Subregional performance
Subregional growth in gross domestic product (GDP) was boosted by a favorable external environment as oil and non-oil commodity prices rose. GDP growth strengthened to 12.4% in 2006 (Figure 1.3.1), up from 11.2% in 2005, and from an average of 9.4% over 2000-2005. The hydrocarbon exporters-Azerbaijan, Kazakhstan, Turkmenistan, and Uzbekistan-accounted for much of the growth. Most non-oil exporters also saw higher growth, benefiting from stronger non-oil commodity prices, and from workers' remittances from, primarily, Kazakhstan and the Russian Federation. Only the Kyrgyz Republic's growth was anemic.
While vibrant external demand is the proximate cause of the growth upturn, domestic demand, in particular private consumption growth, has also been buoyant, stimulated by higher wages, remittances, and credit expansion. The rapid expansion in construction and services across the subregion is bifurcated, from the oil boom on the one hand, and from remittances on the other.
Strong domestic demand, together with rising net foreign assets, put upward pressure on prices and the money supply. Subregional average consumer price inflation rose slightly to 8% in 2006, with higher inflation reported in four countries (Tajikistan, Kyrgyz Republic, Kazakhstan, and Armenia) and a fall reported in two official estimates (Azerbaijan and Uzbekistan).
For countries that experienced higher inflation, contributory factors include wage and pension increases, higher food and fuel prices, and credit expansion. Azerbaijan's officially reported decline in inflation is at odds with alternative estimates that are more consistent with the last couple of years' surge in spending. Reflecting expansion in credit to the private sector and accelerating official reserves accumulation, broad money has grown strongly in several countries. Monetary tightening measures taken by central banks, including raising refinancing rates and reserve requirements, have not been very effective so far.
Fiscal positions showed diverging patterns as oil exporters' soaring revenues were used to ramp up public spending while the non-oil exporters' were accompanied by expenditure restraint. Azerbaijan and Kazakhstan pursued an expansionary fiscal policy, spurred by burgeoning oil revenues: Azerbaijan's non-oil fiscal deficit as a share of non-oil GDP in 2006 was estimated at an unsustainable 36%. Kazakhstan's non-oil fiscal deficit was much lower. The saving factor (literally) was the large increases in net assets of the oil funds of the two countries. With improved tax collections and expenditure restraint, the Kyrgyz Republic and Tajikistan managed to improve their fiscal positions despite the severely constrained fiscal space they had to contend with, while Uzbekistan and Turkmenistan maintained a more or less balanced recorded budget. Of concern are the still sizable energy sector quasi-fiscal deficits in Azerbaijan, Kyrgyz Republic, and Tajikistan, that reflect weak public resource management and that narrow the fiscal space.
External performance reflected differing dynamics of trade and invisibles accounts. Large current account surpluses were recorded in Azerbaijan, Turkmenistan, and Uzbekistan, as commodity price-driven surges in export revenues outpaced imports. There was a notable slowing of import growth in Azerbaijan as hydrocarbon-related imports of machinery and equipment tapered off with the completion of a number of large projects. Kazakhstan's more modest current account surplus as a share of GDP was due to the sizable trade surplus being offset by hydrocarbon-related services and income payments.
On the capital account, hydrocarbon-related net foreign direct investment (FDI) inflows fell in Azerbaijan but picked up in Uzbekistan. Export growth recovered in the Kyrgyz Republic and accelerated in Tajikistan but slackened in Armenia. All three countries saw acceleration in import growth fueled by higher energy costs and strong remittance-driven growth in demand for consumer imports. Trade deficits were partially offset by strong remittance inflows in other accounts of the balance of payments.
On the financing side, net FDI covered around one third (Kyrgyz Republic) to one half (Armenia and Tajikistan) of the current account deficit. Gross official reserves across the subregion have grown. This has proved to be a mixed blessing in that the resulting thicker import cushion comes with pressure on money supply from surging foreign exchange inflows. This is problematic in an environment where, in many cases, sterilization options are limited. Among low income countries that depend largely on official concessional assistance, currently, external debt sustainability is a concern for the Kyrgyz Republic. Among countries with access to capital markets, Kazakhstan's external borrowing by private commercial banks has risen steeply.
The subregion has seen some headway on structural reforms in certain areas such as small-scale privatization, banking reform, and infrastructure reform but in other areas such as governance and enterprise restructuring, the reform backlog is significant. Several countries have continued to improve the private sector incentive framework by streamlining the tax regime (Kyrgyz Republic and Uzbekistan), competition law (Kazakhstan), and business registration and licensing (Armenia and Azerbaijan). Uzbekistan's slow steps in trade reform (both external and domestic) continues to be an impediment to private sector development.
Several countries took measures to tighten bank regulation and supervision. In addition, Tajikistan made tangible progress in deregulating foreign participation in banks, strengthening minimum capital requirements, and delicensing banks. Kazakhstan continued to develop its securities markets and nonbank financial institutions. Areas to be looked at with renewed vigor include ownership transparency and related lending (Armenia), stalled bank privatization (Azerbaijan), and performance by banks of functions inappropriate for financial intermediaries (Uzbekistan).
With regard to sector reforms, in agriculture Uzbekistan continued to transform shirkats (farm cooperatives) into leaseholds, a contributory factor to reported higher productivity in the cotton subsector. In energy, Tajikistan undertook corporatization of the state electricity company and the formulation of a restructuring and unbundling strategy for the sector. Progress on public sector reform was mixed. While small-scale privatization has come on well (and is largely complete in several countries), large-scale privatization has made but a few, faltering steps. Corporate governance in public enterprises is also hobbled. Recent reform of the social protection system include improved social assistance targeting and pension reform (Azerbaijan).
Subregional prospects
Subregional growth is expected to remain strong with subregional growth at about 10% in 2007 and 2008. The external environment is likely to remain favorable even though oil prices are easing and non-oil commodity prices are softening. The subregion's hydrocarbon producers are expanding capacity that will meet higher demand from the larger Asian economies, particularly the People's Republic of China (PRC). Meanwhile, the hydrocarbon-importing countries now seem likely to get a respite from high oil prices. After a pause, hydrocarbon-related FDI inflows to the subregion's two largest oil producers (Azerbaijan and Kazakhstan) are likely to resume, while Uzbekistan is set to see a further pickup in FDI, particularly from the PRC and the Russian Federation.
Although non-hydrocarbon commodity prices are now softening, growth in demand, especially from the PRC, is seen sustaining export growth rates, while import growth rates could decelerate (as easing oil prices relieve pressure on trade balances).
Private consumption in the two big oil producers could moderate if domestic credit conditions tighten and greater wage restraint is exercised to check inflationary pressures. Private consumption in remittance-generating countries could remain strong if the pace of inflows keeps up.
Some downside risks are seen in: further surges in foreign exchange inflows, so creating excess liquidity and feeding through into very high inflation; deteriorating quality of loan portfolios as credit expansion continues unabated; tighter regulation of foreign migrants in the Russian Federation adversely affecting remittance inflows; worsening current account balances among oil-importing countries; and narrowing of fiscal space in countries with external borrowing constraints.
Country highlights
Armenia
Largely on account of the rapidly growing nontradable sectors of construction and services, the economy continued to grow beyond expectations at 13.4% in 2006. The fiscal deficit was kept in check through expenditure rationalization and tax reforms. Higher remittances, public spending, and private investment supported growth in domestic demand. Rising fuel prices and a poor agricultural harvest put some pressure on prices, but inflation remained contained. A moderate deceleration in GDP growth to 9-10% is expected in 2007-2008 as production capacity limits are reached and the pace of expansion in construction and services eases. Prospects are promising, but structural reforms have to continue, parliamentary and presidential elections must be seen to be democratic, and subregional conflicts need to be resolved to allow closed trade routes to open.
Azerbaijan
Phenomenal economic growth at 32% was recorded in 2006, powered by soaring production and exports of oil and gas. Very rapid expansion in government spending and the money supply are putting increasing pressures on prices and inflation in the last quarter of the year accelerated to 11%. Oil and gas production from recent investments will continue to underpin remarkable growth projected at 25% in 2007 and 17% in 2008. Foreign investment, primarily for hydrocarbons, is beginning to taper off as large projects in the sector become operational. The Government is bullish that much higher domestic public investment, especially non-oil, will partly offset this decline. Yet rapid and deep structural reform is imperative for such investment and-along with controlling inflation and preventing excessive exchange rate appreciation-is the key challenge.
Kazakhstan
Strong prices for oil and gas, rapid growth of domestic consumption, and a rebound in investment continued to propel the economy. Money supply grew by 80% over the year, fueled by a huge increase in credit to the private sector. GDP growth in 2006 was 10.6% and is projected to stay high at nearly 9% in 2007 and 2008. But these very strengths carry within them the seeds of future challenges-immediately, keeping rising inflation in check, and improving banks' risk management of their loan portfolios; further out, diversifying the economy, pushing through structural reforms, enhancing competitiveness, and ensuring more equitable development. These measures, plus fiscal and monetary policy coordination, are needed to ensure sustainable growth.
Kyrgyz Republic
Nearly 2 years after the Tulip Revolution, political stability remains elusive. Although the new Government made real efforts to maintain macroeconomic stability, tensions between the different power centers have distracted the authorities and hampered structural reforms, including the passage of key economic legislation. In addition, an accident at the Kumtor gold mine, the largest industrial contributor, kept growth slow at 2.7% in 2006. The medium-term outlook, though positive, is clouded by governance concerns, a poor business climate, and political uncertainty.
Tajikistan
The economy expanded at 7% in 2006, despite higher costs of oil and gas. Burgeoning remittances spurred demand, as supply shocks from higher oil, utility, and food prices pushed inflation back into two-digit territory. Implementation of large infrastructure projects and a favorable outlook for aluminum production (the dominant industry) should propel growth to 7.5% in 2007. Medium-term economic prospects are promising, if the expansion in externally financed infrastructure projects is supported by the broad development reforms.
Turkmenistan
The economy continued to grow rapidly in 2006, but the exact figure was likely lower than the official estimate. It is uncertain whether the newly elected president will embrace reform and engage with the international community. The country is heavily dependent on exports of gas and oil, a situation unlikely to change soon. Growth in 2007 is seen coming in at 8.5%, little changed from a year earlier. The key development challenges are to effectively channel oil and gas revenues toward productive investment, implement market-oriented reforms, and rebuild human capital.
Uzbekistan
Continued strong-but narrowly based-growth was driven by increased net exports, a pickup in workers' remittances, and productivity gains in agriculture. Major challenges over the medium term are to continue managing monetary and fiscal policies to cope with inflationary pressures, integrate the economy with the rest of the subregion, advance structural reforms in banking, restructure state enterprises, and remove state controls hindering private development. Economic growth in 2007 is projected at somewhat higher than 7%, a rate maintained for the past 3 years. Further diversification from commodities and energy would also help sustain growth.
Development challenges
Despite differences in resource endowments, in sources of growth, and in the pace of structural reforms, the countries of Central Asia face three main common challenges. First, all of them are undergoing transition-induced structural change. From overindustrialization before transition (as measured by industry's disproportionate share in employment), these economies are undergoing industrial restructuring that has entailed job destruction in old, inefficient state enterprises, and resource reallocation and job creation in new private firms. Some countries (e.g., Armenia) are quite advanced in the process of industrial restructuring, while others are still lagging. In the latter, a weak business environment is delaying the exit of inefficient state enterprises and new entry by private firms.
Second, much of the new industrial activity in the subregion involves the natural resource industries: energy (Azerbaijan, Kazakhstan, Turkmenistan, and Uzbekistan), gold (Kyrgyz Republic and Uzbekistan), aluminum (Tajikistan), and copper and other base metals (Armenia). On the positive side, the subregion's natural resource wealth has attracted FDI and spurred growth of related construction and services industries. The downside is that the subregion's share of skilled labor-intensive and capital-intensive manufacturing exports is on the decline. The subregion's policy makers recognize the inherent risks in being overly dependent on natural resource-based industries, not the least of which is heightened vulnerability to price shocks. Economic diversification is therefore high on their agendas. The challenge is to pursue this within an industrial policy framework based on a level playing field, and on transparency and accountability.
Third, surging foreign exchange inflows, whether due to oil revenues or remittances, are generating excess liquidity across the subregion. Thus far, the burden of mopping up the excess liquidity has fallen on central banks. Indeed in several cases, the fiscal stance has been part of the problem, not the solution. The challenge for policy makers is to pursue an effective strategy for price stability and enhance economic competitiveness. |
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