OREANDA-NEWS. June 08, 2010. The article has been provided by the IMF Representative Office in Tashkent. It was prepared by Masood Ahmed, Director of the IMF's Middle East and Central Asia Department.

As the revival of the global economy — in particular, Russia — picks up speed, so will economic recovery in the countries of the Caucasus and Central Asia.

The region is already showing signs of a nascent rebound, with output projected to expand by 4.3% in 2010, up from 3.5% in 2009. But financial sector stress in many of these countries has caused a sharp slowdown in private-sector credit and is hampering further growth.

The global financial crisis led to mounting stress in the banking systems of most countries in the region. Banking sectors in Turkmenistan and Uzbekistan have, for the most part, not been impacted by the global crisis. But the situation is different in Armenia, Azerbaijan, Georgia, Kazakhstan, the Kyrgyzstan and Tajikistan.

In many of these countries, private-sector credit growth slowed sharply and even turned negative in real terms, compared with the dramatic increases, ranging from 40% to 80% in the period immediately prior to the crisis.

The credit slowdown is weighing on economic activity and having policymakers seek ways to restore it, thereby laying the foundation for resumption in high and sustainable economic growth.

Understanding the reasons behind the credit slowdown is important for getting the policy response right. In this region, three reasons dominated.

First, balance-of-payments pressures led to depreciation in several countries. With high levels of dollarization and exposure to currency risk, the depreciation contributed to a significant weakening in these countries of balance sheets of banks and unhedged borrowers.

Most countries experienced reductions in their capital-asset ratios by more than 2% and increases in their non-performing loan ratios by more than 4%. Kazakhstan and Tajikistan were particularly hard hit.

Second, the crisis subjected banks to a sharp reduction in funding — deposits, remittances, and external inflows — which had fueled rapid and above-trend credit growth in previous years.

And third, global deleveraging and tougher credit standards have resulted in a tightening of credit supply as well as a contraction in demand for credit due to the slowdown in economic activity.

With impaired balance sheets, lackluster funding growth, and heightened uncertainty, credit to the economy has slumped; since end-2007, real credit growth has fallen by over 60% on average.

What can policymakers do to revive credit? Policies should aid banks in the process of repairing their balance sheets by recognizing losses and supplementing bank capital if needed.

Where banks are fundamentally healthy and mainly affected by a lack of funding, temporary government or central bank liquidity injections may help restore credit growth. Of course, adequate fiscal room is a precondition for such actions to ensure this support does not weaken the public sector balance sheets.

High levels of dollarization of 40% to 80% are a key feature in the region and, over the medium term, sound macroeconomic and macroprudential policies should promote de-dollarization to reduce vulnerabilities to sudden exchange-rate movements.

Precrisis trends in CCA countries, as well as the international experience, have shown that macroeconomic stability is the most successful conduit for sustained de-dollarization.

In addition, the regulatory framework should encourage a proper pricing of currency risk, for example, by requiring higher capital charges for foreign exchange loans to unhedged borrowers, thus addressing indirect currency risk.

In some countries, allowing greater exchange-rate flexibility may also help banks and the corporate and household sectors to better internalize the risks of dollarization.

Developing local currency debt markets can in the medium term contribute to de-dollarization by giving domestic agents access to a wider range of domestic-currency financial instruments.

Moreover, local currency debt markets allow banks to diversify their funding base and thus become less vulnerable to swings in individual funding sources.

For 2010, growth is expected to remain relatively weak in most countries in the region, including those that have a large number of poor people. In some of these countries, it is important that banks extend new credit so as to allow private-sector activity to pick up to sustain growth and improve living standards.