Boons from the Russia-Ukraine conflict

CAUCASUS / CENTRAL ASIA - Report 30 May 2023 by Ivan Tchakarov

With this report we introduce our Caucasus and Central Asia (CCA) service. In order to better grasp the economic positioning of the CCA region, which is less well known and fair to say under-researched relative to other frontier markets, we first analyze it within the broader and better-known CIS coordinate system given that (almost) all CCA countries are also CIS members. We then attempt to contrast the CCA countries with those in the European Union by looking at how successful (or not) individual CCA economies have been in terms of growth convergence with average EU per-capita GDP levels.

We argue that while CCA catch-up with average European incomes since the breakup of the Soviet Union has not been that impressive overall, Armenia and, in particular, Georgia stand out among peers in terms of improving per-capita GDP in the last decade. These two countries also promise to continue outperforming in the medium term. On the other hand, the likes of Uzbekistan, Kyrgyzstan and Tajikistan offer lower prospects for income convergence despite robust GDP growth rates mainly due to equally strong population growth.

We also underscore how more recently the Russia-Ukraine conflict has provided an unexpected economic and geopolitical boon for the region. Significant monetary outflows from Russia into the Caucasus and Central Asia have propped up GDP growth, strengthened currencies and turned structural current account deficits into surpluses. We argue that these flows will continue, albeit at more modest levels, thus reducing the marginal benefit to the region. The Russia-Ukraine conflict has, in addition, changed dramatically the relative attractiveness of the existing trade routes connecting Asia to Europe, rendering the so-called "Central Route" passing through the CCA region much more appealing in comparison to the Northern Route crossing Russia or the Southern Route going through South China Sea, India and Iran.

We present an overview of the region as a whole and summarize the major issues in our key countries of coverage. We forecast that that average GDP growth for the five key economies that will be the focus of our service, i.e., Armenia, Azerbaijan, Georgia, Uzbekistan, and Tajikistan will moderate slightly from 8.1 percent in 2022 to 5.2 percent in 2023. Monetary policy has almost everywhere started to transition to easing, and diminishing inflation pressures will intensify rate cutting into year-end. Nevertheless, we see nominal policy rates falling by less than inflation, ensuring that real policy rates rise substantially across the region. The CA position of all CCA economies has strengthened appreciably over the last year due to excess monetary inflows from Russia, but there are emerging signs that these cross-border flows have become thinner in early 2023, suggesting somewhat less robust external backdrop this year and next. At the same time, overall public indebtedness is quite low, with no country having public debt-to-GDP ratio in excess of 50 percent.

While we are constructive about the Caucasus and Central Asia given the current and prospective geopolitical backdrop, we remain vigilant about existing risks. We identify two main challenges. First, CCA countries have now become the focus of possible secondary sanctions by the West given the way their status has been elevated in terms of enhanced trading with Russia. Second, the region has had its share of military conflicts in the aftermath of the breakup of the Soviet Union and these tend to re-emerge with some regularity, thus providing a cautionary counterbalance to the more optimistic read of their macroeconomic prospects.

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