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When the rouble plunged last autumn, pictures of exchange rate displays on Moscow streets were a staple of international media coverage – at least, until the Russia government ordered them to be taken down in the interests of public morale. What went largely unrecorded, however, was how the Russian currency’s gyrations were being watched just as anxiously in Baku, Yerevan and Almaty.
Nearly 25 years on from the end of the Soviet Union, many of its former member states in the Caucasus and Central Asia still rely heavily on Russia as a source of remittances, foreign direct investment and export demand. Any weakening of the rouble therefore tends to put pressure on local currencies – and when the weakening is of the order seen late last year, the pressure is intense.
As the rouble collapsed in November following Russia’s move to a floating exchange rate, policymakers across the region struggled to keep their own currencies from following suit. Tajikistan’s central bank burned through half the country’s meagre foreign-exchange reserves in an attempt to stabilize the somoni, while Armenia – one of the few CIS states with a fully flexible currency – sold a quarter of its dollar holdings after a series of interest-rate hikes failed to halt the dram’s plunge.
Even so, the somoni lost 16.7% of its value against the dollar in the nine months to April and the dram 15.1%. Kyrgyzstan and Georgia meanwhile, which opted for lower levels of intervention, saw their currencies slump by 19.1% and 22.7% over the same period.
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We have heard similar plans many times over the years and they have nearly always come up short Marcus Svedberg, East Capital |
Countries with pegged currencies fared no better. In February, Azerbaijan was forced to devalue the manat by 34% and swap its dollar peg for a currency basket. Even Turkmenistan, with fewer links to Russia than most of its neighbours, opted for a 22% devaluation – the first in seven years – to maintain competitiveness with the rest of the region.
The notable exception to the devaluation trend was Kazakhstan, which as of mid-April was still clinging to the 180 dollar-tenge rate set in February last year – and paying the price in the form of a dramatic reversal of its trade flows with Russia. Before the Ukrainian crisis, Kazakhstan had been reaping the benefits of its membership of the Eurasian Economic Union (EEU) free-trade area in the form of strong sales of agricultural products and simple manufactured goods to Russia.
The large price disparities created by the fall of the rouble, however, not only put a dampener on exports but also sent Kazakh consumers flocking across the border to do their shopping in Russia – to the severe detriment of local producers.
“If you talk to anyone in Kazakhstan who is trying to sell something locally, in sectors where there is a realistic possibility of buying in Russia, they will say they are affected by the currency dislocation,” says Almaty-based Agris Preimanis, lead economist for Central Asia and Georgia at the European Bank for Reconstruction and Development.
That has translated into a sharp fall in tax revenues and, combined with the fall in oil prices, is pushing Kazakhstan’s current account into deficit. Analysts also report that the uncertainty over the tenge’s fate is acting as a deterrent to investment by both locals and foreigners.
Financial dollarization
Why, then, have the Kazakh authorities been so reluctant to devalue? And why have policymakers elsewhere in the region been so keen to spend much-needed dollar reserves in ill-fated attempts to shore up their currencies, at a time when depreciation would give them a competitive advantage over their neighbours?
The answer lies in the very high levels of dollarization across the Caucasus and Central Asia. In Azerbaijan and Kazakhstan, foreign currency loans make up around a third of all lending, while in Georgia and Armenia the figure is closer to two-thirds. Dollar and euro deposits, meanwhile, account for more than half the total in most countries.
“Financial dollarization is a very significant policy problem for everyone in the region,” says Petr Grishin, head of macro research at VTB Capital. “Russia has the lowest level of dollarization, which, along with its very high reserves, allowed the central bank to be much bolder in its approach to devaluation. Not many CIS countries can afford to do the same.”
Nevertheless, Grishin adds, doing nothing is usually not an option given the high sensitivity to exchange rate fluctuations among citizens of the former Soviet Union. “Every time there is a realignment in the real exchange rate there is a serious threat to financial stability because it never goes unnoticed,” he says. “People always try to anticipate a devaluation, and that creates the risk of a currency run and potentially even a bank run.”
Policymakers thus have to balance the risk of a disorderly adjustment against that of a steep rise in defaults on foreign-currency loans. The dilemma is somewhat mitigated by the fact that banking penetration across the region remains low. According to the World Bank, total bank lending amounted to just 42.1% of GDP in Armenia at the end of 2014, 31% in Azerbaijan, and barely 20% in Kyrgyzstan. Even in Kazakhstan, Central Asia’s largest economy, total bank assets are less than 50% of GDP.
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They are working on social security policies to mitigate the effects if the worst case scenarios materialise, and they are asking anyone and everyone who will listen for help
Agris Preimanis, |
Most banking sectors in the region are also well-placed to withstand a deterioration in asset quality, having gone into the current downturn with high capitalization levels and healthy, well-provisioned loan books. Armenia, Azerbaijan, Georgia and Kyrgyzstan all have non-performing loan ratios in the region of 5% to 7%. Provisioning is generally around the 60% mark and as high as 90% in Georgia, according to the IMF.
In recent years banks in Georgia have also been particularly conservative in their assumptions on devaluation risk with regard to loan applications, according to Giorgi Shagidze, CFO of number two player TBC Bank. As a result, he says, the dramatic depreciation of the lari has so far had little effect on NPL levels on foreign currency debt. “It has also helped that inflation is very low at just 2%, so customers’ payments are still affordable,” he adds.
The big exception to the rule of regional banking sector strength, however, is Kazakhstan. Despite numerous attempts to get to grips with the country’s bad-debt burden, a legacy of the 2008/09 financial crisis, NPLs still stood at around 24% of total lending at end-March. What is more, according to analysts at Fitch Ratings, a large proportion of Kazakh banks’ outstanding FX loans are not only to unhedged borrowers – mainly real estate firms and importers – but also under-provisioned.
Kazakh policymakers have repeatedly pledged to tackle the problem, most recently in November when president Nursultan Nazarbayev listed cutting NPLs to 10% by 2016 as one of the key objectives of his new $9 billion stimulus programme. The Nurly Zhol (Bright Path) five-year plan, which was designed to mitigate the effects of the oil price slump on the Kazakh economy, will be financed from the country’s sovereign wealth fund, which is also due to support infrastructure development and diversification away from the natural resources sector.
Preimanis at the EBRD, which last year agreed to partner with Kazakhstan on a range of initiatives, has faith that this time around policymakers will deliver on their commitments. “There has been a clear change in the way the Kazakh authorities are approaching the reform agenda,” he says. “The new government [led by prime minister Karim Massimov] has clearly been given a remit to do whatever they can to improve the business environment and the investment climate.”
Preimanis says the Kazakh banking sector should see a reduction in bad debts this year, even if a weaker tenge does cause problems for FX debtors. “The net effect will still be a reduction of NPLs due to the work out of legacy loans from the financial crisis,” he says. “I am confident that asset quality deterioration will not pose a risk to financial stability.”
Credibility dented
Others are more sceptical about the Kazakh government’s promises of reform. “We have heard similar plans many times over the years and they have nearly always come up short,” says Marcus Svedberg, chief economist at regional specialist fund manager East Capital. “If the EBRD is convinced, that’s a good step – but I wouldn’t yet be willing to give them the benefit of the doubt.”
Previous attempts to mandate a reduction in the NPL ratio have certainly proved unavailing – a target of 15% set for the end of 2014 was missed by a hefty margin. Policymakers’ credibility was also dented by last year’s tenge devaluation, which analysts say was oddly timed and badly communicated.
In a recent note, Bank of America Merrill Lynch’s analyst Vladimir Osakovskiy describes the move as a “surprise” and “unnecessary”. He adds that it compromised the credibility of any new peg and left the Kazakh central bank with little option but to move to a floating exchange rate – another long-promised reform that has yet to be enacted.
“Kazakhstan will clearly be forced to devalue at some point,” says Evgeny Gavrilenkov, chief economist at Sberbank CIB. “The big question is how they will manage it, whether it will be a one-off devaluation as before or a transition to a more flexible exchange rate. The latter in the long term would be more beneficial for them, but I fear they will opt for a one-off event, which could put pressure on the banks.”
Double hit
If Kazakhstan is particularly vulnerable to the knock-on effects of rouble weakness via trade flows, however, it is largely immune to the other large source of contagion from Russia’s currency and economic crisis. Remittances from Russia have made up a negligible proportion of Kazakh GDP in recent years, in stark contrast to most of its Central Asian and Caucasian neighbours, which still rely heavily on income generated by migrant workers.
These countries have taken a double hit over the past year. The rouble’s plunge has eroded the value of earnings in home-currency terms, while the slowdown in the Russian economy – which began in 2013 and is forecast to deepen into full-blown recession this year – is inevitably affecting the availability of jobs within the country.
Most at risk from this development is Tajikistan, which for many years has been a big supplier of low-skilled workers to Russia’s construction and maintenance sectors – both of which, says Gavrilenkov, are being squeezed as private and public sector contractors slash spending.
Remittance flows to Tajikistan, which account for around half of the country’s GDP, fell by more than 25% in the fourth quarter of 2014 and are expected to fall still further this year as the Russian recession begins to bite. This has sparked fears of rising unemployment and social instability, a particular concern for local authorities given Tajikistan’s long southern border with Afghanistan.
The seriousness of the threat is demonstrated by the recent enthusiasm of the previously reclusive Tajik authorities for engagement with the international community. “They are working on social security policies to mitigate the effects on the economy and social cohesion if the worst case scenarios materialise, and they are asking anyone and everyone who will listen for help,” says Preimanis.
The Tajik government has hosted a succession of investment forums in the past six months and is due to obtain a sovereign credit rating from Standard & Poor’s before the end of June. There has even been talk of a Eurobond – although debt bankers say that, even in an extremely yield-challenged environment, such a deal would test the limits of frontier-market appetite.
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Further reading |
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Kyrgyzstan is another state that is particularly vulnerable to a decline in opportunities for low-skilled workers in Russia. Remittances are less crucial to the economy than in the case of Tajikistan, accounting for closer to 25% of GDP, but it is also a poor country with very limited opportunities for local job creation.
Georgia and Armenia, meanwhile, are seen as less at risk from the Russia slowdown. Remittances make up just 12% of Georgia’s GDP and Georgian workers have historically proved fairly mobile, according to TBC Bank’s Shagidze. “When flows from one country have decreased, those from other countries have increased,” he says.
Armenia’s dependence on remittances is higher, at around 20% of GDP, nearly all of which comes from Russia. Gavrilenkov notes, however, that Armenians working in Russia are mainly business people and entrepreneurs rather than casual labourers, making them potentially less vulnerable to sudden economic shocks.
What could have a more serious impact on the Armenian economy, at least in theory, is a fall in Russian FDI. More than half of foreign flows into the country in recent years have been from Russia, a rarity in a region where China has been gradually taking over as the leading source of FDI. (Tajikistan, Turkmenistan and even Georgia have seen a large increase in Chinese investment in the past five years.)
With Russian FDI worldwide expected to be effectively zero over the next 12 months, according to Sberbank, planned investments in Armenia by private and public-sector companies will likely be postponed.
EEU squeeze
What Armenia loses in FDI from Russia, however, it should recoup in the form of benefits accruing from its accession to the EEU in January. These already include favourable terms for gas imports and financing for a number of key infrastructure projects, as well as free access for Armenian workers to the Russian labour market. The consensus is that further support would be available, given the political importance to Russia of the EEU project and the relatively small sums involved.
“If EEU members are really squeezed then Russia would likely be willing to give them preferential loans,” says Svedberg. “The amounts required would be easily affordable and it is in Russia’s interests to support EEU members in order to keep them within its sphere of influence.”
He adds, however, that in economic terms the best thing Russia could do for its fellow EEU members – including Kyrgyzstan, which is due to join on May 9 – would be to get back to growth. “Remittances provide more jobs and more financing than FDI will ever bring in,” he says.
Analysts note that this also applies to the wider region, which is suffering the direct effects of the Russia slowdown as well as the indirect via negative investor sentiment. Grishin at VTB Capital notes that, while Russian assets have seen a decent rally in the past two months, credit spreads remain wider than in many other emerging market regions. “This creates a second-round contagion effect with CIS countries because investors are even more reluctant to hold higher risk, lower liquidity names in the region,” he says.
