While the Caucasus and Central Asia (CCA) is facing a somewhat better external environment, prospects for growth remain subdued relative to historical standards, and risks remain tilted to the downside. 
A comprehensive set of reforms is needed to help unleash the region’s growth potential and address the legacy of past shocks. A strong financial sector is essential to this much-needed economic transformation. However, the slowdown in economic activity and currency depreciations against the dollar since 2014 have added stress to many of the region’s already overburdened, highly-dollarized financial sectors, leaving them too weak to support a strong recovery. Without urgent financial sector repair, further pressures on fiscal accounts could emerge and the economic transformation could be derailed.
Financial sector distress has manifested itself across the CCA in many ways. Since mid-2014, the decline in commodity prices and a slowdown in key trading partners’ growth have made it more difficult for borrowers to service their debt. This has been especially true for foreign currency loans where currency depreciation has also added to the debt-servicing cost. Consequently, overdue loans have increased, eroding the reserves banks set aside for difficult times. This has reduced their capital further – with many already undercapitalized by international standards. In addition, limited supervisory independence has, in some cases, impeded the resolution of deep-rooted problems, including poor lending practices. These vulnerabilities are holding back credit growth and reducing confidence in banks.
Country authorities have taken steps to address these pressures, including through increases in minimum capital requirements, injections of capital, mergers and closures of problem banks, and the strengthening of supervisory laws and regulations. But more remains to be done. A careful sequencing of reforms is needed, starting with a proper identification of bad loans and capital needs. Second, timely intervention of weak banks is essential to minimize the risk of vulnerabilities spreading further through the broader financial system. Any government support should be provided under strict conditions – for example, funds should be channelled only to viable banks with adequate guarantees – that help minimize costs to the public sector. Third, liquidation of bad assets, and openness to private investment in the sector should be pursued transparently, with the goal of promoting competition. Finally, regulators must continue to strengthen lending practices, develop and implement crisis management frameworks, and fully enforce prudential regulations.
Financial sector repairs will complement the CCA’s on-going fiscal, monetary, and structural reforms in various ways. Fiscal consolidation is needed to address the wider fiscal deficits and higher debt generated by the earlier (and appropriate) increases in public spending to support growth. But this should strike a balance between supporting economic activity in the short term and ensuring sustainability in the long term, while prioritizing productive investments and protecting the poor. A strong financial sector will help this process by not only reducing potential fiscal pressures, but also supporting a successful debt-management strategy. On monetary policy, further improvements to existing frameworks are needed to fully reap the benefits of increased exchange rate flexibility. These should focus on fostering policy credibility, which requires developing clear communication practices and ensuring central bank independence. In this context, a solid and reliable financial sector will contribute to the de-dollarization process, which is necessary for the effectiveness of monetary policy. On the structural front, weaker financial sectors that are incapable of supporting the real economy jeopardize the completion of reforms that promote the much-needed economic transformation away from commodities and remittances.
The CCA countries should take decisive action to fix their banks. A healthy financial sector will help unleash the region’s economic potential and raise living standards.
The author is Deputy Director of the Middle East and Central Asia Department of the International Monetary Fund.
