Fiscal Affairs Department
Exchange Rate Developments and Policies in the Caucasus and Central Asia
IMF Staff Team led by Mark Horton, Hossein Sa miei, Natan Epstein, and Kevin Ross
Copyright © 2016
International Monetary Fund
Staff Review of Exchange Rate Developments and Policies in the Caucasus and Central Asia/prepared by Natan Epstein, Mark Horton, Kevin Ross, and Hossein Samiei – Washington, D.C.: International Monetary Fund, 2016.
“Approved by the Middle East and Central Asia Department.”
ISBN: 978-1-51354-303-1 (paper)
The Middle East and Central Asia Department Paper Series presents research by IMF staff on issues of broad regional or cross-country interest. The views expressed in this paper are those of the author(s) and do not necessarily represent the views of the IMF Executive Board.
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This paper was prepared by a team in the Middle East and Central Asian Department (MCD)—Natan Epstein, Mark Horton, Kevin Ross, and Hossein Samiei—under the guidance of Juha Kähkönen and in consultation with and inputs from a working group comprising Fabio Comelli, Philippe Karam, and Rafael Portillo from the Institute for Capacity Development (ICD); Peter Dohlman and Jesmin Rahman of the European (EUR) Department; Bernard Laurens and Asad Qureshi of the Monetary and Capital Markets (MCM) Department; Felipe Zanna of the Research (RES) Department; and Varapat Chensavasdijai, Greetje Everaert, Martin Kaufman, and Pablo Morra of the Strategy Policy and Review (SPR) Department. Natalia Aivazova, Fagana Stone, and Adelina Zolas (all MCD) helped prepare the report.
Since late 2014, exchange rates (ERs) and ER regimes of the Caucasus and Central Asia (CCA) countries have come under strong pressure. This reflects the decline of oil and other commodity prices, weaker growth in Russia and China, depreciation of the Russian ruble, and appreciation of the U.S. dollar, to which CCA currencies have historically been linked. Weaker fiscal and current account balances and increased dollarization have complicated the picture. CCA countries entered this period with closely managed ER regimes and, in many cases, currencies assessed by IMF staff to be overvalued. CCA central banks have price stability as their main policy objective, and most have relied on ER stability to achieve this objective. Thus, the first policy response involved intervention in local foreign exchange (FX) markets, often with limited communication.
In this context, the IMF staff has reviewed ER policy advice and implementation strategies for CCA countries. Kazakhstan’s adoption of a floating ER regime in 2015 was a key driver of the review, and Armenia, Georgia, and the Kyrgyz Republic were important cases to consider, in light of active Fund-supported programs. Staff’s recommendation—with tailoring to specific CCA countries—has been to correct ER misalignments and increase ER flexibility (as opposed to occasional re-pegging), depending on institutional capacity and the size of buffers. Staff has also called for efforts to preserve financial stability, put in place supportive macroeconomic policies, and improve transparency and communications.
Greater ER flexibility is just one element of a broad-based macroeconomic policy and structural reform mix. Modernization of monetary policy frameworks and institutions, in particular, is essential for supporting ER flexibility. In the financial sector, banking supervision should be enhanced, together with measures to ensure liquidity, provisioning, and capital, especially where balance sheet risks stem from high dollarization and nonperforming loans. Fiscal policy may smooth the impact of shocks, where buffers allow and where spending is efficient or tax measures are well targeted. For CCA energy exporters, ER flexibility would help absorb the fiscal impact of lower hydrocarbon revenues, and reduce the need for offsetting monetary policy measures. At the same time, all CCA countries need a credible fiscal and external adjustment over the medium term. Structural reforms are needed to improve institutions and business environments, in support of greater competitiveness, integration, and diversification, and ultimately higher and more inclusive growth.
While CCA authorities recognize the need to adjust to the new economic environment, adopting greater ER flexibility remains challenging. CCA currencies have depreciated or been devalued against the dollar since late 2014, but in some countries they remain inflexible or overvalued in real terms. In some cases, countries have resorted to step devaluations instead of greater flexibility but this has only led to expectations of further devaluations. Resistance to flexibility has reflected a range of economic, political economy, and institutional impediments. There have also been concerns that greater flexibility may lead to heightened ER volatility and depreciation in the early stages of transition, along with higher inflation and greater dollarization. Such “fear of floating” is not unique to CCA countries or this particular moment and has been a major factor in other regions and at other times.
A key issue is how to help CCA authorities overcome fear of floating and modernize their monetary policy frameworks. The primary objective should be to establish greater central bank independence and the clear primacy of the inflation objective. Once these are in hand, self-reinforcing reforms that enhance credibility may proceed on multiple fronts—even during difficult periods. In the process of overcoming fear of floating and adopting modernized monetary policy frameworks, the pace of transition may reflect the country’s initial conditions as well as stakeholders’ preferences and perceptions. To start, CCA authorities should be convinced that the benefits of greater ER flexibility outweigh the costs. Building a local consensus among key stakeholders (for example, importers, policymakers, politicians), making the investment in capacity, and preparing for the rigors of ER flexibility (for example, tolerating ER volatility and overshooting) call for a medium-term strategy and greater IMF involvement, especially through knowledge sharing, analytical support, technical assistance (TA), and training.
CCA central banks should take a number of immediate actions to achieve greater ER flexibility in the near term. While no one standard sequencing or pace of reforms suits every country, some actions have clear priority. These include strengthening communications, establishing new nominal anchors, moving to develop deeper and more liquid money and FX markets, enhancing financial supervision, and creating robust lender of last resort frameworks.