Forks in the road

Economic prospects in the CIS in 2011

Main patterns of growth in 2010
A drop in real GDP of almost 6% in the east European transition economies in 2009 was the most severe of the regional recessions of that year. Beginning in the first quarter, however, most of east European economies saw a return to economic growth in 2010, which averaged about 3% for the year. In the main, the recoveries were export-led, with the lagged effects of large international stimulus packages, and in some cases substantial multilateral aid programmes, also playing a role. The pace of growth in domestic demand was generally much weaker, or in some cases remained negative. In particular, investment remained weak, depressed by low levels of business confidence linked to the uncertainty of the macroeconomic outlook, as well as to spare production capacity. In addition, household spending was weighed down by low levels of consumer confidence linked to poor employment prospects, high unemployment, falling or slowing wage growth, high levels of indebtedness, the paucity of credit as banks continued to repair their balance sheets, and a drop in workers' remittances.
Notably, the recoveries in the economies of the Commonwealth of Independent States (CIS) were generally stronger than for regional economies further west. The contrast was starkest between those economies that had been tipped into recession in 2008-09 by a fall in external demand and international commodity prices, and those that, before the crisis, had relied for rapid growth on domestic credit booms fuelled from external borrowing. Some of the bigger countries in the CIS, such as Russia and Ukraine, exemplify the first situation, whereas a number of countries in the Baltics and the south-eastern Balkans exemplify the second. [Some latest growth figures, highs, lows, averages, contrasted with rates before the crisis.] A second contrast with the countries of central-eastern Europe is that, whereas their prospects are bound up with those of the EU, where unfolding sovereign debt crises in peripheral countries have threatened the integrity of the common currency, the crucial relation for many CIS countries is with developments in Russia and Kazakhstan, the leading hydrocarbons-exporting economies within the organisation.
Finally, the political uprisings in the Arabian Peninsula and Arab North Africa may hold mixed economic and political prospects for the authoritarian hydrocarbons producers in the CIS, boosting state resources by pushing up hydrocarbons prices on world markets, while at the same time providing potentially replicable models for political confrontation with authoritarian state apparatuses.

The main, interlinked policy dilemmas
With the recovery having gained purchase, governments are now turning to a number of tough common policy dilemmas. The first weighs fiscal austerity against growth, because of the potential damage of withdrawing budgetary support before economic recovery has become self-sustaining. This concern is accentuated by the expectation of a downturn in global economic growth in 2011, as the boost from the big international stimulus packages fades. Thus, with fiscal and growth imperatives pulling in opposite directions, the benefits of running a loose monetary policy are likely to be cast in a favourable light, at least for a time longer. This is because maintaining liquidity could help to sustain economic activity, both directly, through its impact on domestic demand, and indirectly, by way of aiding the repair of bank balance sheets. This second effect could encourage a return to higher rates of credit growth, which plummeted during in the crisis and which are still well below the rates seen in the boom period. Without this, lower rates of economic growth will remain the norm for longer. However, for some governments, the return of inflationary pressures, both from rising international prices for commodities and food, and, further off, from individual economies as consumption demand begins to revive and spare capacity to dwindle, will create pressures in the opposite direction, pitching the desire to boost economic growth against the need to contain the pace of rise in the general price level. Another policy priority facing some governments across the region, and especially a few of the weaker economies in the CIS, will be the need to pursue policies to maintain external stability in the face of large external deficits and the build up of external debt.

Policy and performance in Russia and Kazakhstan
In both Russia and Kazakhstan, high and rising prices for hydrocarbons internationally, relative to 2009, will continue to sustain economic recovery in 2011. In Russia, the pick-up of consumer demand has been relatively unhindered by an overhang of private debt. In contrast, despite some progress in 2010, in Kazakhstan the inability of households and firms to pay pack loans—aggravated by the depreciation of the tenge that was induced by a sharp fall in inflows of foreign-exchange from the end of 2008 as a result of the global financial crisis—continues to place limits on the lending of the Kazakh banks, as they are forced to raise provisions against non-performing loans (NPLs). Thus, NPLs across the banking sector had risen to 26% in the first half of 2010, according to the IMF. Domestic credit growth in Kazakhstan dropped from a peak of almost 80% year on year in 2006, to just below 7% in both 2009 and 2010, according to the Fund. (In contrast, the peak rate of annual domestic credit growth in Russia was lower, at around 44% in 2007, and it dropped much less steeply, to around 22% in 2010.) This will restrict the speed of growth not only of the domestic economy, but also of its smaller Central Asian neighbours in particular. It should push policymakers in Kazakhstan to keep short-term policy interest rates low for the near future.
Of the two, Russia would thus appear to be in a better position economically to attempt to reduce the fiscal deficit in 2011. The possibly short-term boost to hydrocarbons export earnings as a result of a fresh round of political turmoil in the Middle East, which has stoked market fears over supply, should ease official plans to bring down the fiscal deficit, which reached the equivalent of almost 6% of GDP in 2009. Nonetheless, addressing the underlying problem of a structural non-oil fiscal deficit could remain, or even be discouraged by the same development.
Another important factor to keep an eye on for assessing regional economic prospects is the construction sectors in both countries, which continue to perform poorly, reflecting both excess capacity and a reluctance of the financial sector to lend. Construction is traditionally a large employer of migrant workers from other countries in the CIS and will thus feed into the prospects for a revival of private consumption and some kinds of investment in those states, through the link of remittance returns.

Fiscal consolidation in Central Asia

Fiscal consolidation is required not only as the payoff for any fiscal expansion undertaken during the economic crisis: following events in Greece in the first half of 2010, there is the additional incentive for governments to do so to try to convince international lenders of their fiscal rectitude. The kind of response possible will depend on the resources available. Broadly, just as hydrocarbons exports had allowed some countries to build up funds to draw on to cushion the full impact of the fall in external demand during the recession, so the recovery of oil prices and revenue will afford them greater room for manoeuvre for fiscal consolidation during the recovery. Kazakhstan and Azerbaijan both appear to be aiming for fiscal consolidation in 2011. In practice, in Kazakhstan this is planned to happen not only by means of a reduction of transfers from the NFRK, the sovereign oil wealth fund, but also through the imposition of an export duty and a progressive income tax. In Azerbaijan, overall deficit reduction is planned to go hand in hand with a rise in transfers from SOFAZ, its own oil windfall account, for social and infrastructural programmes, as well as part of the medium-term goal of industrial diversification. On the revenue side, non-oil fiscal consolidation will be hampered by an expected sharp slowdown in economic growth in 2011 linked to a fall in oil production volumes, which will put a dent in the growth of fiscal inflows. Hydrocarbons revenue may discourage necessary structural reforms in Turkmenistan and Uzbekistan.

Pulling the rug

More notes from May 2009

The possible impact of the global economic crisis on political instability in Central Asia and the Transaucasus
The level of trust in a range of political institutions across the counties of eastern Europe and the former Soviet Union was low even before the onset of the ongoing global financial and economic crisis, but it will make the situation worse.
In broad terms, the consequences of the crisis have been transmitted to the countries of Central Asia and the Transcaucasus through the impact of the financial meltdown and fall in hydrocarbon prices on the region's leading economies. For many former Soviet countries, the consequent fall in trade, remittances and investment inflows has already started to be felt, although not evenly, in terms of declining incomes and rising unemployment—two factors that tend to presage outbreaks of social and political unrest. However, economic stress on its own would not usually be enough to cause an outbreak of unrest. Rather, it is the interaction of economic stress with specific political and social factors already in place that is crucial.

Much in common
The states of Central Asia, the Transcaucasus and Russia share a number of these underlying factors associated with political upheaval. For instance, all of them, except Russia, have had a limited existence as independent states, all emerging as national entities only with the demise of the Soviet Union in 1991. In many, low levels of public trust hinder the effectiveness of political and governance systems, all of which are also mired by high levels of corruption. Finally, all of them, except Russia and Kazakhstan, are surrounded by countries that are also prone to the structural causes of unrest. This is the so called bad neighbourhood effect, which is one of the main causative factors behind political stability, according to the political science literature.

Most exposed
Those states most at risk because of pre-existing structural weaknesses—the Kyrgyz Republic, Tajikistan and Georgia—share a number of relevant traits in common. The Kyrgyz Republic and Tajikistan exhibit a high degree of ethic fragmentation; for example, conflicts between the ethnic Kyrgyz majority and the Uzbek minority, which is concentrated in the south of the country, have been a persistent source of political tension in the Kyrgyz Republic since independence. Tajikistan and Georgia have both experiences of at least two major episodes of political instability in the recent historical past. Tajikistan, for instance, suffered two bouts of all-out fighting in its five-year civil war of the 1990s, in which at least 50,000 people were killed (fuelled, among other things, by ethnic rivalries). For its part, not only has Georgia seen the outbreak of armed conflict as a part of it effort to bring its breakaway regions of South Ossetia and Abkhazia under control—most recently and disastrously in August 2008—but the existing political order has been overturned by force more than once. The first time was in the early 1990s, when the nationalist president, Zviad Gamsakurdia, was ousted in a coup. His successor, Eduard Shevardnadze, was kicked out in turn in a peaceful, large-scale social protest following a falsified election in the so-called Rose Revolution of November 2003. (Demonstrations in the Georgian capital, Tbilisi, ongoing since April 2009 against the authoritarian drift of the current president, Mikheil Saakashvilli, have suggested to may observers that a similar pattern may be about to be repeated.)
Another important factor, shared by the Kyrgyz Republic and Georgia, is that they are held to be regimes of an intermediate type. That is, they benefit from neither the public consent necessary for the working of a consolidated democracy, nor the combination of institutions and resources for repression necessary to maintain wholly authoritarian rule. Additionally, Georgia's susceptibility to the underlying causes of unrest is greatly heightened by the combination of its intermediate regime type and a fractional polity (mainly reflecting the inability of the central authorities to exercise political control over the country's breakaway regions, which make up 10-15% of Georgia's territory). On the other hand, Georgia's better economic starting point puts it in a healthier position to deal with the consequences of the economic crisis than either Central Asian country. The likely impact the regional economic downturn on unemployment rates in the Kyrgyz Republic and Tajikistan thus put them at highest potential exposure to political instability overall.

Look at the fine print
Finally, at the beginning of 2009, suffering electricity shortages and blackouts, facing factional fallouts within the ruling group, a unifying opposition and a looming economic downturn, the government of the Kyrgyz Republic began to look vulnerable to a financial crisis. However, a large aid package from Russia in February has since turned the situation around completely. This shows the importance of looking at detailed country case studies, in combination with quantitative comparative models, when assessing vulnerability to political unrest in specific cases.

More Tulips in the spring?

Prospects for political instability in Central Asia
Outbreaks of unrest, as far apart as Vladivostok and Kiev, Latvia and Bulgaria since the end of 2008 seem likely to be only the first stirrings of far greater eruptions of social protest in the year to come, as the full impact of the global economic crisis is felt. These events thus raise starkly the question of the possible implications that the global economic crisis might have for political stability in the region—that is, not just for the continued rule of incumbent governments, but also for the continued existence of established political systems.

For the Kyrgyz Republic, this question takes the form of whether the political system that has developed since September 2007 is sufficiently robust to face down any possible surge in political and social unrest, stoked by the economic downturn, or weather it would be more prudent to expect a re-enactment of the "Tulip Revolution" of 2005, in which perceptions of corruption and electoral falsification led to mass demonstrations and the removal of the previous president, Askar Akayev.

To this end, the Economist Intelligence Unit has developed a Political Instability Index to facilitate comparison of countries' vulnerability to unrest, conceived as a product of the interaction of underlying social and political factors brought into sharper relief by economic distress. For this reason, the overall index is made up of two component indices: one that tries to capture underlying vulnerability, and a second that measures economic distress. (For the full results and methodology, see here and here.)

Table: Political Instability Index for Russia and Central Asia in 2009

Although the Kyrgyz Republic does not rate as the east European country most vulnerable to political instability in 2009—that accolade goes to Ukraine—within Central Asia, it vies with Tajikistan for this position, with the two ranked in joint 33rd place globally, along with countries that include Myanmar and Argentina, on an overall score of 7.1, out of a maximum possible instability score of 10. This marks the two Central Asian states as slightly more susceptible to unrest than Columbia, but slightly less susceptible than Sierra Leone.

In our index, the Kyrgyz Republic, along with Tajikistan and Uzbekistan, starts off at greater risk from the impending economic stress, on the assumption that poorer countries are less well-equipped to cope with it. However, the overall political instability scores for all countries in the region, and Russia, worsen significantly in 2009 relative to 2007, reflecting a large increase in their scores for economic distress. This is because, in light of the intensification and spread of the world economic crisis to the region, all of them face a significant risk of a fall in real GDP per head this year—of more than 4% in the case of Russia—and all except Kazakhstan are at significant risk of the rate of unemployment rising above 10%.

For all of the countries in question, corruption is rated as high, and all of them, except Russia, have only become independent states in recent years—that is, since the fall of the Soviet Union in 1991. Tajikistan is scored as slightly more vulnerable to the underlying causes of unrest than the Kyrgyz Republic, partly because it has a greater number of large-scale episodes of political instability in its recent past (an estimated 50,000-100,000 people were killed in its five-year civil war in the 1990s), and partly because its infant mortality rate is higher than expected for its level of income level, a measure that stands in as an indicator of the level of social provision. The Kyrgyz Republic, however, is more vulnerable as a political regime that is neither fully democratic nor wholly authoritarian, whereas all the other Central Asian countries (but not Russia) have the advantage, from the point of view of state stability, of being authoritarian regimes. Additionally, Uzbekistan, Turkmenistan and Russia are more ethnically homogeneous.

Consequently, the least we can say is that for a young, semi-democratic state in a "bad neighbourhood", mired by corruption and enjoying a low level of public trust in its institutions, the expected earthquake of falling living standards and rising joblessness has a high chance of shaking the foundations of the country's political institutions, even if, on its own, this would not necessarily be enough to bring these institutions down.

When you walk through a storm

How will the global economic crisis affect the Kyrgyz Republic?
Up until recently, the view was widely held that countries such as the Kyrgyz Republic would to a great extent be protected from the effects of the global credit crunch by their lack of integration with international financial markets. In late 2008, however, the global financial and economic crisis, having surfaced in the US property market a year earlier, deepened and spread rapidly across eastern Europe. From September the crisis swept over Russia, the region's largest economy, as investors withdrew, and the Russian Central Bank (RCB) was forced to make massive drawdowns on its reserves to increase liquidity in the banking system and to try to prevent a rout of the rouble. Kazakhstan had been an earlier casualty of the drying up of the international credit markets. Because of their size, the spillover of the world financial crisis into the real economies of the two countries has sharply worsened the short-term outlook for regional economic growth. The question of the likely impact on the Kyrgyz Republic has thus become more pressing, and has already forced an adaptive reformulation of Kyrgyz economic policy. At the same time, the country continues to grapple with the aftermath of a number of severe economic shocks from an earlier phase. By tracing some of the knock-on effects of these developments, the scale and complexity of the problems confronting Kyrgyz economic policymakers becomes apparent.

Impact of the regional economic slowdown
Reduced foreign demand. Between them, Russia and Kazakhstan bought around 40% of Kyrgyz exports in 2007. Most obviously, therefore, the regional economic slowdown will substantially reduce the growth in external demand for Kyrgyz goods, making the domestic economic growth rates achieved during the past couple of years more difficult to sustain. By tightening the limits on revenue growth to the budget, it will also constrain the ability of the government to deal with the multiple consequences of economic deceleration.
Reduced foreign investment. Russia and Kazakhstan are both heavily dependent on oil. Until the recent past, they were both also significant players in the international bond and syndicated loans markets. With these capital flows to the region drying up or declining significantly, and the price of oil plummeting from its mid-year peak, it would be prudent—based on purely commercial rather than geo-strategic grounds—to expect a scaling back of foreign investment. On preliminary figures from the National Statistical Committee (NSC), for 2008 as a whole, fixed capital investment from all sources, at Som29.2bn, was already down by more than 5% on 2007. In turn, a reduction in investment will have a negative impact on economic growth and add to difficulties in covering the widening external imbalance.
A slowdown in remittance inflows. Russia and Kazakhstan have been the main sources of inflows workers' remittances to the Kyrgyz Republic. At US$715m in 2007, according to the World Bank, remittances equalled almost one-fifth of the country’s GDP in that year, and were assessed at approximately the same level in 2008. At the beginning of November the head of the Kyrgyz State Committee for Migration and Employment estimated the figure for 2008 at between US$800m and US$1bn. Curiously, local press reports suggest that there has as yet been no large-scale return home of migrant labour from these destinations, but a slowdown in the growth of remittance inflows, particularly as the economic crisis takes its toll of the Russian and Kazakh property and construction sectors, is certain. This will restrain the expansion of household disposable income, and thus the pace of growth of private consumption. It could also add to unemployment and wage competition if migrants begin to return home in large numbers.
Spillover from the Kazakh banks. Although the Kyrgyz financial system has been protected by its underdevelopment and relative lack of international integration, the impact of the crisis in international credit markets on Kazakh banks—which own about half of the Kyrgyz Republic's commercial banks—has already seen a steep slowdown in the growth of "credit to the economy", which peaked at above 110% year on year in late 2007, according to the IMF, but slowed to annual growth rates of 20-30% a year later. The sharp deceleration in credit growth, in combination with a likely tightening up of lending criteria, will affect businesses that had been planning to expand by using resources from outside the firm, as well as the borrowing of households, thus subduing the expansion of private consumption and domestic investment demand.

The effects of other economic shocks
The inflationary surge. In the year from the middle of 2007, a surge in global prices for food and fuel was the main factor behind a rise in inflation, which peaked at 32.5% year on year in July 2008, although it has since tumbled, in line with falling commodity prices, to below 17% in October. According to preliminary figures from the NSC, consumer price inflation crept back up 20% in December 2008, probably under the impact of currency weakening. This compares with a target range originally set for the year of 12-15%. The Kyrgyz Republic’s peak rate was high even for the region. This is mainly because the Kyrgyz economy is heavily reliant on external sources for these items. Thus, as well as boosting inflation, the increased cost of food and fuel significantly raised the country's import bill in 2008, opening up the current account to more than 6% of GDP in 2008. The same development also put additional pressure on budget revenue, as the government tried to replenish its reserves of food and fuel, and to cushion the impact of the prices rises on the population.

A shortfall hydroelectric power. In 2008 a shortfall in domestic production of hydroelectric power because of low water levels in the Toktogul Reservoir constituted a second major economic shock. This necessitated further fuel and electricity purchases from within the Central Asian region (November 2008, Economic policy), at an additional cost of US$60m, on IMF estimates (the then minister of energy, Mr Balkibekov, put the figure at US$88m), widening the trade gap further, taking international reserves uncomfortably close to the "safe" level of three months of import cover, and adding again to unplanned government spending. The power shortages already appear to have had a direct impact on industrial production, which, excluding production from the booming Kumtor gold mine, contracted in real terms by just over 2% in 2008, according to NSC figures, compared with growth of over 10% in 2007. Over the same period, electricity output shrank by more than 20%.

Inflationary outlook. Although falling commodity prices and a slowdown in the economy has eased upward pressure on the price level from these sources, in 2009 other factors will work in the opposite direction. Thus, the new year saw another steep rise in the price of gas imports from Uzbekistan, to US$240 per 1,000 cu metres in 2009, from US$145 per 1,000 cu metres in 2008. Other factors likely to boost inflation include the raising of utility tariffs as part of the programme of energy sector reform, and the impact of imported prices through the sharp nominal depreciation of the som.

If you want things to stay the same, everything has to change

In her recent book, Central Asia’s Second Chance, Martha Brill Olcott attempts to address an apparent contradiction at the heart of contemporary US foreign policy in the Central Asian region. This contradiction is that the failure of the current Bush administration to encourage democratic development more actively—instead relying on partnerships with authoritarian regimes out of short-term expediency linked to the prosecution of the so-called war on terror—risks reproducing long-term security threats to the West because of the potential for ongoing political, social and economic discontent to catalyse anti-Western terrorism.

She argues that the attention and resources of the US administration have been diverted from vital long-term democracy-promotion projects by the war on terror itself, and that this is shown by the low and declining level of US regional funding, which was just US$210m in 2004 (compared with US$1.9bn and US$2.7bn for the more significant US allies, Egypt and Israel, in the same year).

A second important theme of the book is that the nation-building approach adopted by international bodies may have been counterproductive for the region—in particular, in view of the interdependent histories, transport infrastructure, and energy and water resources of the countries involved, the country-specific approach may have encouraged rivalry and protectionism, hindering the development of a regional market.

In some ways, this is a frustrating book, since the author seems to share uncritically the terms and perspectives of the US policy establishment, so that the reader has the feeling of wading through quite a lot of policy-wonk material before getting to a discussion of the details of what has happened regarding the political systems of the Central Asian states themselves (the book might thus more accurately have been called America’s Missed Second Chance in Central Asia).

However, in relation to these political systems, the author makes the points that the countries' leaders were all products of Soviet political structures, and that their emergence, practically intact, from the wreckage of the Soviet Union following the failed Moscow coup of 1991 meant that they lacked the legitimacy that might have been conferred upon them had they risen to power as leaders of independence struggles. Although none of the region’s citizens enjoy as full a range of political rights and civic freedoms as those of the formerly communist countries of central and eastern Europe, there is some variety in the types of political systems that have obtained in Central Asia in the independence period, running along a line from “semi-democratic” to fully authoritarian, with the Kyrgyz Republic usually conceived of as the most democratic and Turkmenistan as the least.

The thesis that US funding was insufficient to allow it to influence positively the political outcomes in the region (in particular, to minimise the chances of political instability by helping to pave the way for the smooth, democratic handover of power) is illustrated by the case of the Kyrgyz Republic. Here, the author argues, such a policy had the best chance of success in the early years of the present decade, because of the country's experience of rapid democratic development in the early 1990s, and because the desire of the then president, Askar Akayev, to compete for prestige with other Central Asian leaders would have predisposed him to accept a high degree of conditionality in return for grant assistance for political reforms already under way, such as of local government, electoral mechanics and anti-corruption programmes. However, the sums involved were too small to yield any decisive influence (funds from the Freedom Support Act for democracy-building were just US$1.16 per head for the Kyrgyz Republic in 2002, although this was the highest per-head level of funding from the US for any country in the region). Instead, therefore, Akayev’s increasing authoritarianism went unchecked, and the chain of events leading up to the Aksy killings of 2002 and resulting in the president’s ouster in the Tulip Revolution of March 2005, while illustrating the greater political influence of public protest in the Kyrgyz Republic relative to its Central Asian neighbours, also began a curious phase of political instability and constitutional struggle that is probably not yet over. Indeed, the regime of Kurmanbek Bakiyev, which replaced Akayev’s, appears to have reproduced many of the features of its predecessor, re-employing many of its personnel, and adopting many of its operation and control techniques.