Countries in the Caucasus and Central Asia region—especially those that import, rather than export, oil—were hit hard by the Great Recession of 2008/09. The good news is that, today, the outlook for those countries is broadly positive. But, as often seems to be the case in today’s world, this good news is tempered with a word of caution.
According to our latest Regional Economic Outlook for the Middle East and Central Asia, there are a number of downside risks. And the key challenge for these four countries—Armenia, Georgia, Kyrgyz Republic and Tajikistan—will be to take actions now to address these risks.
Governments and central banks reacted appropriately to the daunting challenges of the last two years; with fiscal stimulus (financed partly by more donor support), monetary easing and, in some cases, exchange rate depreciation. The policies are paying off: growth has picked up again across most of the region.
But this policy response has also had costs: external debt has ratcheted up again, while current account deficits are chronically high.
- External debt has risen to levels that are high for emerging and developing economies. We anticipate external debt will reach 65 percent of GDP by the end of 2011 in Georgia and the Kyrgyz Republic, and, although somewhat lower in Tajikistan and Armenia, it is on an upward trajectory.
- Armenia and Georgia both have double-digit current account deficits. And, in the Kyrgyz Republic and Tajikistan, current account deficits are less worrisome, but likely to rise in 2011.
Such large current account deficits imply high external financing needs and these may not always be easy to meet, leaving these countries more exposed to the whims of global economic developments.
With limited access to international financial markets, the four countries have relied—to different degrees—on foreign direct investment and donor support to meet their external financing needs. But foreign investment is in short supply today and unlikely to return to its pre-crisis levels. And donor support is declining from its crisis peak toward the levels observed prior to 2008. While this does not pose an immediate problem, over the longer term, external current account deficits will need to adjust to more affordable levels.
Much to do on many fronts
But exactly what actions are needed to reduce these emerging vulnerabilities? The answer lies in two broad objectives.
The first is to rebuild domestic savings, as high external debt and deficits are principally the result of insufficient domestic saving. As such, the key to reducing them lies in containing government spending.
- Armenia and Georgia—where the problem is most acute—have already embarked on this process.
- Beyond next year, policymakers in Tajikistan will have to make tough choices in balancing the need for capital and social spending against limited domestic and external financing.
- The new Kyrgyz government faces difficult fiscal decisions once it takes over from the transitional government.
And, as with the broader call for economic rebalancing by ‘deficit’ countries, steps are needed to ensure that over time the private sector can also play a bigger role. In particular, export industries in some countries need to become more competitive; for example, through continuing to work on improving the business environment so as to attract more investment.
Second, greater exchange rate flexibility can also contribute to the required adjustment. But a careful, indeed gradual, approach is needed given constraints imposed by the banking sector.
- A large proportion of the loans extended by domestic financial institutions are denominated in foreign currencies. So a large and sudden exchange rate depreciation would leave many borrowers (whose income is mostly in domestic currency) unable to repay their debt. This, in turn, could result in banks needing to write-off nonperforming loans, for which they may eventually require a fresh injection of capital.
- Therefore any move toward greater exchange rate flexibility should be accompanied by prudential regulations that will guide banks to take only appropriate exposure to foreign-currency risk. In this regard, Armenia and Georgia have both taken steps to enhance the provisioning against future losses, and capital requirements for, foreign-currency loans.
The region has seen a number of external crises since independence from the Soviet Union. Time and again, high current account deficits and rising external debt precede such crises. Governments and central banks reacted appropriately to the daunting challenges of the last two years.
Now is the time to unwind those policies and ensure that policymakers will again have the necessary policy space to manage possible future external shocks.