Caucasus and Central Asian (CCA) countries need to tighten their monetary policy to anchor inflation expectations, but excess tightening may weaken financial intermediation and hinder economy activity, the IMF warns in its Regional Economic Outlook, presented in Almaty on October 23.
It said exchange rate depreciations since the beginning of this year were going to raise inflation in most countries despite weakening demand and low global food prices. Inflation is expected to increase to an average of 6.75% in the region in 2015 from 5.75% in 2014, the IMF predicts.
“Monetary policy in the CCA region faces complex trade-offs: inflation is picking up while economic activity remains weak and the highly dollarised financial sectors in many countries are under duress,” the outlook says. “Monetary policy needs to be tightened in countries where inflation pressures are high.”
Almost all the regional countries allowed the national currencies to depreciate to absorb external shocks such as the slowdown in the region’s main trading partners – Russia, China and the EU – and low commodity prices, and these depreciations have enabled the countries to protect their foreign reserves and remain competitive, Juha Kahkonen, the deputy director of the IMF’s Middle East and Central Asia Department, said in an interview with bne IntelliNews.
“But the side effect of these depreciations that is undesirable is that they put pressure on the banks. And in the Caucasus and Central Asia this is especially so because there is a lot of dollarisation,” Kahkonen said, referring to the fact that more tha 60% of deposits are in foreign currency in some countries in the region. “When foreign currency depreciates this is difficult for foreign currency borrowers and banks to serve their debts.”
The deputy director believes that for this reason it is important for central banks, while allowing currencies to depreciate, to take measures to improve banking supervision and other measures to strengthen the financial sector to withstand added pressure from depreciations. Central banks need to be “very vigilant” in banking supervision to ensure capital adequacy, and introduce macroprudential measures to keep inflation within the target range, Kahkonen believes.
“That the central banks have managed to keep inflation in single digits except for Uzbekistan where inflation might be slightly over 10% is a good outcome given the circumstances and this is a testimony to the ability of the central banks to do what they have been tasked to do,” he said.
He hailed the National Bank of Kazakhstan’s measures to prevent destabilisation on the currency market after the country abolished a trading corridor for the national currency, the tenge, allowing it to float freely: “In Kazakhstan the central bank introduced the overnight rate as a new policy rate and it has been moving it [up and down] to keep inflation within the target range.”
Currency depreciations, declining remittances, and the economic slowdown are putting pressure on the financial sector in the region, the outlook notes. “The effect of these shocks has been amplified by significant pre-existing vulnerabilities: dollarised bank balance sheets, short open foreign exchange positions, lending to unhedged borrowers, directed lending, and concentrations in loan portfolios. These vulnerabilities imply that capital buffers may overstate the ability of banks to absorb shocks.”
The IMF warns that the balance sheets of banks, households and businesses had already started to weaken as revaluation losses and credit and liquidity risks had risen. Bank profitability and capital adequacy have declined, as currency depreciation eroded capital adequacy buffers for banks that have capital in local currency and risk-weighted assets in dollars. At the same time nonperforming loans have increased in Armenia, Azerbaijan and Tajikistan, the outlook says, while financial conditions have tightened, especially in Kazakhstan and Armenia.
“Rising balance sheet risks have increased risk aversion among banks, which, combined with declining aggregate demand, is curtailing private sector credit growth,” the IMF says. The volume of loans issued in the region’s largest economy – Kazakhstan – shrank by 6% between January and August, according to the country’s central bank.
“Policymakers also need to carefully balance the trade-offs between macroeconomic and financial stability objectives,” the IMF suggests.
Since the IMF sees the current situation in the region as being permanent, the countries need to adjust their policies accordingly and start rebuilding buffers that they had used. “It is very difficult for oil importing countries in the region that have suffered from low remittances, so they need to control their budgets and make sure that they are not intervening too much in the foreign exchange markets because they don’t have large reserves to spend,” Kahkonen said.
In its latest outlook the IMF predicted that lower oil, gas and metal prices, together with spillovers from a contraction in Russia, would slow down the regional economy to 3.75%, one of the lowest rates since independence, and 1.5 percentage points lower than in 2014.