nonperforming loans remain a challenge.
- Ongoing weaknesses: regulatory forbearance, legacy and governance issues, and subdued economic growth continue to challenge containment of risks and enhancement of financial intermediation across the CCA.

### Policy guidance for the financial sector
- Diagnose and remedy bank balance-sheet weaknesses properly and effectively.
- Intervene timely in weak banks to avoid systemic risks.
- Provide support for bank resolution under strict conditions:
  - Public funds should support only viable systemic institutions.
  - Support should be provided with well-defined and fully collateralized guarantees.
  - Shareholders must not retain any claims on assets when support is provided.
- Liquidate bad assets and allow new investors to purchase these assets through a transparent and market-oriented approach that promotes competition in the banking system.
- Avoid forbearance.
- Improve corporate governance of state-owned enterprises, which are major debtors in many jurisdictions.
- Regulators should strengthen lending practices and crisis-management frameworks while enforcing prudential regulations.
- Rationale: Promptly addressing financial sector issues could accelerate financial intermediation and diminish potential pressures on public finances, with positive implications for growth.

### Risks to the outlook and urgency of structural reform
- Baseline assumptions point to a pickup in growth, but risks to the outlook for the CCA region remain tilted to the downside, including regional geopolitical tensions for some countries.
- A weaker-than-expected recovery could undermine prospects for credible fiscal consolidation plans.
- Failing to quickly address financial sector weaknesses could reduce growth prospects further and increase systemic risk, adding to fiscal pressures in a number of CCA countries.
- External shocks since 2014 have increased urgency of diversifying away from oil and other commodities and reducing reliance on remittances.
- Large uncertainty surrounding policy positions in the United States and other advanced economies could have significant global ramifications.
  - Trade and financial linkages with advanced economies are relatively limited for CCA countries, but an inward shift in policies (including toward protectionism) and subsequent disruption of trade and capital flows could significantly affect key trading partners and commodity prices, damping the regional outlook.
- Conversely, firming prices of oil and other commodities and a more favorable outlook in key trading partners risk leading to complacency and delay in implementing structural reforms needed to unleash the region’s growth potential.
- Ongoing reform initiatives cited:
  - Kazakhstan: 100 Concrete Steps.
  - Georgia: Four Point Reform Plan.
- Implementation of these initiatives will require a reduction in the role of the state, which may prove challenging; delays could further stall gains in living standards.

### Key regional indicators and projections (CCA Region: Selected Economic Indicators, 2000–18)
- Notes:
  - Sources: National authorities; and IMF staff calculations and projections.
  - CCA oil and gas exporters: Azerbaijan, Kazakhstan, Turkmenistan, and Uzbekistan.
  - CCA oil and gas importers: Armenia, Georgia, the Kyrgyz Republic, and Tajikistan.
  - Projections.

- CCA (Percent of GDP, unless otherwise indicated)
  - Real GDP (annual growth): 8.3; 5.3; 3.2; 2.4; 3.1; 4.1
  - Current Account Balance: 0.8; 2.3; -3.8; -6.2; -3.8; -3.0
  - Overall Fiscal Balance: 2.7; 1.9; -3.6; -2.4; -4.9; -0.8
  - Inflation, p.a. (annual growth): 9.3; 5.9; 6.4; 10.5; 7.9; 7.2

- CCA oil and gas exporters
  - Real GDP (annual growth): 8.6; 5.4; 3.1; 2.2; 3.1; 4.1
  - of which non-oil growth: 8.7; 6.7; 3.1; 1.5; 2.4; 2.9
  - Current Account Balance: 2.0; 3.5; -3.3; -5.9; -3.2; -2.3
  - Overall Fiscal Balance: 3.6; 2.3; -3.7; -2.1; -5.1; -0.6
  - Inflation, p.a. (annual growth): 9.5; 6.1; 6.6; 11.5; 8.3; 7.6

- CCA oil and gas importers
  - Real GDP (annual growth): 6.4; 4.7; 3.7; 3.3; 3.6; 3.9
  - Current Account Balance: -7.6; -9.1; -8.1; -7.9; -8.7; -8.4
  - Overall Fiscal Balance: -3.4; -1.3; -3.1; -4.6; -3.4; -2.7
  - Inflation, p.a. (annual growth): 7.4; 4.6; 4.8; 1.9; 4.4; 4.0

*Middle East and Central Asia Department — REO Update, May 2017*

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_Source: https://www.imf.org/-/media/files/publications/reo/mcd-cca/2017/may/pdf/cca0517.pdf_