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An Economic Overview of the Caspian Region
by Chris Kushlis and Ben Slay
Chris Kushlis and Ben Slay are economists with PlanEcon in Washington D.C.
Summary
The economies of the Caspian countries experienced a turbulent year in the wake of Russia''s August 1998 financial crisis. Still, the Russian contagion proved less damaging than originally feared. Although three of the five countries'' exchange rate regimes crashed spectacularly in the aftermath of Russia''s crisis, inflation was brought under control, and currencies are once again stabilizing. Only Kazakhstan slipped into recession, while growth in Georgia slowed dramatically. Armenia and Azerbaijan both posted accelerating growth in 1998. Long-term, however, the countries still face daunting challenges, from improving tax collection to creating a stable environment for foreign investment.
* * * Introduction
This paper offers a brief overview of the setting and recent trends in the economies of the Caspian region, which are understood here as Azerbaijan, Armenia, Georgia, Kazakhstan, and Turkmenistan. The paper draws heavily on the relevant country chapters in PlanEcon''s Review and Outlook for the Former Soviet Republics, September 1999. These chapters were authored by David Frye, Mark Katzman, and Derek Westfall. In addition to pointing out the important commonalities of the region''s economies, the paper emphasizes the differences between them in terms of size, economic structure, and policy framework. It describes the effects of the post-August 1998 sharp declines in these countries'' trade with Russia, and discusses some of the key challenges facing the region''s economic policy makers.
Regional Overview: Commonalities and Contrasts
Despite some common legacies in terms of history, geography, and Soviet rule, the economies of the Caspian Basin present as many contrasts as commonalties. In terms of commonalities, the region is generally at low levels of economic development (relative to OECD countries), as is apparent in annual per capita income levels. When measured at market exchange rates in 1998, Kazakhstan had the highest per capita income ($1,400), although this should drop to about $1,000 in 1999 due to the tenge''s depreciation. Georgia was next with $900, followed by Azerbaijan at $540, and Armenia and Turkmenistan at $500 each. All data in this paper come from the relevant countries'' statistical offices and national banks, as well as from the IMF, World Bank, TACIS, and other multilateral agencies. When measured in purchasing power parity terms, 1998 per-capita income was greatest in Armenia ($2,700), followed by Turkmenistan ($2,600), Kazakhstan ($2,500), and Georgia and Azerbaijan ($1,900).
Difficulties in interpreting official macroeconomic data are a second major negative legacy of the Soviet system and the ensuing transition. These economies possess extensive informal sectors, and the abilities of their nascent statistical agencies to accurately measure economic trends within the formal sector frequently merit concern. However, we believe that, when interpreted properly, macroeconomic data provided by country statistical agencies - especially when buttressed by information provided by the IMF, World Bank, TACIS, and other multilateral agencies - offer invaluable assistance in understanding economic trends in transition economies in general, and the Caspian region in particular.
More specifically, the following points are in order in interpreting macroeconomic data on the region. First, the dramatic structural changes these economies have experienced during the 1990s argue against attaching great significance to comparisons of economic performance over extensive periods of time. For example, comparisons of 1998 GDP with 1992 GDP, and especially Soviet-era GDP, for these countries are generally less than helpful. Second, these economies'' extensive informal sectors inevitably make statistical measurement of levels of economic activity - be it production, income, employment, or spending - problematic. On the other hand, these concerns do not invalidate measurements of short-term economic trends - changes in levels over a 1-3 year period - in the Caspian region, or elsewhere. Irrespective of levels of statistical shenanigans in these countries, unless significant changes occur in their magnitudes during the time period in question, trends in the variables in question are necessarily unaffected. Moreover, there are reasons to believe that the magnitudes of these shenanigans have diminished over time. For one thing, national statistical agencies have received extensive technical assistance from multilateral and bilateral agencies since 1992. Also, most of the region''s government''s have emphasized maintaining good relations with the IMF. Doing so requires the adoption of "best practice" national statistical techniques. By the same token, the relatively favorable economic indicators sometime reported by transition economies that do not have a relationship with the IMF - such as Uzbekistan, Turkmenistan, and Belarus - should be viewed with more circumspection than those reported by the other countries examined in this paper.
Common statistical issues aside, all of these countries went through a transition shock during the early 1990s, when steep declines in output and high inflation rates were recorded. The output shock reflected a number of factors, including: (1) the disruptions in economic activity that accompanied the dissolution of the USSR; (2) the inflationary consequences of price liberalization in the context of the ruble zone; and (3) the weaknesses of nascent economic policy institutions. The introduction of national currencies during 1993-1994, and the conclusion of agreements with the IMF and World Bank, then allowed these countries to sharply reduce inflation rates. Most of the region then saw economic growth restart during 1995-1996, but even countries like Georgia that posted high growth rates during this time probably remain well below pre-1992 levels of income and output.
Despite these similarities, the severity of the output declines, the extent of the inflation, and the pace of the subsequent recoveries have differed across the region. These differences can be explained by three key factors. First, the wars of the early 1990s led to sharper falls in output in Georgia, Armenia, and Azerbaijan than in Kazakhstan or Turkmenistan. Official Georgian GDP fell by 20-40 percent each year between 1991 and 1993, before stabilizing in 1995. Armenia suffered a 40 percent collapse in output in 1992, while Azerbaijan endured annual GDP declines of 11-23 percent during 1992-1995. By contrast, Kazakhstan''s GDP fell by "only" 13 percent in its worst year, with annual GDP declines limited to under 10 percent in the early 1990s. Turkmenistan''s GDP actually rose 10 percent in 1993, before falling 18 percent in 1994 due to problems with natural gas exports.
A second key difference lies in the fact that some countries are endowed with significant hydrocarbon resources and others are not. Although much of their potential remains unexploited, the economies of Azerbaijan, Kazakhstan, and Turkmenistan already show a strong contribution from the hydrocarbon sector. In Kazakhstan, oil accounts for about a quarter of industrial production and an eighth of GDP. In Azerbaijan, oil is over 50 percent of industrial production and 10 percent of GDP. In Turkmenistan natural gas accounts for 50 percent of industrial production, and 15-18 percent of GDP. In addition, oil-related investment, trade, and service activities are becoming strong contributors to GDP, especially in Azerbaijan and Kazakhstan. Kazakhstan and Azerbaijan have been able to attract strong inflows of foreign investment, over $1 billion per year, compared to only $100-300 million for the rest of the region. This translates into a respectable 5 percent of Kazakhstan''s 1998 GDP and a whopping 33 percent of Azerbaijan''s 1998 GDP. On the other hand, these economies are increasingly linked to international energy and metals markets, and are therefore vulnerable to sharp swings in energy and metals prices.
By contrast, the non-hydrocarbon economies rely more extensively on agriculture and the service sector. In Armenia, agriculture produces about 40 percent of GDP. In Georgia, agriculture accounts for 26 percent of GDP, and industry and trade account for 12 percent each. Armenia and Georgia are also quintessential small open economies with large current account deficits that are financed by transfers and concessional lending from abroad.
Economic policy responses to the challenges of transition, particularly the steep output declines and high inflation of the first half of the 1990s, are a third key factor differentiating the economies of the region. All of the countries except Turkmenistan initially accepted IMF policy conditionality in return for financial and technical assistance. As a result of the IMF-sponsored stabilization programs initiated in the mid-1990s, annual inflation rates - which in 1994 peaked at 15,000 percent in Georgia, 5,000 percent in Armenia, 1,800 percent in Kazakhstan, and 1,600 percent in Azerbaijan - had declined to single-digit levels by 1998. Economic growth also restarted in the mid-1990s, first in Armenia in 1994, then in Georgia in 1995 and Kazakhstan, and Azerbaijan in 1996.
Turkmenistan represents a special case as it has attempted to follow a gradualist path to transition, rejecting help or advice from the IMF. In this respect, Turkmenistan is more similar to other economies in the Commonwealth of Independent States (CIS) such as Uzbekistan and Belarus, where the 1995-1996 rejection of IMF policy conditionality and assistance has met with varying success.) Turkmenistan''s output decline, while somewhat less steep than other countries'', only turned into growth in 1998. Turkmenistan''s approach to transition means that its growth prospects are heavily dependent on natural gas production, and on the sector''s ability to find solvent export markets.
While many have noted the seeming paradox that Uzbekistan, which rejected IMF policy advice, has suffered the lowest cumulative fall in GDP in the CIS since 1991, there are reasons to suggest that Uzbekistan''s performance may not be as stellar as it seems. First, the exchange rate is heavily overvalued, with the black market rate currently trading at four times the central bank rate. The increasing pressure on Uzbekistan''s administered exchange rate regime reflects strong inflationary tendencies in the economy, which threaten to produce accelerating inflation rates. Second, it is difficult to talk of success when dealing with relative levels of poverty in the region. With only 50 percent capacity utilization in its industrial sector, Uzbekistan''s performance may be less vibrant than official GDP numbers indicate. Several other factors mitigated Uzbekistan''s transition shock that were not present in other countries. These include a low level of industrialization when compared to other CIS countries, near energy self-sufficiency, and the availability of a ready hard currency earner, namely cotton, to support the exchange rate. Perhaps most significantly however, is that Uzbekistan''s gradualist approach is sacrificing more dynamic growth in the future. The exchange rate regime and the distortions it causes are leading to under-investment in restructuring industry, and are hurting export and import-dependent sectors of the economy. Although, it may have "suffered" somewhat less than other transition economies, Uzbekistan has done so at the risk of creating its own poverty trap.
Russia''s role in the region''s economy, although steadily declining, remains significant, as can be seen in the knock-on effects of the August 1998 financial crisis. One measure of the vulnerability of each country''s economy to events in Russia is the country''s share of total trade represented by trade with the CIS. (In addition to capturing the direct effects of trade with Russia, this measure reflects the indirect ability of changes in Russian import demand to slow growth and trade among other CIS trading partners.) In 1998 the share of CIS exports in total exports was 54 percent in Georgia, 39 percent in Kazakhstan, 38 percent in Azerbaijan, 37 percent in Armenia, and 63 percent in Turkmenistan. Turkmenistan had the highest import share (51 percent), followed Kazakhstan (47 percent), Azerbaijan (38 percent), Georgia (35 percent), and Armenia (25 percent). When compared with data from 1992, these shares reflect a sharp fall from 80-100 percent of both exports and imports. Only Azerbaijan was less dependent on trade with Russia in 1992, as only 49 percent of Azerbaijan''s exports and 65 percent of its imports were with other CIS countries.
These countries'' CIS trade flows are generally dominated by bilateral trade with Russia. This reflects the institutional legacy of Soviet rule, which linked each of these economies to Russia while developing relatively few intra-regional links. This pattern has been slow to change despite some Western assistance, such as the EU''s TRACECA transport corridor project and World Bank loans, to improve intra-regional infrastructure links. The non-Russian intra-CIS trade that is developing is mainly small-scale, and growth is likely to remain slow over the medium-term given the low of demand for each others products.
The declines in the share of CIS trade in total trade accelerated in late 1998 and early 1999, as the ruble''s crash choked off these countries'' exports to Russia and to one another. CIS exports in the first half of 1999 (relative to mid-1998 levels) were down 55 percent in Kazakhstan, 51 percent in Armenia, and 31 percent in Georgia. In Azerbaijan, CIS exports have fallen to 29 percent of total exports (from 48 percent in 1998). One positive to emerge from the recent crisis has been the reorientation of trade to non-CIS markets, which picked up significantly in 1999. Non-CIS exports in the first half of 1999 were up 35 percent in Armenia, 49 percent in Azerbaijan, and 22 percent in Georgia. The surge in non-CIS exports may have been helped by currency depreciation in all three of these countries. It also suggests that some countries at least have been able to find new markets for their goods in the wake of the Russian crisis. Even though some of this shift in export patterns may reverse as Russian demand revives and the ruble begins to appreciate in real terms, another part will certainly remain as producers continue to tap these new markets.
Despite some mitigating effects, the export collapse has on balance been quite severe and has reduced growth throughout the region. Only Azerbaijan and Armenia reported strong GDP growth in 1998. Oil production and oil-related construction projects picked up in Azerbaijan, while a bumper crop in Armenia boosted the all-important agricultural sector. Georgia''s GDP growth decelerated sharply from 11 percent in 1997 to 2.9 percent in 1998, while Kazakhstan slipped into recession. Turkmenistan actually posted a surge in growth in late 1998 and early 1999 due to a new gas deal with Ukraine, although the sustainability of this growth is now in doubt after financing for the deal collapsed in May.
Aside from slowing exports and growth, the Russia crisis put heavy pressure on the region''s currencies. Kazakhstan''s tenge, the Georgian lari, and Azerbaijan''s manat fell especially hard, with the Armenian dram depreciating less sharply. These devaluations in turn ignited new inflationary pressures, which the authorities struggled to contain with tighter fiscal and monetary policies. Turkmenistan has thus far avoided a devaluation through administrative controls and a surge in gas exports. Still, year-on-year inflation rates have remained under control in the region: at mid-year, they ranged from 30 percent in Turkmenistan to - 10 percent in Azerbaijan, with 21 percent in Georgia, 10 percent in Kazakhstan, and 4.3 percent in Armenia. These relatively low inflation rates contrast both with Russia - which saw consumer price inflation hit triple-digit levels in early 1999 - and Belarus and Uzbekistan, where relatively loose fiscal and monetary policies have meant much greater pressures on prices and exchange rates. In Uzbekistan inflation was running at 29 percent mid-year, while the som was trading at a black market premium almost four times the official rate. In Belarus, CPI inflation was running at 357 percent by August, while the official rate fell from $1 = 107,000 rubles in January to $1 = 279,000 in early September.
The progress made with macroeconomic stabilization during the mid-1990s has therefore not been lost in the wake of the Russian crisis. As a result, the major issues facing the region''s economies are now of a structural and institutional nature. All of these countries suffer from severe deficiencies in market and institutional infrastructure. Financial markets are only weakly developed. To date, Kazakhstan is the only country that has succeeded in raising a significant amount of financing on the international capital markets. Other concerns include the prevalence of corruption, weak judicial systems, poor protection of investor rights and contracts, and lagging privatization programs (with the partial, and arguable, exceptions of Kazakhstan and Armenia). The implementation of structural reforms in these areas is crucial for generating long-term sustainable economic growth.
Country Overviews
Armenia
Compared to other CIS countries, Armenia has thus far survived the Russian crisis relatively unscathed. GDP growth accelerated in 1998 and remained strong in 1999. Fueled by rapid growth in agriculture, transport, and trade, GDP rose 7.2 percent in 1998, while strong growth in construction led to 4.9 percent GDP growth during the first half of 1999. Although the current account deficit rose to $390.3 million last year (20.7 percent of GDP), a four-fold increase in direct foreign investment, combined with balance-of-payments support from the IMF and the Diaspora, allowed Armenia to finance the current account deficit without running down official reserves. Thanks to central bank intervention, the exchange rate has remained relatively stable. Between August 1998 and August 1999, the dram depreciated by 6.9 percent against the dollar in nominal terms and by just 3.5 percent in real effective terms.
The dram''s stability, combined with falling food prices in the summer of 1998 and the effects of a macroeconomic stabilization program initiated by then Prime Minister Robert Kocharian in late 1997, helped slow annual inflation from 13.8 percent in 1997 to 8.7 percent in 1998. Although price pressures intensified during the fourth quarter of 1998 and early 1999 (during the worst of the Russian crisis), inflation then slowed significantly, and the dram appreciated against the dollar in 1999. Year-on-year consumer price inflation had fallen to 2.2 percent in June 1999.
Armenia''s medium-term outlook seems relatively favorable as long as inflows of foreign direct investment and progress on privatization continue. The main policy challenges concern the budget and current account deficits, which raise questions about the sustainability of such growth. Knock-on effects from the Russian crisis have weakened the government''s fiscal position and could precipitate a budget crisis. The drop in exports is cutting into profit tax receipts, while lower imports have reduced customs duties. Without corresponding cuts in expenditures, the government estimates that the general government budget deficit swelled to 40 billion drams by the end of June ($74 million). For the year 1999, the original budget law called for a deficit of 57 billion drams ($104 million), or 5.1 percent of GDP, down from 5.9 percent in 1998. To finance the deficit in a non-inflationary manner the government must rely on foreign borrowing, particularly concessional loans from bilateral and multilateral lenders. The new "right-left coalition" that took office following the May 1999 parliamentary elections appears committed to restoring fiscal order. The government has raised taxes and cut expenditures in an effort to offset tax revenue shortfalls during the first half. These measures recently secured the release of delayed credits from the IMF and World Bank, which are vital to covering the government budget and current account deficits.
Georgia
Economic growth slowed in Georgia to 2.9 percent in 1998 from 11.3 percent in 1997 as drought dampened agricultural growth. Falling exports to Russia contributed to slower growth in industry and trade, while a deepening budget crisis forced the government to raise taxes and cut expenditures, thus restraining domestic demand. These austerity measures earned the release of delayed credits from the IMF and World Bank, which, along with a substantial decline in the current account deficit, helped to stabilize the lari following a sharp depreciation in early 1999. The lari''s stabilization, combined with tight monetary policies, has since slowed the inflation that followed the lari''s initial slide.
Georgia is trapped in a budget crisis, as the central government has been unable to raise the share of GDP collected in tax revenues above 9 percent. The main problems are with collecting customs duties and excise taxes, and these reflect Tbilisi''s limited control over its borders and regional governments. In 1998 the government failed to meet most of the fiscal targets set in its policy framework agreement with the IMF. The tax revenue shortfalls forced the government to abandon its pledge to completely eliminate existing expenditure arrears by the end of 1998. Instead, arrears on wages, pensions, and social transfers, rose to 2 percent of GDP. The consolidated government budget deficit rose to 3.4 percent of GDP on a cash basis, up from a planned deficit of 2.9 percent of GDP.
The government in 1999 has responded to these pressures by attempting to tighten fiscal policy, boost its revenue collection system, and accelerate the pace of structural reform. Bankruptcy proceedings were initiated against the 10 largest delinquent tax payers, and legislation requiring state enterprises to remit dividends due to the state budget has been enforced. The British ITS firm has been hired to run Georgia''s customs agency, and the government is attempting to eliminate wage and pension arrears so as to break the vicious cycle of non-payments. But despite these measures, tax revenues during the first half of 1999 were 25 percent below target. Without further expenditure cuts, the consolidated budget deficit would rise to 5.0 percent of GDP, which could produce a rupture in relations with the IMF. IMF financing is all the more crucial given the government''s inability to tap local or international debt markets. Aside from resolving its budget crisis, the keys to Georgia''s medium term growth will be to the government''s ability to attract foreign direct investment and accelerate privatization, in order to help modernize and expand its industrial agricultural, transport and communications sectors. Foreign investment has picked up noticeably since 1996, thanks primarily to investment in the countries energy and transport sectors.
Kazakhstan
Kazakhstan is feeling the knock-on effects from the Russia crisis rather severely. In 1998 growth fell prey to the collapse of demand in Russia following the ruble devaluation: GDP fell 2.5 percent in that year after rising modestly in 1996 and 1997. First-half 1999 results have shown substantial contractions in industry and other sectors, which are likely to keep Kazakhstan in recession for some time. After struggling to support the exchange rate, at the beginning of April, the National Bank of Kazakhstan (NBK) was forced to abandon its managed float of the tenge. The exchange rate then fell from $1 = 87 tenge in March to $1 = 113 tenge in April. After some additional bumps, it stabilized at $1 = 130 tenge in mid-summer, before weakening slightly to $1 = 140 tenge by the start of October.
However, the tenge has not careened out of control, and year-on-year inflation rates have remained around 10-15 percent. Because inflation has not skyrocketed, economic activity has not been derailed. The drop in the tenge has relieved some pressure on domestic producers from cheap CIS imports and helped make exports more profitable. Retail sales are up, and the service sector should contribute to output growth this year. A firming in international commodity prices (especially in energy) is increasing revenues from Kazakhstan''s commodity exports.
External imbalances are the major problem facing Kazakhstan, as the tenge''s depreciation in 1999 was directly attributable to pressures stemming from the current account deficit. Although Kazakhstan remains the only CIS country able to tap the international capital markets, even Kazakhstan has had great difficulty in raising much additional finance this year. Securing financing from the IMF and other international financial institutions will therefore be crucial in covering current account deficits in the next few years. (A three-year $450 million IMF standby agreement expired in July, and a new agreement had not yet been reached by October.) In the medium term, however, as production of metals and energy - especially oil from the Tengiz field - expands Kazakhstan''s external imbalances should moderate. Fiscal policy remains tight. Kazakhstan''s parliament passed an austere 2000 budget in late September in line with IMF recommendations, limiting the deficit to 3.0 percent of GDP. This should remove one of the main obstacles to renewed IMF lending later this year. Not only are loans from other institutions, such as a $100 million tranche from the World Bank for pension reform, dependent on successful negotiations with the IMF, but an IMF program is also needed to reassure foreign investors about Kazakhstan.
Azerbaijan
Azerbaijan remained the fastest growing economy in the CIS in the first half of 1999, although growth was well below 1998''s torrid 10 percent. While oil and gas production continue to expand significantly, oil companies in early 1999 appear to have decided to cut costs and scale back investments, when international energy prices were weak. This in turn undermined growth in sectors such as construction and services. In addition, the aftermath of the Russian financial crisis and the other devaluations in the region put pressure on the non-oil sector via import competition. Deflation has also been a problem: average inflation was -0.8 percent in 1998, and year-on-year inflation rates had fallen to -10 percent by June 1999. Falling prices have caused real interest rates to rise substantially and further aggravated a lack of liquidity and credit in the economy.
In light of these deflationary pressures, the IMF suggested loosening monetary and fiscal policy, as well as floating the manat. Following this advice, the central bank (ANB) in July 1999 allowed the currency to float. The exchange rate dropped from $1 = 3,976 manat in July to $1 = 4,310 manat in late September. Whether it is possible to keep the
manat down over the medium-term is another issue, as large inflows of foreign investment will continue to enter the energy sector and put upward pressure on the currency. The non-oil economy is likely to continue to experience "Dutch disease" due to the effects of noncompetitive exports and cheap imports - unless they are outpaced by productivity gains. In light of the slow pace of privatization and structural reform, this is not likely.
Higher energy prices in the last few months should help boost investment in Azerbaijan and lead to higher GDP and export growth. Large current account deficits, which will continue until oil exports begin to boom in the next few years, should be covered by strong foreign investment inflows of about $1.5-2.0 billion per year. The non-oil sector is likely to suffer, however, as the currency appreciates (due to these inflows) and because reform and restructuring remain slow. The government has been a laggard in pushing privatization and structural reforms, which would boost the non-oil sector''s prospects.
Turkmenistan
Turkmenistan''s economy combines seductive potential, particularly in its natural gas sector, with deep underlying problems. The geography of gas export routes has thus far been intractable. Gas exports, the mainstay of the economy, have often been disrupted by non-payments from a number of key customers, particularly Ukraine. The resumption of gas exports to Ukraine in early 1999 seemed to have a cascading series of benefits for the economy. Industrial output soared, pushing GDP growth for the first half well over 10 percent. Dramatically higher export figures, due almost solely to gas sales, pushed the mounting trade deficit back into surplus. After two years of stagnation, Turkmenistan''s economy boomed in the first half of 1999.
Unfortunately, rapidly mounting arrears in Ukraine forced Turkmenistan to cease gas shipments, and production then plummeted. Ashgabat''s best hopes now seem to rest with the prospects for a trans-Caspian pipeline Turkey, but even this project received a blow in 1999 with the discovery by Azerbaijan of a large gas field of its own. Significantly closer to the Turkish market, Azerbaijan could easily undercut Turkmenistan if the field is successfully developed.
Turkmenistan''s economic policy is highly centralized, in keeping with the "gradual" approach to market reforms that seeks to avoid the economic and social dislocation often found with rapid and chaotic transitions.
The country''s leadership has until recently rejected cooperation with the IMF, and sought to make do without international financial support. Although Russia''s post-August 1998 turmoil is seen as proving the validity of the government''s philosophy, in practice economic policy in Turkmenistan is simply a means for continuing highly centralized control over economic affairs. Policy decisions are subject to the whims of the president, as every major economic issue requires presidential approval. The monetary authorities are not independent and are under political pressure to finance budget deficits. The fiscal accounts are extremely opaque, and only show a surplus when natural gas exports are substantial. The exchange rate is fixed at $1 = 5,200 manat, thanks to a variety of capital controls. (The black market rate is three times the official rate.) Although the surge in natural gas exports early in 1999 helped stave off a nascent foreign exchange crisis, pressures for a devaluation are likely to build further. Still, while leaving much to be desired, Turkmenistan''s track record has not been an unmitigated failure. Inflation fell to 20 percent in 1998 from over 1,000 percent in 1996. Conclusions
The past year has been turbulent for the region''s economies, and the aftereffects of the August 1998 Russian crisis continue to be felt. Still, the Russian contagion has proved less damaging than originally feared. Although three of the five countries'' exchange rate regimes crashed spectacularly in the aftermath of Russia''s crisis, inflation has not spun out of control, and currencies are once again stabilizing. Only Kazakhstan slipped into recession during this period, while growth in Georgia slowed dramatically. Armenia and Azerbaijan both posted accelerating growth in 1998, while Turkmenistan''s economic problems remain tied to the problem of finding paying customers for its gas exports. The Russian crisis has accelerated the decoupling of these economies, reducing the Russian share of their total trade CIS and making them less vulnerable to future economic crises in Russia.
Growth prospects and policy challenges for the region vary across countries. Assuming a modicum of political stability is retained after the Aliyev succession and the resumption of the Karabakh conflict is avoided, Azerbaijan is poised to enjoy the region''s highest growth rates in the coming years, as foreign investment pours in and oil exports begin to take off. Baku''s major economic policy challenge will be managing this sudden oil wealth and investing it in a constructive manner. It will also be challenged to avoid the institutional distortions often associated with petro-wealth. The non-oil sectors of its economy will hard be pressed to restructure to maintain their competitiveness. The early signs are that Azerbaijan still has a long way to go in recognizing and meeting these challenges.
Turkmenistan is likely to have the most volatile growth in the region as production continues to be based on natural gas. The key challenge in this context is overcoming the problems of geography and regional politics, in order to find stable, solvent export markets. Turkmenistan will also have to contend with the rather erratic economic policies of its supreme leader - and with a possible succession crisis - which make developing non-oil sectors of the economy more difficult.
The economic challenges facing Armenia and Georgia are largely of a different nature. Both can only flourish as small open economies and must devote considerable effort to structural reforms and creating a favorable investment climate and trade regime. Armenia also faces the geopolitical problem of the Turkish-Azerbaijani blockade that cuts off many of its export routes. It has had to rely mainly on Georgia for contact with the outside world (contacts with Iran being strongly discouraged by the US). A resolution of the Karabakh issue and a removal of this blockade could open significant trade and other opportunities for Armenia. Over the medium-term it will be difficult for Armenia to develop if it is unable to trade with two of its most important neighbors. Georgia on the other hand enjoys a more favorable geopolitical situation. It has access to the Black Sea and enjoys good relations with Turkey. Georgia also straddles one of the main non-Russian export routes for Caspian oil, and has already begun to benefit from investment and transit fee windfalls in that regard. Tbilisi''s main challenge is creating a single national economy and consolidating control over its borders. This is crucial in collecting taxes and overcoming the budget crisis that threatens to hold Georgian growth in check.
Kazakhstan has the most diverse economy in the region, and faces the most complex policy challenges. On the one hand, Kazakhstan like Azerbaijan is poised to participate in the oil bonanza, and as such will face the challenges of managing this wealth. Foreign direct investment flows will be large, but not nearly as high a percentage of GDP as in Azerbaijan. To generate higher growth rates going forward, policy will have to focus on developing Kazakhstan''s significant non-oil sectors, such as agriculture, food processing, and metallurgy. This will require continuing the difficult structural reforms outlined above. Finally, due to its geography, Kazakhstan will remain more tied to Russia than any other economy in the region. Managing relations with Moscow could be a significant challenge in the years ahead.