Journal Issue

1. Introduction

Mark Horton, Hossein Samiei, Natan Epstein, and Kevin Ross
Published Date:
May 2016
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Recent ER Movements

Since late 2014, CCA currencies have been under pressure, given the decline of oil and other commodity prices, weaker growth in key emerging markets, depreciation of the Russian ruble, and expectations of a rise in U.S. Federal Reserve policy rates. Since CCA currencies are typically linked to the U.S. dollar, pressures have also reflected dollar appreciation against major currencies. CCA currencies have depreciated in nominal terms by 20–50 percent against the dollar (Figure 1), with Azerbaijan and Turkmenistan undertaking step devaluations of their currencies (by 20 and 25 percent against the dollar, respectively) in early 2015, and Azerbaijan devaluing again (by 32 percent) in December 2015. Kazakhstan took a similar step by devaluing its currency in early 2014 by 19 percent. The Kazakh tenge has depreciated by an additional 45 percent against the dollar following adoption of a floating rate regime in August 2015.

Figure 1.Bilateral Exchange Rate Movements CCA Energy Exporters, 2014–15

CCA Energy Exporters, 2014–15

Sources: Bloomberg and IMF Staff Estimates.

A depreciation of the Russian ruble over the period has offset changes in the values of most CCA currencies. Accordingly, both nominal and real effective ERs (NEER/REER) have experienced periods of appreciation during the past two years, particularly among CCA energy exporters (Figure 2). Moreover, for many CCA countries, the traditional NEER/REER measures understate the appreciation, as they are based on country trade weights and do not take into account movements in the predominant currency of denomination of imports—the U.S. dollar, which has been appreciating. While in some countries the real ER has depreciated in recent months, this may not imply gains in competitiveness given that the equilibrium real ER has also depreciated.

Figure 2.CCA: Nominal and Real Effective Exchange Rates

(January 2014=100, a rise means appreciation of the domestic currency, through Dec 2015)

Source: GDS, and IMF Staff Estimates.

Besides links with Russia and China (Figure 3), other contributing factors have included slow growth in the Euro area—an important destination for CCA exports, as well as high financial dollarization (Figure 4) and unclear policy responses in many CCA countries. Strong links with Russia and lower exports and reduced remittances have contributed to weaker current account and fiscal balances.1 High dollarization has complicated all aspects of ER policy decisions, as it has limited monetary policy transmission mechanisms and raised financial soundness concerns. These factors have led some central banks to work to stabilize ERs. Indeed, the policy response of some CCA central banks has lacked clarity, consistency, and effective communication. Capital flight has not been a serious issue.

Figure 3.CCA External and Internal Balances

Figure 4.CCA Linkages with Russia and China

Monetary and ER Regimes in the CCA

All CCA central banks have price stability as their main monetary policy objective. However, the instruments to achieve this vary and typically include both the ER and the interest rate, as well as direct control over liquidity. Four CCA countries (Armenia, Georgia, Kazakhstan, and the Kyrgyz Republic) have a form of inflation-targeting (IT) in place. ER intervention remains an important instrument in these countries and in non-IT countries. De jure, only Turkmenistan has a pegged ER regime (see Table 1). De facto, however, many countries resort to some kind of management of the ER. Across all CCA countries, effective liquidity management remains challenging, owing to weak monetary transmission. Direct lending by central banks to governments or firms is applied in some CCA countries, and reserve requirements are generally low, with limited differentiation between local currency (LC) and FX deposits.

Table 1.CCA ER Arrangement AREAER2 Classification(as of March 2016)
De JureDe Facto
ArmeniaFree floatingFloating
AzerbaijanManaged floatingStabilized
KazakhstanManaged floatingOther managed arrangement3
Kyrgyz RepublicFloatingOther managed arrangement
TajikistanManaged floating, no predetermined pathOther managed arrangement
TurkmenistanConventional pegConventional peg
UzbekistanManaged floatingCrawl-like arrangement

Primary reasons for tightly managed ER regimes in the CCA are limited operational capacity and “fear of floating.” Fear of floating reflects mistrust in the domestic currency, high and fast pass-through from ER changes to prices, significant balance sheet currency mismatches, and underdeveloped domestic capital markets. Pegs of CCA currencies to the dollar are also rooted in the immediate post-Soviet period of high inflation and are also associated with commodity-export characteristics, which argue for a nominal (ER) anchor and efforts to limit the pass-through of volatility in commodity prices. However, ER pegs cannot be sustainable if FX buffers are insufficiently large, or if supporting monetary, fiscal, and structural policies are inadequate. Tightly managed ERs may limi0t the scope for diversification and balanced growth—a key priority for all CCA economies.

Assessment of CCA Currency Misalignments

According to latest IMF external sector assessments, most CCA currencies were judged to need adjustments in real terms to bring external current account balances to equilibrium levels over the medium term. During the pre-shock period (2013), the degree of uncertainty around these valuation estimates was relatively large, with about half of CCA currencies assessed as possibly undervalued. Despite the depreciations over the past 18 months—both in nominal and real terms—in most CCA countries, the equilibrium real ER has also depreciated; hence, updated assessments for end-2015 indicate that seven out of the eight CCA currencies still require adjustment in the range of 5–30 percent to bring external current account balances to equilibrium levels over the medium term (Figure 5).4

Figure 5.Financial Dollarization in the CCA

While misalignments may call for efforts to adjust ER parities directly or to increase ER flexibility, other supporting policies are also needed. Complementary policies include maintaining sound fiscal positions and implementing structural reforms to reduce imbalances and restore equilibrium. This is illustrated by Georgia, where the ER is one of the most flexible in the region, but is still assessed to be overvalued by as much as 5–15 percent. This assessment, in part, may be due to the policy mix as well as transitory shocks that affect the current account balance—a key input in the misalignment estimate.

CCA Financial Sectors

Many CCA countries have reported rising stress in domestic financial systems, including due to ER changes and weaker economic conditions. In some countries, NPLs have increased, while bank capital, liquidity, and profitability have deteriorated. Recent IMF-WB financial sector stability assessments (FSSAs) have also noted vulnerabilities.5 In other CCA countries, the external shocks appear to have had a limited impact thus far, as evidenced by relatively healthy financial soundness indicators. This may reflect, in part, low levels of financial intermediation and state support, or the quality and timeliness of FSI data.

A challenge for financial stability is dollarization of lending, in light of credit risk associated with local currency depreciation. Lending dollarization is high, while limited hedging by FX borrowers (both household and corporate) accentuates risks. In addition, in the face of ER pressures, tight liquidity, and falling oil prices and exports, stability risks may arise from strains on bank profitability, provisioning, and capital.

Capital Controls in the CCA

As in other regions, CCA countries have maintained capital flow management measures (CFMs) to allow for more independent monetary policy while maintaining managed ERs. The extent of these measures has been higher among CCA countries with conventional pegs (Turkmenistan) or other peg type arrangements (Tajikistan, Uzbekistan). Most CCA countries have measures on: (1) issuance of securities by nonresidents; (2) FDI flows; (3) foreign borrowing by residents; (4) real estate purchases by nonresidents; and (5) resident personal financial transactions abroad. Administrative measures have also been employed.

Table 2.CCA: Controls on Capital Transactions
CCA Countries: Controls on Capital Transactions
1Repatriation requirementsNoNoNoNoNoYesYesYes3/8
2On capital and money market instrumentsYesYesYesNoYesYesYesYes7/8
3On derivatives and other instrumentsYesYesNoNon.r.Yesn.r.n.r.3/8
4On credit operationsNoNoNoYesYesYesYesYes5/8
5On direct investmentNoYesYesYesYesYesYesYes7/8
6On liquidation of direct investmentNoNoNoNoNoNoYesYes2/8
7On real estate transactionsYesNoYesNoYesYesYesYes6/8
8On personal capital transactionsNoYesNoYesNoYesYesYes5/8
Source: AREAER 2014. (Depending on the country, the positions are as of various months in 2015).Note: “n.r.” is not regulated, and does not necessarily indicate a lack of market. Red highlights majority of cases.
Source: AREAER 2014. (Depending on the country, the positions are as of various months in 2015).Note: “n.r.” is not regulated, and does not necessarily indicate a lack of market. Red highlights majority of cases.

Figure 6.CCA: Exchange Rate Misalignment

(In percent, +: overvalued)

Source: IMF Staff Estimates.

Central Bank Independence and Transparency in the CCA

Over recent decades, there has been a global trend toward increased central bank independence and transparency. Policymakers have gained greater freedom to choose objectives, tactics, and instruments in carrying out mandates, and independent central banks are considered to deliver better outcomes, including lower and more stable inflation, and less output volatility. As accountability goes hand-in-hand with independence, central banks have also become more transparent. A well-communicating central bank is able to explain to the public and markets its views on current and future economic conditions, the rationale for its actions, and the expected outcome of these actions. In doing so, it helps ensure that monetary and ER policies remain credible and that expectations are better anchored, even if inflation or ERs deviate from targets or an equilibrium level.

Based on legislation, CCA central banks appear to be relatively independent and transparent, although not necessarily in practice. Using measures developed by Dincer and Eichengreen (2014),6 the central banks of the Kyrgyz Republic, Armenia, Azerbaijan, and Georgia rank high in comparison to central banks in other regions on independence, while on transparency, most CCA central banks score well, with Armenia, Georgia, and Kazakhstan close in performance to the emerging market average. However, as discussed elsewhere, legislation does not always ensure adequate independence and transparency in practice.

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