By Masood Ahmed

The global financial crisis has led to mounting stress in the banking systems of most countries in the Caucasus and Central Asia. Private sector credit growth has slowed sharply and even turned negative in real terms in a number of countries, compared with the dramatic increases, ranging from 40 to 80 percent in the period immediately prior to the crisis. The credit slowdown is weighing on economic activity and having policymakers seek ways to restore it, thereby laying the foundation for a resumption in high and sustainable economic growth.

How did we get there?

Understanding the reasons behind the credit slowdown is important for getting the policy response right. In the Caucasus and Central Asia, three were dominant.

First, balance of payments pressures led to depreciation in several countries. With high levels of dollarization and exposure to currency risk, the depreciation contributed to a significant weakening of balance sheets of banks and unhedged borrowers. Most countries experienced reductions in their capital/asset ratios by more than 2 percentage points and increases in their nonperforming loans ratios by more than 4 percentage points. Kazakhstan and Tajikistan were particularly hard hit: the nonperforming loans ratio increased by 14–16 percentage points.

Second, the crisis subjected banks to a sharp reduction in funding—deposits, remittances, and external borrowing—which had fueled rapid and above-trend credit growth in previous years.

And third, the slowdown in economic activity may have resulted in a tightening of credit supply as well as a contraction in demand for credit due to heightened macroeconomic uncertainty.

With impaired balance sheets, lackluster funding growth, and heightened uncertainty, credit to the economy has slumped—since end-2007, real credit growth has fallen by about 63 percentage points on average.

What can policymakers do?

Policies should aid banks in the process of repairing their balance sheets by recognizing losses and supplementing bank capital if needed. Where banks are fundamentally healthy and mainly affected by a lack of funding, temporary government or central bank liquidity injections may help restore credit growth. Of course, adequate fiscal room is a precondition for such actions.

Over the medium term, macroeconomic and macroprudential policies should promote dedollarization to reduce vulnerabilities to sudden exchange rate movements and currency risk; high levels of dollarization of 40 to 80 percent were a key transmission channel of the global crisis to the region. Precrisis trends in Caucasus and Central Asia countries, as well as the international experience, have shown that macroeconomic stability is the most successful conduit for sustained dedollarization. In addition, the regulatory framework should encourage a proper pricing of currency risk, for example, by requiring higher capital charges for foreign exchange loans to unhedged borrowers, thus addressing indirect currency risk. In some countries, allowing greater exchange rate flexibility may also help banks and the corporate and household sectors to better internalize the risks of dollarization.

Developing local debt markets can contribute to dedollarization by giving domestic agents access to a wider range of domestic-currency financial instruments. Moreover, local debt markets allow banks to diversify their funding base and thus become less vulnerable to swings in individual funding sources.

What else might policymakers in the Caucasus and Central Asia do to revive credit? What lessons can be learned from other countries’ experience? We'd like to hear from you.