FINAL--CCA REO Presentation-ENG (with notes)

Editor's Notes

• #3: Today we are launching our Regional Economic Outlook for the Caucasus and Central Asia (CCA). I will present our latest forecast for the region and discuss the risks surrounding these forecasts. And I will also share with you how we see policy priorities for the region. But before that, let me give you a brief overview of global developments that are especially relevant for the region.
• #4: At present the global economy is being affected by three large shocks, which are also affecting the Caucasus and Central Asia (CCA) region. These shocks are likely to be long lasting and hence the region needs to adjust to the new realities. Global shock 1: International prices of key commodities for the CCA region have fallen rapidly, especially oil. Since June of 2014, oil prices dropped from about $110 a barrel to less than $50 a barrel, amid resilient supply by both traditional and shale producers and still weak demand, especially in emerging economies. Looking forward, oil prices are expected to remain at these relatively low levels for a prolonged period of time. Volatility and uncertainty about future prices have increased considerably, however.
• #5: Aside from oil, many of the CCA economies export gas and metals whose price has also fallen substantially. Metal prices have fallen as commodity-intensive investment and manufacturing activity in China has slowed down, and production in many places has come on-stream reflecting the past investment boom. Food prices are declining as supply growth, helped by high levels of stocks, outpaces demand increases. Declines are broad-based (meat is a notable exception) and are especially large for cereals and vegetable oil prices, particularly those for wheat and soybeans.
• #6: Global shock 2: Economic activity in Russia, an important economic partner, has contracted sharply. Growth has slowed to well below the average growth of the last 15-20 years. This has accelerated in 2015, with the decline of oil prices and a rise in geopolitical tensions. While growth in Russia is expected to recover from 2016, medium-term growth is projected by the IMF staff at around 1.5 percent, much lower than historical levels. Against this backdrop, growth in the CCA region has weakened, as it relies heavily on commodity exports and has close trade, investment and remittance linkages with Russia.
• #7: Global shock 3: Exchange rate changes Besides sharp movements in commodities prices, we have also seen large exchange rate movements over the past year. Between August 2014 and 2015, U.S. dollar appreciated by 16 percent on average against its main trading partners. This, for the most part, reflects asymmetric monetary policy in major advanced economies, particularly, the expectation of monetary policy normalization on the back of relatively robust economic growth in the United States. Following the drop in oil prices, the Russian ruble has nearly halved in value, closely tracking oil price movements.
• #8: China has been a key driver of global economic growth in recent years, and developments there have an important bearing on the CCA’s economic outlook. In particular, the economic slowdown, recent heightened volatility in China’s financial markets and currency depreciation have impacted sentiment and contributed to a weakening of confidence in China’s economic prospects and potential spillovers to its trading partners, including in the CCA region.
• #9: Linkages between China and the CCA have strengthened in recent years, increasing potential for spillovers. Trade between China and the CCA region grew almost tenfold in the past decade, to $48 billion at end-2014 from only $5 billion in 2005. China is the main trading partner for the Kyrgyz Republic, Tajikistan, and Turkmenistan, with trade in excess of 25 percent of total. Chinese foreign direct investment has also increased rapidly in recent years, reaching $5,555 million in 2012 for the region as a whole. Kyrgyz Republic, Tajikistan, Kazakhstan and Uzbekistan received the bulk of these investments. Over the next three to five years, China is expected to invest an additional $30–$35 billion in the CCA, mainly in infrastructure and mining.
• #10: Global growth is expected to decline from 3.4 percent to 3.1 percent this year, before strengthening to 3.6 percent next year – with substantial variation across the globe. Recovery in advanced economies is expected to strengthen relative to last year, with growth rising by some ¼ percentage point next year. The pickup in growth is largely led by the U.S. economy with consumption and investment improving owing to lower energy prices, reduced fiscal drag, strengthened balance sheets, and an improving housing market. Recovery in the euro area is proceeding gradually, sustained by lower oil prices, easy financial conditions, the recent euro area depreciation, as well as a shift to a broadly neutral fiscal stance. Uncertainties in Greece continue to present risks for this outlook. By contrast, growth in emerging economies is projected to decline for the 5th year in a row. This year growth slowed mainly due to the dampening impact of lower commodity prices and tighter external financial conditions. In 2016,  it is set to rise to 4½ percent, largely on account of the projected improvement in economic conditions of a number of economies, including Brazil, Russia, and Iran. As you know, Russia’s economy is in a recession but the pace of the decline in economic activity is expected to slow next year. Growth in China is expected to decline this year and next year, as previous excesses in real estate, credit, and investment continue to unwind. And China risks have risen recently, as I will discuss later.
• #11: The CCA region has both oil and gas exporters and importers. Oil and gas exporters comprise Azerbaijan (AZE), Kazakhstan (KAZ), Turkmenistan (TKM), and Uzbekistan (UBZ). CCA oil and gas importers are Armenia (ARM), Georgia (GEO), the Kyrgyz Republic (KGZ), and Tajikistan (TJK).
• #12: Growth in most CCA economies has slowed down considerably in 2015, largely as a result of the global shocks described, particularly the sharp decline in oil prices and the recession in Russia. Growth in oil exporters is expected to be 3¾ percent for 2015, down from almost 5½ percent in the previous year, despite a sizeable fiscal stimulus in some countries (3 percent of GDP in Kazakhstan and 1 percent of GDP in Uzbekistan). Slower growth in oil production (Azerbaijan, Kazakhstan), remittances from Russia (Uzbekistan), and public investment (Turkmenistan), as well as weaker confidence resulting from currency depreciations, have contributed to the slowdown in growth. For the oil importers, growth is expected to slow down to 2¼ percent in 2015 from 4¾ percent in 2014, despite a sharp increase in real fiscal expenditure in the Kyrgyz Republic and Armenia. The oil importers have strong economic links with Russia through trade, investment, and particularly, remittances (Tajikistan, Kyrgyz Republic, Armenia), and consequently, the contraction in Russia of 3¾ percent in 2015 has had a strong impact on these economies. Growth in the CCA is expected to recover in 2016, but only gradually, as oil and commodity prices stabilizes and growth improves in the region’s trading partners, particular Russia and Euro Area. The oil importers also have significant export ties with some of the oil exporters, and they will also be benefited by the improvement in their growth.
• #13: Growth is expected to recover only modestly in the medium term, remaining much lower than the 2000-08 average. The weak medium term growth outlook reflects a decline in productivity growth, inadequate physical infrastructure investment, overreliance on commodities whose prices have fallen, and a weakened outlook for Russia, as well as, to a lesser extent, for China.
• #14: Risks are tilted to the downside and mostly relate to a possible further deterioration in the external environment. They have risen in recent months. Weaker-than anticipated growth in trading partners, especially China, Russia and Europe would weaken demand for CCA exports and reduce foreign direct investment, stalling the recovery in 2016. A further decline in oil prices, possibly caused by a slowdown of growth in China and other emerging markets, or a return of Iran to the oil market, would adversely affect not only oil exporters but oil importers as well, because of lower imports and remittances from Russia, an oil exporter whose currency has been following oil price movements in recent months. The same applies to prices of other commodities (particularly metals), given China’s large share of their global consumption. Another downside risk is that the normalization of U.S. monetary policy would raise borrowing costs for countries with access to international markets (Armenia, Azerbaijan, Georgia, Kazakhstan) by more than is currently anticipated. A further strengthening of the U.S. dollar, reflecting asymmetric monetary policy in major advanced economies, together with a weakening of emerging market currencies, could put further pressures on CCA currencies.
• #15: This year, exports dropped sharply across the region. Lower prices for oil (for oil exporters) and metals (aluminum for Tajikistan and copper for Armenia) were a key factor. A weakening of demand from Russia also contributed to this decline. With external environment expected to improve only gradually and commodity prices remaining persistently low, exports of CCA are likely to recover only gradually, failing to reach recent historical averages. In fact, among CCA’s oil exporters, export values are projected to decline further in 2016 because of a continued slump in oil prices.
• #17: Besides exports of goods and services, remittances are an important source of external revenues for the CCA region. Remittances in US dollars (RHS chart) have fallen sharply over the past year due to the drop in the value of the Russian ruble and weaker economic activity in Russia. Being dependent on Russia’ economic prospects, remittance flows are expected to recover only gradually.
• #18: The current account balance in the CCA oil exporters is expected to turn from a surplus of 3.3 percent of GDP in 2014 to a deficit of 2.7 percent in 2015, reflecting large oil export revenue losses. The projected decline in exports in 2016 from lower oil receipts is expected to push the current account deficit to 3.2 percent of GDP that year. The current account deficit in the CCA oil importers is expected to remain high at about 10 percent of GDP. Weaker exports and a large drop in the dollar value of remittances—in part the effect of a weakening of the Russian ruble—are expected to offset gains from lower oil prices and slowing import growth. The current account deficit is expected to improve modestly in 2016 but remain above 9 percent.
• #19: Declining foreign currency inflows from exports, remittances, and foreign direct investment, together with the appreciation of the U.S. dollar and the sharp drop in the value of the Russian ruble, have created pressure on the CCA currencies to adjust. Between November 2014 and August 2015, all the CCA currencies weakened against the U.S. dollar. The exchange rate adjustment helped to moderate the strengthening of their currencies against trading partners in inflation-adjusted terms and hence helped reduce the loss of competitiveness. It also helped to reduce the impact of lower oil prices on the governments’ revenues in local currency terms for the oil exporters.
• #20: However, weaker currencies have pushed up inflation, which is rising in most countries this year--in Tajikistan it is projected to reach double digits. Next year, inflation is expected to moderate in most countries, as the impact of recent depreciations wears off and food and fuel prices remain benign. Notable exceptions where inflation is anticipated to drift up in 2016 are Georgia, Kazakhstan and Kyrgyz Republic, partly from the exchange rate depreciations.
• #21: The public sector has not been immune to the external shocks either. Fiscal deficits rose in most CCA countries in 2015. Revenue contracted from lower oil prices in oil exporters, and weaker economic activity across the region. Public expenditure accelerated as governments tried to support economic activity in response to the shocks. The fiscal response to these shocks has been appropriate in the short term. However, it has resulted in reduced policy buffers and/or higher public debt, limiting the margin to respond in the event of additional shocks and calling for adjustment in many cases. Public debt has been rising in most CCA countries, especially among oil importers. During 2015 public debt has increased to about 45 percent of GDP in this group (some 7 percentage points). Debt to GDP ratios expanded rapidly in Armenia and Kyrgyz Republic, which are also among the highest in the region. With external conditions expected to improve in 2016, most CCA countries are projected to return to the path of fiscal consolidation. In the medium term, governments should preserve debt sustainability, rebuild policy buffers and share resource wealth with future generations.
• #23: The long-lasting nature of the shocks means that postponing policy adjustment is not an option, and policies need to adjust to the new reality. Policy Priority 1: Fiscal policy should ensure medium-term sustainability. Fiscal policy needs to strike a balance between supporting near-term growth and ensuring debt sustainability in oil importers and sufficient savings for future generations in oil exporters. Both groups of countries need ample buffers to deal with future adverse shocks. One way to achieve this balance is by carefully choosing the composition of medium-term fiscal consolidation programs. Improving the quality of public expenditure, and preserving capital and social expenditure, will help to safeguard growth and make it more inclusive.
• #24: Policy Priority 2: Monetary and exchange rate policies should strike the right balance. Monetary policy should be primarily calibrated toward curbing inflationary pressures and anchor inflation expectations. However, due consideration should be given to economic activity and the financial sector. Excess monetary tightening may inhibit economic growth and weaken financial intermediation. Greater exchange rate flexibility, accompanied by clear communication to the public, can help absorb shocks, maintain competitiveness and prevent a rundown of external buffers. Financial Sector Oversight This, however, should take place in the context of strong supervision, effective macro-prudential regulation, and a crisis management framework to ensure that the financial sector remains healthy. Forbearance and directed lending should be discouraged.
• #25: Policy Priority 3: Design and implement structural reforms to support long term growth Developing the private sector beyond the extractive industries and making growth more inclusive will help the CCA region reduce its reliance on commodities and remittances. To achieve this, the CCA countries need to address important structural bottlenecks. As the chart shows, the region has been lagging behind other emerging markets in the quality of education, financial development, and export diversity, while control of corruption and the business environment are also weak in many countries. Addressing these shortcomings, together with infrastructure bottlenecks and market-based restructuring of state-owned enterprises, would help boost medium-term growth prospects, and create employment opportunities for returning migrants and new entrants to the labor market.