On behalf of our Kyrgyz authorities, we would like to thank management and staff for their continued support to the Kyrgyz Republic through the three-year arrangement under the Extended Credit Facility (ECF). The authorities are highly appreciative of the Fund’s steady engagement with them and broadly agree with staff’s assessment and policy recommendations. In a turbulent regional economic context, the Fund program provides a solid framework for the design, prioritization, and implementation of sound policies to support the economy in the short term, as well as to lift its potential and enhance its resilience in the long term. Ultimately, preserving macroeconomic stability and putting economic growth on a higher trajectory are essential to sustain social stability and to achieve permanent gains in the fight against poverty. Against this background, the authorities remain strongly committed to the set of measures agreed under the Fund program. Program implementation has been strong. All end-June 2015 quantitative performance criteria and all indicative targets were met. For the most part, structural benchmarks for this review were met. On this basis, the authorities request the completion of the first review and the related disbursement in the amount of SDR 9.514 million.
Recent economic developments
The turbulent regional economic context is taking a toll on the Kyrgyz economy. The economic slowdown in major trading partners has contributed to lowering exports and has also slashed remittances, an important source of foreign exchange and driver of domestic demand. Remittances are equivalent to almost one third of GDP. In the first nine months of this year, remittances decreased by 28 percent (y-o-y) in USD terms. The knock-on effect on the som from the depreciations of other regional currencies and the appreciation of the US dollar elevates the risks to the financial sector and has contributed to the higher-than expected level of public external debt. Overall, this wave of external shocks sharpens some of the policy tradeoffs faced by the authorities and complicates macroeconomic policy management.
In this difficult external environment, economic growth will remain modest in 2015 due to a decrease in gold production and despite relatively good results in the rest of the economy. Year-on-year inflation slowed down from 10.5 percent in December 2014 to 6.4 percent in September 2015 due mainly to lower food prices. The favorable state of world food markets, the good harvest in the Kyrgyz Republic along with tight monetary policy resulted in an inflation rate of 1.1 percent on a cumulative basis for the first nine months of 2015. The benefits from lower fuel import prices were partially offset by the depreciation of the som against the US dollar. The National Bank of the Kyrgyz Republic (NBKR) has maintained a tight monetary policy and allowed the exchange rate to adjust to external shocks, limiting its interventions to smoothing excessive fluctuations.
The authorities will ensure that the end-of-year fiscal deficit is in line with the program target. Their second supplementary budget targets an overall deficit of 3.7 percent of GDP. However, it is expected that through frugal budget execution, the deficit will be brought down to 3.5 percent of GDP.
The Kyrgyz Republic officially became a member of the Eurasian Economic Union (EEU) on August 12, 2015. The Russia-Kyrgyz Development Fund has started its operations. So far, the Russian Federation has disbursed USD 300 million to overcome the structural changes caused by the new trade regime, to enhance the access to credit for the private sector, and to support the Kyrgyz economy.
Fiscal policy: a balancing act geared towards fiscal consolidation and maintaining debt sustainability
The authorities remain committed to resume fiscal consolidation in 2016 to maintain public debt at a sustainable level, as planned at the time of the program request. For the remainder of this year, program commitments will be met by streamlining expenditures as needed and by avoiding new recurring spending unless these are financed by new permanent revenue measures.
The budget for 2016 is being prepared in line with program targets, through a combination of revenue measures and further expenditure streamlining, including a reduction of the wage bill and refraining from ad hoc wage increases. While the overall balance will deteriorate due to the postponement of some PIP projects from 2015 to 2016, an operating surplus of 5.9 percent of GDP is targeted. To meet this target, a fiscal effort of at least 1.6 percentage points of GDP will be undertaken, excluding expected EEU customs revenues which should be saved to gradually rebuild thin fiscal buffers.
Education is a powerful driver of development and one of the most effective instruments for reducing poverty and improving health, gender equality, peace, and social stability. To this end, the authorities have decided to dedicate the USD 100 million windfall revenue from the sale of a gold mine to the improvement of existing schools and the construction of new schools in remote areas, as a national commitment to the Sustainable Development Goals. Given the fact that the salary of teachers was around USD 80 per month, the Kyrgyz authorities also decided to increase it to USD 120 on average.
To ensure that the increase of teachers’ salaries stays budget neutral, a number of revenue measures will be implemented such as upgrading the mechanisms of accruing and paying certain types of non tax payments, strengthening the administration of the VAT to reduce tax evasion and broaden the tax base, and raising excise taxes as part of the process of harmonization with EEU rules.
The authorities remain fully committed to maintaining public external debt at a sustainable level over the medium term. In the period ahead, to that effect, an action plan will be introduced to improve the quality and the efficiency of the public investment process. Furthermore, among other measures, the authorities will revise their Medium Term Debt Strategy in line with the outcome of the new debt sustainability analysis. The authorities intend to refrain from nonconcessional borrowing and request an indicative target of zero nonconcessional borrowing to that effect, in addition to the quantitative performance criterion on the present value of new external debt contracted or guaranteed.
Monetary and financial sector policies
Monetary policy will continue to focus on containing inflation within the target range. As in the past, the NBKR will maintain a positive policy rate in real terms and stands ready to adjust its level in response to inflationary and exchange rate pressures. Foreign exchange interventions will continue to be used only to smooth excessive fluctuations. Their tightening impact will be carefully monitored to avoid unduly restricting credit growth and damaging growth prospects.
The authorities will further pursue their efforts to preserve financial sector stability and reduce dollarization through market-based measures. They are analyzing the impact of the macroprudential measures introduced in May 2015 with a view to fine-tuning them as needed. To address the challenges arising from exchange rate volatility, higher reserve requirements were set on foreign exchange deposits. In addition, the authorities stand ready to consider and introduce regulation to restrict foreign exchange lending to borrowers with less than 50 percent of their income in foreign currency.
The authorities remain committed to make every effort to work with the newly elected Parliament to enact the Banking Law in a form substantially similar to the draft that was initially submitted to Parliament. Once the Banking Law is implemented, it will contribute substantially to the strengthening of the Kyrgyz financial system.
Meanwhile, banking sector supervision is being further strengthened by developing a strategic plan to build supervisory capacity and to provide for a robust supervisory program, including risk based supervision. A crisis simulation exercise will be conducted by March 2016 and a crisis preparedness framework will be developed together with the Ministry of Finance and the Deposit Protection Agency by September 2016. The model for macrofinancial stress testing will be enhanced, and banks will be closely monitored, particularly those with a large exposure to trade, construction, mortgage and consumer loans.
While the audit of DEBRA could not be completed as expected, the authorities remain fully committed to completing this audit. Progress has been made and an auditor has been appointed (prior action). This auditor has been tasked to complete its work by March 2016.
Structural and institutional reforms to strengthen long-term growth
The Kyrgyz authorities are well aware of the importance of further improving the business environment, a key pillar of sustainable and inclusive growth. This issue was stressed by the President of the Kyrgyz Republic, Mr. Atambaev, during the opening ceremony of the first session of the newly elected parliament.
Improving the business and investment climate is crucial to strengthen long-term growth in general, and to reap the full benefits from EEU membership in particular. A review of the tax regime will be undertaken to ensure simplicity, fairness and equal treatment of all tax payers. The new government has committed to put all its efforts to find a mutually beneficial resolution of the dispute with Centerra, based on high environmental and social standards, to prevent any disruption in gold production. The Kyrgyz authorities are deeply aware of the fact that a stable and predictable investment climate with proper contract enforcement, as well as less red tape and corruption, are essential for attracting investment and spurring private sector-led growth.
The authorities will continue their efforts to reform the energy sector with the aim of improving service delivery and putting it on sound economic footing. As such, these reforms will reduce the sector’s fiscal burden and, maybe even more importantly, help improving the business environment by facilitating access.
The authorities remain devoted to implementing the EEU commitments for promoting trade with regional countries. They will continue to pursue greater regional economic and social integration, and to advocate further steps to open up the country with a view to enhancing competition and efficiency.
The Kyrgyz authorities are fully aware that the key near-term challenge is to maintain macroeconomic stability and to put the financial sector on a sound footing. The authorities also agree that key medium-term priorities include diversifying the economy away from gold, reducing dependence on remittances and external support, and creating a business environment conducive to private sector-led growth. This position will be reflected in the overarching National Sustainable Development Strategy for the next decade.