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3. The Caucasus and Central Asia: Challenges Beyond the Crisis1

International Monetary Fund. Middle East and Central Asia Dept.
Published Date:
October 2010
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At a Glance

In virtually all countries in the Caucasus and Central Asia (CCA), the recovery, helped by the lagged effect of fiscal stimulus and a favorable external environment, has gained firm momentum. The outlook is broadly positive, but risks are largely on the downside and, in certain countries, it will take some time for per-capita disposable income to return to pre-2009 levels. Exit from fiscal stimulus has commenced in most CCA countries and will continue in 2011. Banking sector balance sheets remain impaired in several countries, including Kazakhstan, requiring continued policy attention. Some oil and gas importers face large current account deficits and rising external debt levels that need to be reined in to preserve external sustainability. To expand the macroeconomic policy tool kit, the effectiveness of monetary policy will need to be enhanced. Gradually moving toward greater exchange rate flexibility would help in this regard. The recent spike in international wheat prices is likely to adversely affect poor households that rely on wheat-related products. Over the medium term, removing barriers to intraregional trade will help raise the region’s growth potential.

Population, millions (2009)

GDP per capita, U.S. dollars (2009)
Sources: IMF, Regional Economic Outlook database; and Microsoft Map Land.Note: The country names and borders on this map do not necessarily reflect the IMF’s official position.

Recovery Gains Traction

CCA countries were hit hard by the global crisis in 2009. But the recovery, supported by the lagged effect of fiscal stimulus and a favorable external environment, is gathering momentum across the CCA. The upswing in Russia is helping the region, particularly the oil and gas importers, through trade and remittance channels (Box 3.1). The oil and gas exporters are also benefiting from higher hydrocarbon prices.

Exports are picking up, and remittances are rebounding, though at a slowing pace. After bottoming out around mid-2009, export growth turned positive again across the region in early 2010 and peaked in May at more than 80 percent year-over-year in Azerbaijan and Kazakhstan. More recently, export growth has moderated, but remains robust (Figure 3.1). With Russia’s economy returning to growth—at an estimated 4 percent in 2010—CCA remittance inflows are also recovering, having grown by 26 percent during the first half of 2010 relative to the same period in 2009.

Figure 3.1Exports and Remittances Pick Up

(Exports of goods and remittances; annual growth; percent)

Sources: Central Bank of Russia; EMED Emerging CIS; and national authorities.

1Excludes Turkmenistan and Uzbekistan.

2Includes Georgia, Kyrgyz Republic, and Tajikistan.

In light of these developments, virtually all CCA economies are seeing a recovery in growth in 2010 (Figure 3.2). Growth is expected to be strongest among the oil and gas exporters, with projections ranging from 4.3 percent in Azerbaijan and 5.4 percent in Kazakhstan, to 8 percent in Uzbekistan and 9.4 percent in Turkmenistan. Among the oil and gas importers, Armenia and Georgia are rebounding from negative growth in 2009 and are projected to grow at 4 percent and 5.5 percent in 2010, respectively. In Tajikistan, growth is estimated at 5.5 percent for 2010—about 2 percentage points higher than in 2009. In the Kyrgyz Republic, however, the political events in April and ethnic conflict in June are weighing heavily on the outlook, and economic activity is expected to shrink by 3.5 percent in 2010 (Box 3.2). Despite the rebound in growth in 2010, disposable incomes have not yet recovered to precrisis levels in many CCA countries (Figure 3.3).

Figure 3.2Growth Gains Ground, but Remains below Precrisis Levels

(Real GDP; annual percentage growth)

Sources: National authorities; IMF, World Economic Outlook; and IMF staff projections and calculations.

Figure 3.3Disposable Income Has Not Yet Recovered in Many Countries

(Gross national disposable income per capita; U.S. dollars)

Sources: IMF, World Economic Outlook; and IMF staff calculations and projections.

Box 3.1Russia Recovers

After contracting by some 8 percent in 2009, the Russian economy is recovering, driven by high oil prices and strengthening consumption. The recent heat wave and drought dampened economic activity, but the effect is likely to be short-lived and contained. For 2010, growth is projected at 4 percent. Over the medium term, growth is projected to remain at about 4 percent, slower than before the global financial crisis. The pickup in Russia should benefit CCA countries, mainly through trade and remittance channels. However, Russian construction sector activity—which traditionally has been a source of employment for migrant workers from the CCA—remains subdued and may constrain remittance flows to the region.

The outlook for 2011 is generally positive. With oil prices foreseen to remain near US$80 per barrel in 2011, CCA oil and gas exporters should see broadly similar growth rates to those in 2010. Armenia, Georgia, and Tajikistan are projected to grow at 4–5 percent, benefiting from Russia’s anticipated recovery. In the Kyrgyz Republic, economic growth is expected to recover in 2011, to 7 percent. On balance, however, growth rates for most CCA countries remain below precrisis levels.

Box 3.2Political and Ethnic Turmoil Leaves its Mark on the Kyrgyz Economy

The near-term economic outlook for the Kyrgyz Republic changed for the worse after the political turmoil in April 2010 and the ethnic conflict that followed in June. Instead of an expected recovery, economic activity is now projected to contract by about 3½ percent in 2010, driven by shrinking trade and agricultural production, as well as subdued confidence arising from continuing insecurity. As a result, the overall fiscal deficit is set to widen in 2010 by 8 percentage points to 12 percent of GDP—reflecting massive increases in critical crisis-related spending, including rehabilitation of damaged infrastructure and bank recapitalization. Donors have pledged more than US$1 billion over a 30-month period—for reconstruction, rehabilitation and resettlement, particularly in the south—which includes budgetary support, sufficient to meet most of the government’s financing needs in 2010. Exchange rate pressures also heightened during the political unrest, but the central bank intervened successfully to smooth volatility and avoid overshooting.

Inflation rates across the region have come down and are forecast to stay below 8 percent in 2010—much lower than their precrisis levels. An exception is Uzbekistan, where inflation is expected to remain high, at 11 percent. Continued fiscal stimulus, combined with an accommodative monetary stance and directed lending, give rise to the risk of a further buildup in inflationary pressures—a risk that Turkmenistan also faces. The recent increase in international wheat prices could also put some upward pressure on headline inflation in the region, to the extent that higher international prices are passed through to domestic consumers (Box 3.3).

In line with the global picture, risks to the outlook are largely on the downside. In particular, a weaker-than-expected recovery in Russia would adversely affect trade and remittance flows to the region. A double-dip recession in the United States and a weaker-than-expected recovery in Europe would also weaken economic activity in the region, primarily through a drop in demand for oil and gas. Another risk pertains to the extent of recovery in foreign direct investment inflows, which have failed to recover fully in some countries, particularly Georgia. In Central Asia, continued political tensions are affecting energy trade and transport, with adverse implications for economic activity. Closer cooperation on energy trade and water sharing, and improved regional infrastructure would enhance intraregional trade and, hence, foster growth. In this context, the recent Belarus-Kazakhstan-Russia customs union may dampen exports of some CCA countries, although Kazakhstan itself is likely to benefit (Box 3.4). Finally, in a number of countries, continued banking sector vulnerabilities could hold back credit growth and weigh on the economic outlook.

Box 3.3Wheat Price Woes?

Most CCA countries rely only moderately on wheat imports. The recent 85 percent increase in international wheat prices (in the two months up to mid-August) is therefore unlikely to have much of an impact on the region’s import bill. An exception is Tajikistan, which could face higher import costs of more than ½ percent of GDP during the remainder of 2010. Kazakhstan—a net exporter of wheat—stands to gain, with export receipts potentially increasing by up to 0.3 percent of GDP.

Government spending is not expected to increase on account of higher wheat prices, given that food and wheat-related subsidies are not prevalent in the CCA region. However, the Kyrgyz Republic has responded by reducing import duties on some wheat products, although this is not expected to result in a significant loss in government revenues. To the extent that international prices are passed on to domestic consumers, headline inflation could also pick up in countries where wheat comprises a large share of consumption—in Armenia, Georgia, Kyrgyz Republic, Tajikistan, and Uzbekistan, wheat and wheat-related products account for 10–20 percent of the consumer price index basket. Certainly, poor households that rely heavily on wheat and wheat-related products in their daily lives will bear the brunt of any price increase. Here, there may be a need to scale up government support for low-income households. Some governments are using moral suasion to entice wheat importers to absorb the higher international prices and keep domestic prices stable.

Banking Sectors Are Not Out of the Woods, Yet

Banking sectors in many CCA countries have not yet recovered from the impact of the 2008/09 crisis, and credit remains subdued, notwithstanding supportive policy measures. Policymakers have provided capital and liquidity injections to help banks repair their balance sheets, and in some countries—notably Armenia, Azerbaijan, and Georgia—banking systems appear to have stabilized, although private-sector credit growth is only gradually beginning to rebound (Figure 3.4).

Figure 3.4Private-Sector Credit Growth Remains Largely Subdued

(Real credit;1 annual percentage growth)

Sources: IMF, International Financial Statistics; and IMF staff calculations.

1Real credit, exchange rate adjusted.

In other countries, however, balance sheets remain impaired, particularly in Kazakhstan, the Kyrgyz Republic, and Tajikistan. In these countries, comprehensive and transparent resolution strategies to tackle high and rising nonperforming loans (NPLs) would contribute to a recovery in credit growth, although the combination of heightened risk aversion by banks and, in some cases, ongoing deleveraging of private-sector balance sheets is likely to adversely affect lending for some time. Stricter lending standards, combined with increased competition among borrowers and lenders, would help prevent a recurrence of the NPL problem.

Box 3.4The Impact of the Belarus–Kazakhstan–Russian Federation Customs Union

In November 2009, the governments of Belarus, Kazakhstan, and Russia signed an agreement to create a customs union as a first step to a single economic space by 2012.1 This new arrangement is intended to maximize the benefits of the already strong trade relationship and an enlarged market. The agreement came into force in January 2010, when the three countries eliminated most duties on mutual trade, and moved to harmonize customs rules. In July 2010, member countries adopted a common customs code, finalized customs rules, and began to redistribute collected duties.

Russia is a key trading partner of Kazakhstan (Figure 1), accounting for about 20 percent of total trade. The customs union will allow Kazakhstan to benefit from greater access to the large Russian market and the eventual free movement of labor and capital. In particular, agricultural and commodity exports should benefit from the removal of customs duties. At the same time, the potential increase in these exports, and the possible exposure of the manufacturing sector to competition from more established Russian companies, could affect Kazakhstan’s plans for economic diversification. In addition, trade diversion may arise as Kazakhstan’s import tariffs on most goods from outside the union have increased to the levels of Russia.2 But higher tariffs are likely to provide a boost to fiscal revenues through Kazakhstan’s share of customs duties—the authorities expect an additional 0.3 percent of GDP in revenues in 2010—and, all in all, the customs union is likely to have a positive impact on growth in Kazakhstan.

Figure 1Kazakhstan: Structure of Exports and Imports by Region, 2009

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

The impact of the customs union on other CCA countries is expected to be limited. With higher import tariffs, Kazakhstani importers may switch from suppliers in other CCA countries to suppliers within the customs union. Kazakhstan currently accounts for about 14 percent of total exports from the Kyrgyz Republic and 8 percent from Uzbekistan, but less than 1½ percent of total exports from other CCA countries (Figure 2). Although part of these exports will likely fall under the temporary exemption from increased customs duty, a trade diversion effect could be expected in the long term. A decline in trade flows between CCA countries and Russia is not anticipated, since import tariffs in Russia have remained practically unchanged.

Figure 2CCA Countries’ Trade with Kazakhstan

(Percent of the country’s total exports and imports, 2009)

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

In addition, the Kyrgyz authorities have expressed concern about a potential adverse impact of the customs union on transit trade. In recent years, the Kyrgyz Republic has played an important trade intermediary role for Chinese goods bound for markets in the former Soviet Union: a more restrictive customs administration on the Kyrgyz-Kazakhstani border may restrain the re-export of Chinese products to the Commonwealth of Independent States.

The authors are Ali Al-Eyd and Dmitriy Rozhkov.1 A single economic space provides for the free movement of all factors of production and sets the basis for coordination of macroeconomic policies across member states.2 Kazakhstan has obtained a temporary exemption from raising customs duties on goods deemed to be strategically important for the country; these exemptions are expected to be eliminated by July 2011.
  • In Kazakhstan, high and rising NPLs—currently at 26 percent of total loans—are exerting pressure on provisioning levels and weighing on banks’ capital and ability to lend (Figure 3.5). Indeed, real credit growth remains negative. With activity in the real estate and construction sectors—to which banks have their largest exposure—continuing to shrink, it is unlikely that NPLs will recede quickly, even as the rest of the economy recovers. If the problem of high NPLs stays unresolved, banking sector balance sheets will remain under pressure, and additional contingent fiscal liabilities could arise.
  • Banking sectors in the Kyrgyz Republic and Tajikistan are also suffering from high and rising NPLs, and private-sector credit growth is subdued. In the Kyrgyz Republic, NPLs increased in the wake of the events of April and June and also because of banks’ exposure to borrowers affected by the conflict in the south. Credit is expected to continue to shrink in real terms during the second half of 2010 owing to weak demand—driven by the decline in economic activity—and the emerging problems in the banking sector. In Tajikistan, NPLs have increased most notably among state enterprises, the agricultural sector, and leasing activity—partly as a result of poor lending standards and directed lending—and have weakened banks’ balance sheets. Continued public support, including bank recapitalization, is needed to help the banking sector repair its balance sheets. However, a long-term solution will also require subjecting state enterprises to greater financial discipline.

Figure 3.5High, and Mostly Rising Levels of Nonperforming Loans

(Nonperforming loans; percent of total loans)

Source: National authorities.

190-day basis.

2Overdue by 30 days or more.

Banking sectors in Turkmenistan and Uzbekistan, by and large, have not been affected by the global crisis on account of their limited integration with global financial markets. Moreover, in both countries, overall credit—the bulk of which was in the form of policy-directed loans—continued to grow during the crisis.

Macroeconomic Policies as Recovery Gathers Momentum

With growth recovering from the 2009 trough, countries across the CCA can start exiting from accommodative policies. Here, as in many other regions, the authorities should first exit from fiscal stimulus, also in light of fiscal sustainability considerations.

Monetary policy can remain accommodative for some time, not least because banking sectors in many countries remain impaired. At the same time, the authorities need to pay close attention to inflation developments and prevent an increase in inflation expectations. A key challenge facing some CCA oil and gas importers is to reduce external vulnerabilities. Macroeconomic policy needs to rein in current account deficits and reverse the recent buildup of external debt. Additional exchange rate flexibility should help in this regard.

Fiscal Policy Should Aim for Consolidation in 2011

The oil and gas importers face shrinking fiscal space. Donor support is, for the most part, projected to decline to precrisis levels by 2011, and public debt is rising, driven largely by the policy response to the crisis (Figures 3.6 and 3.7). As such, most oil and gas importers are planning to consolidate in 2011 to preserve medium-term fiscal sustainability.

Figure 3.6Grants to Return to Precrisis Levels in Oil and Gas Importers

(Grants; percent of GDP)

Sources: National authorities; and IMF staff calculations.

Figure 3.7Public Debt Has Risen in Oil and Gas Importers

(Public debt; percent of GDP)

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

  • Armenia is planning to undertake a marked fiscal adjustment under an IMF-supported program (Figure 3.8). The fiscal deficit is expected to be scaled back by 3 percentage points of GDP in 2010, and further deficit reductions of about 1 percentage point of GDP per year are planned for 2011‒13. This scale-back will be achieved partly through enhanced revenue collection, enabled by improved tax administration. Spending should also be restrained and better targeted, but allow for sufficient allocations for social and capital spending.
  • Georgia is also consolidating through various measures, including expenditure containment and new excise taxes. The budget deficit is projected to decline to 6.1 percent of GDP in 2010 from 9.2 percent of GDP in 2009, with a possible further reduction of about 1½ percentage points of GDP in 2011.
  • In Tajikistan, given pressing social and development needs, as well as the cost of recapitalizing the banking system, the fiscal stance in 2011 is expected to remain broadly neutral.
  • In the Kyrgyz Republic, a large fiscal expansion is projected for 2010 in reaction to the economic fallout from the April and June events; fiscal consolidation will be needed starting in 2011.

Figure 3.8Trimming Down Deficits in Oil and Gas Importers

(Fiscal balance; percent of GDP)

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

While lack of fiscal space is not an immediate issue, the CCA oil and gas exporters also should aim for fiscal consolidation, given their positive growth outlook. For example, in Kazakhstan, the authorities plan to gradually withdraw fiscal stimulus—including off-budget funds—in line with the anticipated recovery in economic activity (Figure 3.9). Azerbaijan is maintaining a broadly neutral stance in 2010, and fiscal consolidation is projected for 2011. However, in Turkmenistan and Uzbekistan, despite the strong growth forecast, the fiscal stance remains expansionary in 2010. For 2011, Turkmenistan appears to maintain an expansionary stance, while Uzbekistan is projected to shift to a broadly neutral stance. In both countries, fiscal tightening would help prevent the likely buildup of inflationary pressures which, if materialized, could lead to real effective exchange rate appreciation and, hence, weaken competitiveness.

Figure 3.9Oil and Gas Exporters: Time for Fiscal Consolidation

(Non-oil fiscal balance; percent of non-oil GDP, except Uzbekistan)

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

1Includes off-budget expenditures financed by Samruk-Kazyna under the anticrisis plan.

2Overall fiscal balance in percent of GDP.

Over the medium term, fiscal policy in the CCA oil and gas exporters should be set with a view to safeguarding a sustainable use of hydrocarbon revenues while developing the non-oil economy. Managing hydrocarbon wealth by ensuring an efficient use of public resources remains a key challenge, particularly in Turkmenistan and Uzbekistan. In these countries, public-sector investment projects are designed to strengthen growth, but there is a need to ensure the quality and efficiency of spending. Laying the basis for high and sustained growth also requires that the authorities speed up structural reforms aimed at improving the business environment and creating more room for private-sector activity. In Azerbaijan, the authorities are seeking to foster the non-oil economy and are encouraged to reduce the non-oil fiscal deficit to ensure medium-term fiscal sustainability, especially as oil production is projected to decline over the medium term.

Monetary Policy Can Remain Accommodative, Mostly

Monetary policy can remain accommodative in most CCA countries for the time being. Indeed, in some countries, nominal policy rates have remained unchanged—for example, in Azerbaijan and Kazakhstan since May and September 2009, respectively—and are not expected to be increased in the near future. This stance should help stimulate fledgling private credit growth while banks repair their balance sheets. At the same time, the Central Bank of Armenia raised its policy rate in five successive steps from 5 percent to 7¼ percent during the first five months of 2010 in an effort to keep real rates positive as inflation nudged up. Likewise, in Georgia, the authorities have continued to tighten monetary policy in response to rising inflation.

Having said this, it is important to note that monetary policy has only limited traction in most CCA countries, due to low levels of financial sector development, imperfectly competitive banking systems, excessive government intervention, and high dollarization levels (Annex 3.1). As such, policymakers have rightly embarked on reforms to foster financial deepening—including those aimed at developing government securities markets—in an effort to enhance the effectiveness of monetary policy. Allowing for more competition in the banking sector and avoiding unnecessary government intervention should help in this regard. Lastly, countries should also promote dedollarization, including by allowing for greater two-way exchange rate flexibility.

Addressing External Vulnerabilities

Current account deficits remain elevated in several CCA oil and gas importers, reaching up to 12 percent and 14.6 percent of GDP in Georgia and Armenia, respectively, in 2010 (Figure 3.10). In virtually all countries, foreign direct investment inflows have not yet recovered relative to precrisis levels, and external debt is high and rising—currently ranging from about 38 percent to 67 percent of GDP (Figures 3.11 and 3.12).

Figure 3.10High Current Account Deficits in Oil and Gas Importers

(Current account balance; percent of GDP)

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

Figure 3.11Foreign Direct Investment Still in Short Supply in Oil and Gas Importers

(Net foreign direct investment; percent of GDP)

Sources: National authorities; and IMF staff calculations.

Figure 3.12Oil and Gas Importers’ External Debt Is High and Rising

(External debt; percent of GDP)

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

Therefore, in the future, policy needs to increasingly focus on reining in current account deficits to help preserve external sustainability. In Armenia, sustaining fiscal consolidation, stepping up structural reforms aimed at boosting competitiveness, and allowing for greater exchange rate flexibility will help in that regard. In Georgia, continued exchange rate flexibility is also key to achieving external sustainability. There—as in a number of other CCA countries—exchange rate policy needs to carefully balance external and financial-sector stability. Allowing for exchange rate depreciation will, on the one hand, facilitate external adjustment. On the other hand, a large depreciation may endanger the stability of the banking system, which remains highly dollarized and thereby exposed to substantial currency risk (Figure 3.13). Therefore, countries should follow a gradual approach in allowing for greater exchange rate flexibility and, at the same time, continue to strengthen prudential regulations to limit exposure to foreign-currency risk.

Figure 3.13High Levels of Dollarization

(Foreign currency loans; percent of total loans)

Sources: IMF, International Financial Statistics; and EMED Emerging CIS.

1Loan reclassification explains the large drop in Tajikistan’s foreign currency loans at end-2009.


Prepared by Yasser Abdih with input from country teams.

Annex 3.1. Strengthening Monetary Transmission in the CCA

A lack of monetary policy traction in the CCA during the 2009 crisis and the authorities’ general interest in moving toward greater exchange rate flexibility have brought renewed urgency to strengthening the monetary transmission mechanism (MTM)—the mechanism by which monetary policy affects real economic activity and prices. To that end, countries in the region should deepen financial markets, increase competition in the banking sector, avoid unnecessary government intervention, allow for more exchange rate flexibility, and promote dedollarization. Together with other development partners, the IMF is providing technical assistance in many of these areas.

The MTM tends to be significantly weaker in low-income countries than in advanced and emerging market economies, and is even weaker in the CCA.1 For instance, the short-term correlation between policy rates and lending rates in CCA countries is markedly lower than in other regions, indicating that the monetary authorities’ ability to affect interest rate—sensitive components of aggregate demand is relatively weak. In addition, the size of CCA banking systems, as measured by total bank assets to GDP, is much smaller than in other regions (with the exception of Kazakhstan), thus reducing the leverage of monetary policy in general (Figure 1).

Figure 1Weak Monetary Transmission in the CCA

Sources: National authorites; IMF staff calculations; and Mishra, Montiel, and Spilimbergo (2010), “Monetary Transmission in Low-Income Countries,” CEPR Discussion Paper No. 7951 (London: Centre for Economic Policy Research).

1Correlation for Georgia covers Mar 2007–Dec 2008.

What are the impediments to effective monetary transmission in the CCA?

Limited financial development and weak regulation: CCA countries have small banking systems and, in most cases, lack deep and liquid money and interbank markets. As a result, chronic excess liquidity accumulates in the banking system and reduces the effectiveness of monetary policy. Furthermore, underdeveloped government securities markets diminish the scope of open market operations and restrict the operation of monetary policy mostly to the use of direct central bank credit. Finally, weak regulation contributes to high spreads between lending and deposit rates (Figure 2) by increasing the cost of bank lending (for example, by making it difficult for banks to enforce contracts or recover collateral), as does overregulation (for example, through excessively tight loan provisioning requirements). While regulatory quality in Armenia and Georgia is generally in line with that of emerging markets, it lags significantly behind in Turkmenistan and Uzbekistan (Figure 3).

Figure 2Spreads between Lending and Deposit Rates

(Percentage points)

Sources: National authorites; IMF staff calculations; and Mishra, Montiel, and Spilimbergo (2010), “Monetary Transmission in Low-Income Countries,” CEPR Discussion Paper No. 7951 (London: Centre for Economic Policy Research).

Figure 3Regulatory Quality and Rule of Law, 20081

Sources: National authorites; IMF staff calculations; and Kaufmann, Kraay, and Mastruzzi (2009), “Governance matters VIII: aggregate and individual governance indicators 1996–2008,” Policy Research Working Paper Series 4978, The World Bank.

1Indices; higher values indicate better outcomes.

Market concentration and excessive government intervention: Given their still incomplete transition from centrally planned to market economies, many CCA banking sectors are characterized by high degrees of market concentration and government intervention. This reduces the pass-through of changes in policy rates—particularly rate cuts—to lending rates, and contributes to high spreads. One reason for the lack of competition—in, for instance, Azerbaijan, Turkmenistan, and Uzbekistan—is the high market share of public banks, which operate under implicit or explicit government guarantees and hold a favorable position in providing services to the public sector. In Turkmenistan and Uzbekistan, private banks are also constrained by interest rate controls and policy-directed lending.

Dollarization and fear of floating: Due to their experience with high inflation and often unsuccessful attempts by central banks to resist currency depreciation, dollarization in CCA countries remains high, especially in Armenia, Georgia, and Tajikistan (Figure 4). These high levels of dollarization dilute the effectiveness of the interest rate channel of monetary policy: central banks have little control over foreign currency interest rates and can in principle only affect the (reduced) share of domestic currency assets and liabilities. In addition, dollarization tends to make domestic money demand more volatile, as it becomes a function of expected depreciation, thereby making it difficult for central banks to target monetary aggregates. Furthermore, dollarization often gives rise to “fear of floating” so as to prevent negative balance sheet effects arising from exchange rate movements. This constrains CCA countries in their attempts to move toward more exchange rate flexibility, and limits the role of the exchange rate in the MTM.

Figure 4Foreign Currency Deposits

(Percent of total deposits, 2009)

Sources: National authorites; and IMF staff calculations.

How can monetary transmission in the CCA be strengthened?

Deepen financial markets. To improve the MTM, CCA countries should continue their efforts to develop efficient and liquid primary, secondary, and derivative securities markets and instruments. Measures in this area include introducing modern payment systems for interbank cash transfers; developing efficient and reliable securities settlement systems for clearing and settling repo transactions; improving liquidity management by central banks to induce interbank market participation; issuing more long-term, local currency—denominated government securities; encouraging domestic investment, for example, by pension funds; and developing sound regulatory and prudential frameworks. The IMF is providing technical assistance to CCA countries in many of these areas, financed in large part by the State Secretariat for Economic Affairs of Switzerland.

Increase competition and reduce government intervention. Competition should be increased by strengthening banking supervision, encouraging the entry of foreign banks and strategic investors, and restricting the behavior of large banks so as to avoid market domination. In this regard, it is encouraging that the Azerbaijani authorities have expressed a willingness to privatize the country’s dominant state bank. While extraordinary measures were introduced during the financial crisis that temporarily increased the government’s financial sector role in some countries (for example, Kazakhstan and the Kyrgyz Republic), it is important that these measures not be made permanent and that CCA governments do not rely on direct central bank credit for financing. Furthermore, interest rate controls and policy-directed lending should be phased out in Turkmenistan and Uzbekistan to improve the efficiency of credit allocation.

Dedollarize. The most effective way to achieve durable dedollarization is to establish a history of macroeconomic stability, involving low and stable inflation, coupled with sufficient two-way exchange rate flexibility.2 The current low-inflation environment in the CCA provides an excellent opportunity to build such a track record, but also necessitates a strong and credible commitment to sound and transparent policymaking. A gradual increase in exchange rate flexibility, combined with appropriate prudential regulation, would internalize the risks of balance sheet dollarization and reduce incentives to hold foreign currency. Examples of such prudential regulation already implemented include higher loan-loss provisioning requirements for foreign currency loans (Armenia, Kazakhstan) and higher risk weights on foreign currency loans in capital requirements (Armenia, Georgia). Also, public debt management that shifts away from foreign currency denomination would further reduce concerns of exchange rate flexibility and increase the potential role of the exchange rate channel in MTM. The IMF is providing technical assistance in many of these areas, and is working with the European Bank for Reconstruction and Development on promoting local currency financing and local capital market development.

Selected Economic Indicators: CCA



Real GDP Growth9.413.712.
(Annual change; percent)
Kyrgyz Republic4.
Consumer Price Inflation9.79.311.416.
(Year average; percent)
Kyrgyz Republic6.55.610.
General Government Fiscal Balance0.
(Percent of GDP)
Kyrgyz Republic-5.6-2.1-0.30.0-3.7-12.0-8.5
Current Account Balance-
(Percent of GDP)
Kyrgyz Republic-0.1-3.1-0.2-8.12.1-5.4-9.4
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.

The authors are Nienke Oomes, Anke Weber, and Niklas Westelius.


Mishra, P., P. Montiel, and A. Spilimbergo, 2010, “Monetary Transmission in Low-Income Countries,” CEPR Discussion Paper No. 7951 (London: Centre for Economic Policy Research).


See Kokenyne, A., J. Ley, and R. Veyrune, 2010, “Dedollarization,” IMF Working Paper No. 10/188,

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