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Chapter 8. Policies to Strengthen CCA External Linkages

Author(s):
International Monetary Fund. Middle East and Central Asia Dept.
Published Date:
April 2014
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Enhanced economic and financial cooperation with the rest of world and within the CCA offers tremendous opportunities for economic diversification and structural transformation to ensure sustainable growth. CCA countries’ strong growth performance over the past two decades has been accompanied by the region’s increasing trade openness. Nonetheless, intra-regional trade remains low due to the dominance of major trading partners (China and Russia), the high cost of trade, and the similarity of product structure across CCA countries. Moreover, external financial linkages are limited, reflecting the underdevelopment of local financial markets. These challenges and vulnerabilities reinforce the need for sound policy frameworks.

Trade Linkages

Trade openness supports economic growth. The literature supports the premise that increased international trade leads to faster growth (Frankel et al. and Kraay et al.). Trade allows producers to access bigger markets and encourages the development of technological knowhow, thereby increasing returns to investment and economic growth. Growth in the CCA has been associated with its greater trade openness (Figure 8.1),27 but trade openness for the region as a whole has still lagged the fast growing emerging economies28 (Figure 8.2).

Figure 8.1.CCA: Economic Growth vis-a-vis Trade Openness in 1996–2011

Source: World Development Indicators.

Figure 8.2.Trade Openness in CCA vis-a-vis Fast Growing Emerging Economies

Source: World Development Indicators.

Regional cooperation has long been seen globally as an instrument for promoting economic growth. Sophisticated buyer-supplier networks and the emergence of a value-added chain have been major features of globalization in the world’s most dynamic regions, such as Southeast and East Asia. Likewise, increased specialization generates more trade, which can provide opportunities for small, poor, and landlocked CCA economies. However, most CCA countries do not have the required number of skilled workers, local financial capacity, or ability to sustain clusters of suppliers and complementary services. Economic cooperation among countries with shared borders can help create larger markets and allow for efficiencies and economies of scale by reducing barriers to trade, capital, and labor mobility. Cross-border cooperation also facilitates the development of regional infrastructure networks that support trade, and permits the efficient management of cross-border spillovers. This is particularly important for landlocked countries like those in the CCA, since they have neighbors on all sides with whom they must cooperate not only to increase integration within the region but also to permit integration with global markets. Increased regional economic cooperation should also allow CCA countries to support growth through enhanced energy and water security and possibly to make progress on longstanding conflicts and tensions.

While the CCA has made significant progress in integrating with the rest of the world, intra-regional trade has yet to expand. Despite rapid economic growth, the share of intra-regional trade in the CCA relative to the region’s overall global trade dropped significantly over the past two decades (Figure 8.3). This lower intra-regional trade in the CCA contrasts with that of the gradually rising figure among the Association of Southeast Asian Nations (ASEAN) countries.

Figure 8.3.Intra-regional Trade over Total Trade

Source: IMF Direction of Trade Statistics.

Several factors explain the relatively slower pace of regional trade integration and economic cooperation.

  • CCA economies have benefitted from trade with two major trading partners, China and Russia, more than within the CCA (Figures 8.4 and 8.5). Russia’s ties with the CCA remain strong, although trade with Russia, which had reached 25 percent of total CCA trade in 2000, fell to 15 percent in 2012.

Figure 8.4.CCA: Trade Composition in 2000

(Percent of total)

Source: IMF Direction of Trade Statistics.

Figure 8.5.CCA: Trade Composition in 2012

(Percent of total)

Source: IMF Direction of Trade Statistics.

Forced to look outside for energy supplies in the CCA, China opened up its borders and routes to foster trade with the region, expanding its economic engagement in the region (Figure 8.6). Agreements focused on energy, trade and finance, and infrastructure, cementing China’s role as Central Asia’s primary economic partner. Indeed, trade between the CCA and China rose from 3 percent of total CCA trade in 2000 to about one quarter by 2012. Notably, China has become the largest trading partner of CCA countries sharing their borders with China (Kazakhstan, Kyrgyz Republic, and Tajikistan) and with Turkmenistan (Figures 8.7 and 8.8).

Figure 8.6.China’s Official Assistance in CCA

(Project contracted amount, US$ millions)

Source: National Bureau of Statistics of China.

Figure 8.7.CCA: Direction of Trade in 2000

Source: IMF Direction of Trade Statistics.

Figure 8.8.CCA: Direction of Trade in 2012

Source: IMF Direction of Trade Statistics.

  • Intra-regional trade costs remain exceedingly high. Given that much of the CCA is landlocked, sea access for traded goods is primarily through Russia and Iran. Much of the region faces geographic and climate barriers, leading to high costs of transportation, communications, and energy, as well as extended transit and delivery times, including at borders. In addition, limited and weak physical infrastructure contribute to making trade costs in the CCA the highest among Asian sub-regions (Table 8.1).
  • CCA economies are similar in terms of their product structure. CCA energy exporters and importers produce, respectively, roughly the same set of final goods (Figure 8.9). As a consequence, the market for these goods lies elsewhere. Meanwhile, in the ASEAN region, intermediate goods account for as much as 40 percent of intra-ASEAN trade with a high degree of product chain dependence on Japan and China.
Table 8.1.Intra-regional Trade Costs(Tariff-equivalent trade costs in 2007)
CCASAARCASEANEAST AsiaNAFTAEU5
162%150%61%128%62%72%
Note: CCA (for this table: Armenia, Azerbaijan, Georgia, Kazakhstan, and Kyrgyz Republic); SAARC (Bangladesh, India, Pakistan, and Sri Lanka); ASEAN (Indonesia, Malaysia, Philippines, and Thailand); East Asia (China, Japan, Korea, and Mongolia); EU5 (France, Germany, Italy, Spain, and UK).Source: UNESCAP, Intra-regional Trade Costs in Asia, 2010.
Note: CCA (for this table: Armenia, Azerbaijan, Georgia, Kazakhstan, and Kyrgyz Republic); SAARC (Bangladesh, India, Pakistan, and Sri Lanka); ASEAN (Indonesia, Malaysia, Philippines, and Thailand); East Asia (China, Japan, Korea, and Mongolia); EU5 (France, Germany, Italy, Spain, and UK).Source: UNESCAP, Intra-regional Trade Costs in Asia, 2010.

Figure 8.9.Selected CCA Countries: Export Composition

Source: UN Comtrade Database.

Figure 8.10.Selected CCA Countries: Import Composition

Source: UN Comtrade Database.

Financial Linkages

Enhanced financial linkages provide better opportunities for consumption smoothing and efficient capital allocation. Increased liquidity in the capital market allows better access to finance that is crucial to support economic activity (La Porta et al. and Rajan et al.). Given their relatively low levels of physical capital and their inherently greater volatility, developing economies, in particular, have the most to gain from increased financial linkages (some already discussed in Chapter 5).

Financial inflows to the CCA have grown rapidly since 2000, predominantly driven by foreign direct investment (FDI) (Figure 8.11). The literature widely supports the view that FDI contributes to economic growth (Borensztein et al., and Alfaro et al.). In the CCA, selected countries with higher FDI have enjoyed faster growth rates (Figure 8.12). This is particularly true for the energy exporters. Since the global crisis, FDI inflows have largely flowed to energy sectors (Figure 8.13). For the region all together, FDI flows are stronger than fast growing emerging economies (Figure 8.14).

Figure 8.11.CCA: Financial Flows

(US$ billions)

Source: IMF staff calculations.

Figure 8.12.CCA: Economic Growth and FDI

(1996–2011)

Source: IMF staff calculations.

Figure 8.13.CCA: FDI in Energy Exporters vis-a-vis Energy Importers

(Percent of GDP)

Source: IMF staff calculations.

Figure 8.14.FDI in CCA vis-a-vis Fast Growing Emerging Economies

(Percent of GDP)

Source: IMF staff calculations.

Foreign investors’ appetite for CCA financial assets has yet to materialize. Portfolio inflows to the CCA remain largely limited to Kazakhstan, a market access country (Figure 8.15), while debt financing flows remain a predominant financing source for low income CCA countries (Figure 8.16). A combination of factors constrain foreign portfolio investment: a low level of capital market liberalization, underdevelopment of financial markets, few bond offerings by CCA corporate, a lack of institutional capacity, weak governance, and the fragility of security in some countries.

Figure 8.15.Portfolio Investment in CCA

(Average in 2005–2011, US$ millions)

Source: IMF staff calculations.

Figure 8.16.Other Financing Flows in CCA

(Average in 2005–2011, US$ millions)

Source: IMF staff calculations.

Other Linkages—Remittances

Remittances are an important source of income for Armenia, Kyrgyz Republic, and Tajikistan (see also Chapter 2). Russia is the primary destination for labor migration in the region, though there are also substantial CCA migrant worker populations in Belarus, Ukraine, and Kazakhstan. Russia is by far the largest source of remittances for CCA remittance-receiving countries, with, for example, Tajikistan receiving more than 80 percent of its remittance income from Russia. CCA countries and the destination countries for their migrant workers have recently taken steps to regularize the labor migration process and simplify documentation requirements for migrant workers. Remittances are an important source of growth and of external financing for Kyrgyz Republic and Tajikistan. Given these two countries’ limited access to external market financing, they have benefitted from the availability of international financial institutions’ official financing when faced with falling remittance inflows triggered by a severe deterioration of the external environment (Figures 8.17 and 8.18). Armenia, on the other hand, is less dependent on remittances and has market access.29

Figure 8.17.CCA: Remittances vis-a-vis FDI

(Percent of GDP, average in 1996–2011)

Source: IMF staff calculations.

Figure 8.18.CCA: Remittances vis-a-vis IMF Financing

(US$ billions)

Sources: IMF staff calculations and Central Bank of Russia.

Policies and Actions to Strengthen External Linkages

While deeper economic and financial cooperation can yield substantial benefits, it also poses macroeconomic challenges and vulnerabilities. Key challenges and their associated vulnerabilities are as follows:

  • Limited diversification of exports and imports make CCA countries particularly susceptible to sudden fluctuations in terms of trade and foreign demand shocks.
  • Sudden changes in the direction of capital flows can induce boom-bust cycles in developing countries, most of which do not have financial sectors that are developed enough to cope with highly volatile capital flows.
  • Country size is an important factor, and developing economies in the CCA are relatively much smaller than industrialized countries. Both terms of trade shocks and foreign aid flows are particularly important in accounting for highly volatile macroeconomic fluctuations in low-income countries.

Exploit existing opportunities to become “land-linked” to the world.

  • Significant divisions among CCA countries persist due to intra-CCA political tensions (see Chapter 9). This prevents beneficial interaction and the pooling of resources. The current low share of intra-regional trade in the CCA total trade demonstrates that there remains much to be done to improve their inter-connectedness, and highlights that many CCA countries are currently handicapped by their landlocked positions. Various efforts have been made through sub-regional arrangements to foster regional cooperation (Box 8.1). Some notable progress is being made in reducing intra-regional trade costs. For example, the six CAREC corridors are being constructed to link the region’s key economic hubs to each other, and connect the landlocked CAREC countries to other Eurasian and global markets (Figure 8.19).

Figure 8.19.CAREC Corridors

(Kilometers, cumulative progress)

Source: Asian Development Bank, 2012.

Box 8.1Institutional Arrangements to Foster Regional Cooperation

Several institutional arrangements have been put in place to promote regional cooperation. Early efforts to maintain cooperative arrangements to prevent economic disintegration were not successful, notably the failure of the Commonwealth of Independent States (CIS) to maintain open borders, trade, transport, and capital mobility. Since then, various efforts have been made to forge improved economic links through sub-regional cooperative arrangements. There are some signs that regional cooperation has been given a new impetus in the last few years, albeit coming from very different directions. Three of the most prominent examples: the Eurasian Economic Community (EEC), involving mainly a customs union; the Shanghai Cooperation Organization (SCO), led by China and Russia; and the Central Asia Regional Economic Cooperation program (CAREC), led by the Asian Development Bank with the support of China.

Notwithstanding these institutional efforts, progress on regional cooperation has been slow. The multiplicity of regional organizations among CCA countries has tended to dissipate the limited managerial and decision-making capacity in the region and perhaps has led to a degree of cynicism about regional cooperation.

  • EEC: Comprised of Belarus, Kazakhstan, and Russia, the EEC presently involves mainly the Eurasian customs union (ECU). Armenia announced its intentions to join the ECU in September 2013. Asymmetry of economic size of the member states and high external tariffs under the associated ECU complicate economic cooperation. The disparity in the economic size of the largest state, Russia, and that of the other members of the ECU is perhaps greater than in any other regional economic grouping. Kazakhstan’s population and GDP are around one-tenth of Russia’s, while Belarus’s GDP is ⅕ of Kazakhstan’s.
  • SCO: Established in 2001 with six members: China, Kazakhstan, Kyrgyz Republic, Russia, Tajikistan, and Uzbekistan. The leading two member countries, China and Russia, often have not reached agreements on key issues of energy and trade development, particularly regional oil and gas transit.
  • CAREC: Emerging from a regional initiative in 1997, the current membership consists of 10 countries: Afghanistan, Azerbaijan, China, Kazakhstan, Kyrgyz Republic, Mongolia, Pakistan, Turkmenistan, Tajikistan, and Uzbekistan. Some key regional players are missing, foremost among them Russia. Russia was invited to join CAREC but has yet to respond to the invitation.

Successful economic integration in the CCA critically depends on how to cooperatively involve both Russia and China as well as the European Union. Russia and China are competing to maintain their influence in Central Asia, and Russia and the EU have been competing in European part of the former Soviet Union and in the Caucasus countries. Greater cooperation could accelerate economic integration in the region and further buttress the relationship among China, Europe, and Russia.

Diversify exports and strengthen buffers.

  • Export diversification in CCA countries is quite low. For example, in Azerbaijan, the top three export commodities account for 92 percent of total exports (Figure 8.20). Moreover, geographical concentration of exports shows that Kyrgyzstan’s top three export destinations account for 73 percents of its total exports (Figure 8.21).
  • Given terms-of-trade and external demand shocks, adequate foreign exchange reserve buffers would help countries better manage external volatility. The CCA region maintains broadly adequate reserve buffers, but some countries have seen their reserves depleted during the recent global crisis and need to rebuild buffers (Figures 8.22 and 8.23).

Figure 8.20.CCA: Top Three Export Product

(Percent of total exports)

Source: UN Comtrade database.

Figure 8.21.CCA: Top Three Export Destination Share

(Percent of total exports)

Source: UN Comtrade database.

Figure 8.22.CCA: Reserve Cover

(Months of imports in 2012)

Source: IMF staff calculations.

Figure 8.23.CCA: Assessing Reserve Adequacy (ARA)

(Reserves as Percent of ARA Metric)

Note: ARA is composed of 30% short-term debt, 15% long-term debt, 10% M2, and 10% exports.

Source: IMF staff calculations.

Adopt measures to reduce potential vulnerabilities associated with increased financial linkage.

  • External debt in most countries in the region is projected to stay at low levels over the medium term (Figure 8.24). CCA countries with a high current level of external debt should be cautious about further borrowing, and all CCA countries should ensure that borrowed funds are used only for productive investment that supports growth.
  • For market access countries (e.g., Kazakhstan), the potential for a sudden reversal of capital inflows warrants capital flow management measures (CFMs), which are price-based or administrative tools to limit capital flows. CFMs would be particularly useful in cases where (i) the room for adjusting macroeconomic policies is limited; (ii) the needed policy steps require time, or the macroeconomic adjustments require time to take effect; and (iii) an inflow surge raises risks of financial system instability (See the IMF Board Paper, the Liberalization and Management of Capital Flows, 2012).
  • For low-income CCA countries that rely heavily on official borrowing and grants, or on remittances, (e.g., Kyrgyz Republic and Tajikistan), a sharp macroeconomic adjustment would be unavoidable if these channels dry up. Even potential market access countries (e.g., Azerbaijan) might lose their access to international capital markets when faced with greater political instability and worse perceptions of their policies and institutions. Hence, these countries need to step up the implementation of a comprehensive set of structural and policy reforms to help create jobs, foster access to international capital markets, and allow them to manage volatility. See chapters on policy frameworks and on structural reforms.

Figure 8.24.CCA: External Debt

(Percent of GDP)

Source: IMF staff estimates.

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