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Addressing External Vulnerabilities in the Oil-Importing Countries of the Caucasus and Central Asia

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.

Emerging vulnerabilities

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.

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.

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.

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.