Commonwealth of Independent States:
Managing Large Foreign Currency Inflows

Real GDP growth in the Commonwealth of Independent States (CIS) is on course to reach close to 7 percent in 2006, before easing to about 6.5 percent in 2007 (Table 2.6). The region continues to benefit from high commodity prices and correspondingly strong export earnings (Figure 2.8).  

In several countries, domestic demand has received an additional boost from substantial private capital inflows (Russia, Kazakhstan), official financing (Georgia), and/or remittances (Armenia, Georgia, Kyrgyz Republic, Moldova, Tajikistan). Investment is recovering, including in Russia, where the impact of factors responsible for the slowdown in 2004–05—including banking sector turbulences and a tax-induced decline in oil sector profitability—is waning. Short-term growth prospects are generally positive, although they remain heavily dependent on commodity price developments. In the Ukraine, growth picked up quite strongly in the first half of 2006, but the outlook remains clouded by a projected deterioration in the terms of trade—due to the repricing of gas imports from Russia and a possible reversal in the export price of steel—and lingering policy uncertainties (at present, the Russian energy company Gazprom charges between $47 (Belarus) and $160 (Moldova) for 1000 cubic meters of natural gas. This compares to a price of $230 per 1000 cubic meters for customers in western Europe. Gazprom increased export prices to some CIS customers earlier this year, and has announced its intention to bring prices even more closely in line with “market valuations”).

The favorable external environment has created important challenges for macroeconomic management, however, that need to be addressed with some urgency to boost longer term growth prospects. High commodity prices have relaxed short-term fiscal policy constraints, both directly—by increasing export tax revenues and the profits of state-owned enterprises—and indirectly by boosting aggregate demand, and thereby receipts from consumption and income taxes. Often policymakers have used these extra funds prudently, including to pay down public debt and/or to build up foreign currency reserve cushions. More recently, however, some governments have granted large pension and wage increases (Azerbaijan, Belarus, Kyrgyz Republic, Tajikistan), which have further boosted consumption, undermined competitiveness, and would be hard to reverse should the commodity price cycle turn. Policymakers should not assume that recent revenue gains will all be permanent (see Chapter 5). In countries where scope for fiscal easing exists—such as in Russia, where there is room for some increase in public spending without sacrificing sustainability, and in Kazakhstan—a more expansionary stance should be accompanied by a reinvigoration of stalled reforms to ensure that higher spending boosts investment and potential GDP growth. 

Monetary policy also faces important challenges. While inflation has declined in recent months, it remains at or close to double-digit levels in many countries, especially oil exporters. Further progress is needed, but addressing disinflation is complicated by the focus of many central banks on stabilizing the nominal exchange rate against the U.S. dollar in the face of large current account surpluses and capital inflows. With the scope for sterilization of foreign exchange purchases limited by underdeveloped domestic debt markets, base money growth remains above levels consistent with low, single-digit inflation rates. The danger is that inflationary pressures may become entrenched, in which case costly measures may be required in the future to reverse the inflation buildup. While early repayment of external public debt or transfers into offshore oil funds (Azerbaijan, Kazakhstan) can help to reduce base money growth, the most effective way to lower inflation would be to allow for further nominal exchange rate appreciation, thus enhancing the scope for monetary control aimed at disinflation. In some energy-importing countries, inflationary pressures could also emerge from the prospective repricing of fuel and gas imports, in which case monetary policymakers will need to ensure that the necessary pass-through of higher costs does not feed into core inflation, wages, and inflation expectations. 

The commodity price boom has also complicated efforts to diversify production and exports away from primary materials to goods with a higher value-added component. Attracted by high expected export earnings, recent investments— both domestic and foreign financed— have often focused on extractive industries (Azerbaijan, Turkmenistan) or on commodity transport infrastructure (oil and gas pipeline projects in Armenia, Azerbaijan, Georgia, Kazakhstan). Moreover, the overall level of investment in the region remains too low at 21 percent of GDP—the recent recovery notwithstanding— which casts doubt on the sustainability of current growth rates over the medium term. Structural reforms to improve the investment climate are crucial to avoid the emergence or aggravation of supply bottlenecks. In countries with large current account surpluses— notably Russia—higher investment would also contribute to reducing global macroeconomic imbalances. 

External positions are strong in many countries in the region, especially fuel exporters. For the region as a whole, a current account surplus of over 10 percent of GDP is projected for 2006. Large surpluses have permitted a rapid reduction in the overall level of external debt in oil exporters, especially by the public sector. In several countries (including Azerbaijan, Kazakhstan, and Russia), however, the private sector has accumulated substantial foreign currency liabilities in recent years (Figure 2.8), often intermediated by the banking system. As a consequence, the private sector’s vulnerability to a tightening in external financing conditions has increased. Financial system soundness indicators have remained broadly stable, but this is partly on account of the favorable macroeconomic environment. A strengthening of prudential regulations and risk-based supervision would help to reduce risks of financial instability in the face of a downturn, as would measures to restrict regulatory forbearance and—in some cases—policies to assure that the risks associated with the buildup of foreign currency liabilities remain contained.