With economic recovery, the governments of Armenia and Georgia managed to reduce budget and current account deficits; however, the gross government and external debts still remain to be significant.  To reduce the debt risks, their governments need to increase attractiveness of their economies for investments and boost exports. The other Caucasian republic, Azerbaijan, due to high oil revenues, does not experience any problem with balancing its budget and maintaining external sustainability. However, in order to secure fiscal and external sustainability in future, the Azerbaijani government has to accelerate the diversification of the national economy. 

BACKGROUND: The 2008-2009 financial crisis led to a decline of government revenues of Armenia and Georgia and consequently to an increase of their budget deficits. As is seen in Figure 1, in 2009, Armenia and Georgia had bigger deficits in comparison with the previous year. One of the main reasons for the decline in budget revenues was the decrease of tax receipts due to a fall in remittances. Remittances make a sizeable contribution to the GDP of these countries. For example, in 2009, they made up 9 percent of Armenia’s GDP and 6.4 percent of Georgia’s. Since remittances are mostly consumed; their decline led to a decrease of sales tax and import duty receipts.  Although in the financial crisis, Azerbaijan managed to avoid a budget deficit, the crisis negatively affected the fiscal balance of Azerbaijan. The surplus of 2009 was smaller than the surplus of 2008. The observed decline of budget revenues is attributed chiefly to the decline in the price of oil.  

Figure 1. General Government Fiscal Balance, (percent of GDP)

Source: International Monetary Fund

To finance a budget deficit, a government can borrow, print money, or raise taxes. Borrowing leads to an increase of government debt, printing money increases inflation, and tax increases negatively affect economic growth. With a rise of budget deficits, the governments of Armenia and Georgia preferred to increase borrowing, and their debt mounted as a result, as indicated in figure 2. The government debt of Azerbaijan also increased; however, the debt increase was not related to a budget deficit since the budget was in surplus in spite of the world recession.

Figure 2. Total Government Gross Debt, (percent of GDP)

Source: International Monetary Fund

Another challenge for Armenia and Georgia is the large current account deficit which negatively affects their external sustainability (see figure 3). The current account balance was exacerbated due to a decline in exports, remittances and foreign investments. Later, with recovery of the Russian economy, exports and remittances started rebounding and the balances improved; however, the deficits remained sizeable. Furthermore, despite the increase of remittances and exports, foreign investments did not demonstrate a strong recovery. The slow recovery of investments is linked to high risk aversion of foreign investors. The decrease of the current account surplus of Azerbaijan in 2009 was a consequence of the fall of oil prices and as oil prices snapped back in 2010, the surplus started growing.    

Figure 3. Current Account Balance (percent of GDP)

 

Source: International Monetary Fund

A current account deficit puts downward pressure on an exchange rate. Hence, in order to maintain the exchange rate or prevent it from significant fluctuations, a government needs to supply foreign currency to the market.  Foreign exchange can be sourced from the foreign exchange reserves of a country and in a case of urgency, reserves can be replenished by external borrowing. Figure 4 shows that after 2008, the external debt to GDP ratios for Armenia and Georgia increased. This implies that their governments resorted to external borrowing. Despite the current account surplus, the external debt to GDP ratio of Azerbaijan also increased. The external debt grew because the Azerbaijani government relied on external sources to finance some of its infrastructure projects. However, the increment was insignificant and the ratio started to decline in 2010 as oil prices increased.

Figure 4. Total Gross External Debt, (percent of GDP)

Source: International Monetary Fund

IMPLICATIONS: Although the budget deficits of Armenia and Georgia decreased as exports and remittances gained momentum, their debt remained substantial, and therefore their fiscal and external positions remain vulnerable. The reason is that government revenue and foreign currency inflow increases generated by the growth in remittances and exports were not sufficient to reduce the gross government and external debts.

When debt becomes extensive, governments tend to implement austerity policies, which assumes the reduction of government spending. Such policies enable governments to direct savings to the payment of debts. However, in reality, reduction of government spending and accompanied increases in interest rates in a time of economic downturn can inhibit recovery or even cause the second wave of recession. Furthermore, taking into consideration the relatively low standards of living in Armenia and Georgia, a decrease of government spending can also raise social problems.

The further growth of current account deficits in these two countries, together with external debt, could at some point trigger a depreciation of the national currencies. A rapid decline of exchange rates fuels inflation and interest rates and hence jeopardizes macroeconomic stability. Lower degrees of macroeconomic stability can discourage foreign investment and trade, imposing a high risk on further economic growth. Furthermore, the increase of macroeconomic risks will increase the cost of external borrowing for domestic banks and companies and this will force businesses to postpone their investments.      

As long as the oil price does not fall below US$80 per barrel, Azerbaijan’s budget will not experience any deficit. Considering the current oil prices at over $100 per barrel, no significant threat to the fiscal and external sustainability of the Azerbaijani economy should be expected in the near future. Furthermore, low external debt, large trade surplus and significant foreign exchange reserves give confidence to the national currency. However, in the medium period, there is a risk that oil price fluctuations may challenge fiscal and external sustainability.   

   

CONCLUSIONS: The recuperation of exports and remittances allowed Armenia and Georgia to reduce their budget and current account deficits to some degree; however, gross government and external debts still threaten their fiscal and external sustainability. From the implications suggested above, it can be concluded that austerity programs are not desirable measures to resolve the debt problems. For this reason, the governments of these countries should concentrate on implementation of institutional reforms which will enhance the competitiveness of their economies. The increase of economic competitiveness will boost production and exports, increase government revenues and stimulate domestic and foreign investments. Hence, the solution of the problem of fiscal and external sustainability lies with institutional reforms.

Although Azerbaijan does not have any problems with its budget, debt, or current account deficit, its fiscal and external sustainability is challenged by fluctuations of oil prices since oil revenues play a crucial role in budget formation and are the main source of foreign currency. For this reason, the Azerbaijani government needs to boost the diversification of the national economy, and the implementation of institutional reforms can accelerate the process.

AUTHORS’ BIOS: Ramiz Rahmanov is a senior consultant and Zaur Valiyev is a research fellow at the Center for Strategic Studies under the President of the Republic of Azerbaijan. The views expressed here do not necessarily represent those of the Center for Strategic Studies.