Commonwealth of Independent States: Strong Growth but More Economic Diversification Needed

Activity in the Commonwealth of Indepen­dent States (CIS) continues to expand briskly, reflecting the solid performance of energy exporters and a pickup in activity among energy importers, many of which have benefited from rising nonfuel commodity prices and strength­ened domestic demand (Table 2.6). Looking forward, while real GDP growth is expected to moderate, its pace would be second only to emerging Asia among the major regions. In Russia, growth would remain strong, although output appears to be running close to capac­ity in the face of robust domestic demand. Oil production growth has slowed, however, reflect­ing limited past investment. In Ukraine, the rise in international steel prices and robust domes­tic demand are underpinning a strong growth rebound, but the pace of activity is expected to moderate in response to large increases in the price of imported natural gas and an associated overall deterioration in the terms of trade.

Upside risks to the outlook for the region as a whole relate to a possible rebound in oil prices and stronger-than-anticipated demand for the region's principal non-oil commodity exports. On the downside, a sharp slowdown in global activity could adversely affect exports, although domestic demand should be resilient in most countries.

Current account positions have strengthened in energy exporters such as Turkmenistan and Azerbaijan. In other countries, current account balances have deteriorated due to a strong rise in import volumes as well as the rising costs of energy imports (Ukraine and Georgia) and the weakening demand for specific exports (Armenia). Looking ahead, the regional current account position is expected to remain strong, reflecting the continued underlying strength in demand for the region's principal exports.

Reflecting the strength of domestic demand and strong capital inflows, inflation among CIS countries remains among the highest in the world, despite some moderation in several countries. In Russia, headline inflation came down by 2 percentage points during 2006, reflecting lower administered price increases and some nominal appreciation of the ruble, but at 9 percent still remained above the official target of 8.5 percent for end-2006. Bringing inflation down to the 2007 target of 8 percent will depend on allowing greater nominal appreciation of the ruble and a more restrictive fiscal stance. In Ukraine, inflation has recently accelerated into double digits following the pass-through of higher energy import prices. Monetary policy needs to play a more active role to ensure that the recent spike in inflation does not feed into higher inflationary expectations. The authorities' preliminary steps toward an inflation targeting regime are welcome, but a gradual transition to greater exchange rate flexibility will be needed to support this framework.

Fiscal balances in several countries have deteriorated as large spending increases have outpaced the increase in revenues related to higher export earnings and stronger domestic economic activity. In some others, fiscal positions have strengthened. In Russia, the primary fiscal balance has improved as a large proportion of the higher oil revenues has been placed in the stabilization fund, although spending has also accelerated. In Ukraine, spending has been held below budgeted levels while revenue growth has been strong. More generally, in the context of already strong domestic demand, governments will need to be careful to avoid excessive public spending increases, particularly in areas that boost consumption—such as on pensions and wages—and exert upward pressure on inflation. In countries where there is scope to boost public spending over the medium term, governments should ensure that expenditures are geared toward generating high-quality growth that is not linked to the commodity price cycle and are allocated efficiently in the context of often weak institutional capacity.

More generally, sustaining the recent strong growth momentum will require a diversification

of the sources of growth away from exports of primary commodities. The strength of domestic demand in recent years has been driven to a large extent by consumption, fueled by capital inflows, rapid credit growth, and, in some countries, increased public sector spending in the form of wages and pensions. Despite sizable public investment in some countries, focused mainly in resource extraction industries and related transportation infrastructure, the overall ratio of investment to GDP among CIS countries remains relatively low (Figure 2.9). This underscores the need to attract greater private investment in noncommodity sectors. Foreign direct investment, in particular, is low in these sectors. Many countries in the region have a large unfinished structural reform agenda, as seen, for example, by the region's slower pace of reform relative to central Europe and the Baltics, and further progress is needed to improve the investment climate. The main priorities are broadening and deepening domestic financial markets, reforming civil services and the energy sector, making tax systems more growth- and investment-friendly, strengthening the protection of property rights, reducing corruption and state intervention, and strengthening legal and regulatory systems.
 

Figure 2.9. Commonwealth of Independent States (CIS):
Further Reform Needed to Raise Investment Levels

The CIS region attracts relatively low levels of foreign direct investment, while
overall investment is still dominated by the natural resources sector and related
transportation infrastructure. Further reform is needed to improve the investment
climate.

Sources: EBRD, Transition Report; and IMF staff calculations.

    Notes:
1/ The transition Index is the unweighted average of large-scale privatization index, smallscale
privatization index, enterprise restructuring index, price liberalization index, trade and
forex system index, competition policy index, banking reform and interest rate liberalization
index, securities markets and nonbank financial institutions index, and overall infrastructure
reform index.
2/ Belarus, Kazakhstan, Russia, Turkmenistan, and Ukraine.
3/ Armenia, Azerbaijan, Georgia, Kyrgyz Republic, Moldova, Tajikistan, and Uzbekistan.