Charting a path forward amid a new economic shock to the Caucasus and Central Asia region

The war in Ukraine and international sanctions against Russia are likely to strike a significant blow to economies in the Caucasus and Central Asia (CCA) region, while they are still recovering from the COVID-19 shock and grappling with elevated inflation.

CCA countries are among the most exposed, given geographic proximity, close trade and financial linkages with Russia, reliance on remittances and tourism, and exchange rate spillovers. Countries in the region also have trade linkages to Ukraine and are exposed to global spillovers from higher commodity and food prices, as well as tightening financial conditions.

The multifaceted impact of the war in Ukraine has considerably weakened CCA growth prospects for this year. Our recently published economic outlook projects real GDP growth to drop to 2.6 percent in 2022, a downgrade of 1.5 percentage points from October, after a strong recovery of 5.6 percent in 2021. We also project that inflation will increase to 10.7 percent in the region this year.

However, the reverberations from this shock will likely be felt differently across the region, with energy exporters, such as Azerbaijan and Kazakhstan, benefitting from higher oil and gas prices, offsetting some of the negative impact of the war. Yet, these countries’ energy exports to or through Russia may be at risk. Meanwhile, the growth downgrade to energy importers, such as Armenia, Georgia, and the Kyrgyz Republic, is substantial (2.4 percentage points relative to October), given the impact of higher commodity prices.

Across the region, food security concerns are rising, given surging global food prices and since Russia supplies more than 20 percent of the region’s food imports, with some countries particularly reliant on both Russia and Ukraine for wheat.

Remittances from Russia are also at risk, given the expected slowdown of its economy and potential disruptions to cross-border payment systems. Their decline would reduce disposable income and growth, and weaken external accounts, especially in the Kyrgyz Republic and Tajikistan where they top 20 percent of GDP. Together with rising food prices, this could also heighten risks of social unrest.

In this context, near-term policy tradeoffs have become even more challenging than just a few months ago. The COVID crisis had already raised inflation and debt levels, limiting macroeconomic policy space. With a deteriorating outlook, central banks must thread the needle of containing inflation without excessively hindering economic growth. Governments need to carefully gauge the scope to cushion the impact of high prices on the vulnerable. Finally, they must also be mindful of financial stability risks created by external spillovers, given high levels of dollarization in the region and banking sector linkages with Russia.

This is a testing moment for policymaking. Uncertainties and long-term challenges that will shape the region’s future still loom large—from adapting to climate change to securing high and inclusive growth.

So, what could be the path ahead? In countries where inflation expectations are increasing, central banks may need to raise policy interest rates further. Exchange rate flexibility can help cushion the shock.

Energy importers with limited fiscal space should implement growth-friendly fiscal adjustment policies that prioritize health and social spending.

Addressing food security risks is urgent, and countries should mitigate the impact of high international prices on the poor. The most effective way is to ensure vulnerable households are protected through targeted and temporary transfers. Where safety nets are less strong, prices could be raised gradually. Bolstering food supplies by supporting production and ramping up international cooperation could also help.

More broadly, these challenges underscore the importance of reforms that can make the economies of the CCA more resilient and inclusive. Priorities include staying the course on reforms that reduce the state footprint in the economy and support private sector-led growth and job creation. With the right blend of policies, the CCA region can emerge from these consecutive shocks on a path toward a better future.