Kyrgyz Republic: Staff Report for the 2002 Article IV Consultation, Second Review Under the Poverty Reduction and Growth Facility, and Request for Waiver of Performance Criterion
Author: International Monetary Fund
Publication Date:
07 Mar 2003
eISBN:
9781451821352
ISBN:
9781451821352
Language:
English
Keywords:
ISCR; CR; authority; Kyrgyz authorities; prudent fiscal policy; Kyrgyzstan; tax; tax-to-GDP ratio; U.S. dollar; debt service; state government; Public investment and public-private partnerships (PPP); Exchange rates
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This paper examines the Kyrgyz Republic’s 2002 Article IV Consultation, Second Review Under the Poverty Reduction and Growth Facility (PRGF), and a Request for Waiver of Performance Criterion. All performance criteria but one were observed for the period under review (April 1, 2002–September 30, 2002). The end-September targets on net international reserves and net domestic assets were met with wide margins. The fiscal deficit was within the program limit, despite the shortfall in revenues owing to the decline in real GDP. The target on tax collection was met thanks to improved tax administration.

Abstract

This paper examines the Kyrgyz Republic’s 2002 Article IV Consultation, Second Review Under the Poverty Reduction and Growth Facility (PRGF), and a Request for Waiver of Performance Criterion. All performance criteria but one were observed for the period under review (April 1, 2002–September 30, 2002). The end-September targets on net international reserves and net domestic assets were met with wide margins. The fiscal deficit was within the program limit, despite the shortfall in revenues owing to the decline in real GDP. The target on tax collection was met thanks to improved tax administration.

I. Introduction

1. On December 6, 2001, the Executive Board approved the Kyrgyz Republic’s request for a three-year arrangement under the Poverty Reduction and Growth Facility (PRGF) (IMF C.R. No. 01/223).1 The first review of the program was completed on July 1, 2002 with a disbursement of SDR 11.72 million (IMF C.R. No. 02/150). On October 31, 2002, the total Fund credit outstanding to the Kyrgyz Republic was SDR 139.2 million, or 157 percent of quota. On completion of the second review, a disbursement of SDR 11.72 million would become available. In the attached Letter of Intent (LOI), the government presents the policies for the period October 1, 2002 to September 30, 2003 and requests a waiver for the nonobservance of the continuous performance criterion on external arrears.

uA01fig01

Macroeccmoroic Performance, 1991-2002 (proj.) 1/

Citation: IMF Staff Country Reports 2003, 051; 10.5089/9781451821352.002.A001

Source: Kyrgyz authorities.1/ Stand-by Arrangements (May-Apri1 1993), ESAf Trust Fund (July 1994-Mar 1998), PRGF 2 Trust Fund (June 1998-July 2000), PRGF 2 Trust Fund (December 2001-December 2004) Shaded areas represent periods when the program was on-track.

II. Achievements and Setbacks Under the past Programs

2. The Kyrgyz Republic has received financial support from the Fund since 1993.2 Over this period, although economic policies have succeeded in stabilizing prices and restoring growth, structural reforms have lagged and external debt has reached unsustainable levels. The authorities identified three different periods during the ten years of transition. The initial period after independence until 1994 was “euphoric” despite the continuous output contraction common to the early stages of transition in other countries as well. Reforms started with great enthusiasm sparked by the new economic and political system. The policy climate was favorable at the time of the first of the four IMF-sponsored programs. Foreign reserves improved, inflation fell, exchange rate stabilized, and several first-generation structural reforms were implemented.3 The country was perceived as one of the front-runners in economic transition among the CIS countries. As a result, the government was able to attract significant amounts of donor assistance. However, the first program went offtrack in the first half of 1994 because of large directed credits, inadequate progress in restructuring loss-making public enterprises, and delays in formulating the 1994 budget.

3. A period of “dismay and frustration” (1995–2000) came with the realization that despite the sacrifices of the population, living standards were not improving rapidly. The 1994–97 ESAF-supported programs went repeatedly offtrack. For example, in 1995, nontax revenue fell significantly short of targets and the central bank monetized the resulting fiscal gap. The pension reform stalled, and external debt arrears increased. The arrangement expired in 1998 after delays in implementation. In 1999, weak expenditure management led to large spending arrears and two reviews under the new PRGF arrangement were not completed because of fiscal slippages. Fiscal deficits remained high, in part, because of the inability to manage effectively the rapidly expanding Public Investment Program (PIP) which peaked at 9.4 percent of GDP in 1999. Although the primary balance (excluding PIP) has recorded a surplus since 1999, the external debt rose to 130 percent of GDP at end-2000 after the sharp nominal depreciation of the som following the Russian financial crisis. Apart from the exchange rate depreciation, the PIP was the main contributor to the external debt but it failed to produce enough growth to avoid the debt problem. In part, this reflected the high share of infrastructure investments in the PIP which take a long time to produce growth. Government debt service increased, thus compressing public savings with a negative contribution to the economy’s saving-investment balance.

uA01fig02

State Government Fiscal Deficit, 1993-2002

(In percent of GDP)

Citation: IMF Staff Country Reports 2003, 051; 10.5089/9781451821352.002.A001

Source: Ministry of Finance.1/ Projections.

4. Structural reforms in the second half of the 1990s progressed slowly. The privatization program for medium- and large-enterprises was only partially successful as insiders gained control overmuch of the former state-owned enterprise block. Also, several program benchmarks on fiscal reforms were not met. In 1998–99, after the Russian crisis, the banking sector faced a major crisis as the largest three commercial banks were bankrupt. A government default on a series of recapitalization bonds and a currency mismatch between assets and liabilities contributed to these bankruptcies. Overall, the implementation rate for structural conditions (i.e., performance criteria and benchmarks) under the Fund-supported programs fell to 63 percent in the period 1998–2000 from over 80 percent in 1994–97.

5. The authorities characterized the period starting in 2001 as the time of “realism and pragmatism.” Pragmatism came with the acceptance that much work remained to be done, and there were no easy solutions. Constraints imposed by the high external debt and the obvious need to restructure external liabilities also contributed to greater realism. The authorities believe that the program ownership is now stronger as the economy is moving in the right direction with low inflation, a stable exchange rate, and resumed growth. Their confidence was also boosted by the well-appreciated debt rescheduling from the Paris Club providing a temporary relief from the heavy debt burden.4 However, the civil society remains critical with regard political reforms and economic results that are late in coming. Although the government has embarked on a comprehensive constitutional reform trying to calm the political climate, tensions are likely to remain high because of the approaching parliamentary and presidential elections in 2005.

6. The Kyrgyz economy began to grow in 1996 with an average rate of 5 percent in the following five years. Improving total factor productivity was the main source of growth. A comprehensive land reform was completed in 1996 establishing 72,000 private farms, which boosted yields. With the new Kumtor mine, gold production expanded rapidly improving aggregate industrial productivity, and hydro-power output benefited from high demand of irrigation water in Uzbekistan and Kazakhstan in 2000–01. In 2001–02, nongold, nonenergy industrial production recovered as well. Employment increased in agriculture and services absorbing labor from declining state-owned industries, but the capital stock declined despite extensive investment in infrastructure under the PIP. With economic growth, poverty headcount has decreased by almost 20 percent since 1998, especially in rural areas. Income distribution improved and poverty declined in all regions. Overall, 47 percent of the population were poor at end-2001 down from 57 percent in 1999.

III. Performance under the current program

7. In January-November 2002, real GDP declined by 1.7 percent over the same period a year ago. This reflected a landslide in the Kumtor gold mine and a sharp decline in hydropower production owing to weather conditions.5 Excluding gold and energy, real output grew by 3.4 percent. Main contributions came from agriculture, and services, the latter largely reflecting tourism and the spending from the new military base.6 With a return of Kumtor’s high-grade ore production to the earlier-planned level and normal energy production, real GDP is projected to grow by 5.2 percent in 2003.

uA01fig03

Kyrz Rebpublic: Real GDP Growth and Inflation, 1996-2003

Citation: IMF Staff Country Reports 2003, 051; 10.5089/9781451821352.002.A001

Source: Kyrgyz authorities, and Fund staff estimates1/ Projections.

8. Prices continued to stabilize as the confidence in local currency increased and the exchange rate vis-à-vis the U.S. dollar and the Russian ruble strengthened. During the first-year program (October 1,2001-September 30,2002) the 12-month rate of inflation fell from 5.3 percent to 3.5 percent, and further to 2.3 percent at end-November 2002. The nominal exchange rate appreciated by 3.6 percent vis-à-vis the U.S. dollar, and the nominal and real interest rates declined from 19 and 13 percent to 10 and 7 percent respectively. Narrowing interest rate differentials between domestic and foreign short-term securities and the declining ratio of foreign deposits to broad money suggest that confidence in economic policies improved significantly during the first-year program.

9. The current account improved despite a weaker trade balance. In 2002, the volume of gold exports fell by over 30 percent because of the Kumtor accident, although the impact on the value of exports was mitigated by higher gold prices. Energy exports halved from their 2001 level, mainly because of abundant rainfall in neighboring Uzbekistan and Kazakhstan which reduced water release from the Kyrgyz reservoirs.7 On the other hand, expenditures by the new military base generated $30 million of net exports. This, coupled with stronger tourism and transport receipts and greater official transfers more than compensated the negative effects of gold and energy on the trade balance. As a result, the current account deficit narrowed from 3.3 percent of GDP to 2.8 percent in 2002. With a surplus in the capital account and Paris Club debt restructurings, official gross reserves reached 4.5 months of imports by year-end.

10. Despite the revenue shortfall from Kumtor, the end-September 2002 fiscal targets were met. In the first three quarters of 2002, the fiscal deficit was 4.7 percent of GDP—lower than the program ceiling of 5.6 percent of GDP mainly on account of lower-than-projected public investment spending. The tax collection target was met mainly through strong administrative measures. Special task forces were set up both at the central and local government levels to increase tax collection and reduce arrears. In addition, customs collection increased by 39 percent during the first nine months reflecting improved administration. Weaker tax revenue in October and November suggests, however, that the good revenue performance in the third quarter was in part achieved through advance payments. At end-September, there were no outstanding budgetary arrears by the central government on items covered by the performance criteria.8 However, the continuous performance criterion on the non-accumulation of external arrears was breached, but the underlying obligation was cleared in late January 2003.9

11. The program targets on net international reserves (NIR), and net domestic assets (NDA) were observed with wide margins (Figure 1). NIR exceeded the programmed floor by 23 percent of reserve money as the NBKR bought $9.1 million from the foreign exchange market in July-September. The resulting growth in broad money reflected a significant remonetization of the economy. NDA were below the adjusted program ceiling by 6.3 percent of reserve money as part of the foreign exchange inflow was sterilized by increasing government deposits in the central bank. Credit growth to the private sector remained moderate during 2002 (6.7 percent at end-November).

uA01fig04

Contribution to Broad Money Growth, Dec. 2001-Dec. 2002

Percentage Points

Citation: IMF Staff Country Reports 2003, 051; 10.5089/9781451821352.002.A001

Source: Kyrgyz authorities.
Figure 1.
Figure 1.

Kyrgyz: Performance Under the Program

(December 2001-September 2002)

Citation: IMF Staff Country Reports 2003, 051; 10.5089/9781451821352.002.A001

Source: Kyrgyz authorities; and Fund staff estimates.

12. The end-September 2002 structural performance criteria and benchmarks were observed. Several amendments to legislation were presented to Parliament. According to these amendments, in liquidation cases, the court should accept only a bank’s financial statement confirmed by the NBKR as the factual representation of that bank’s financial position (a performance criterion). Amendments to the Law on Licensing (structural benchmark) stipulate that licensing associated with financial institutions will be regulated only by banking laws thus removing an inconsistency with the Law on Licensing. Following discussions with the Fund-World Bank FSAP missions (structural benchmark), the NBKR also introduced stricter supervisory standards and approved a banking sector reform strategy. On the other hand, the NBKR also experienced some setbacks. The liquidation case against Asia Universal Bank, whose asset quality remains dubious, was rejected by a court in the absence of sufficient evidence. In addition, the central bank lost a court case against Krambds Bank last summer, and, in September, was ordered by a court to return the license to Issyk Kul Bank.

13. Progress was made in fiscal reforms. The government issued a resolution to increase enforcing and monitoring powers of the Large Taxpayer Unit (performance criterion). The Treasury established a new Financial Division which prepared its first short-term cash flow forecast (structural benchmark). Finally, the government approved the restructuring plan for the Ministry of Finance. It includes a reduction of overstaffmg, a reorganization of the departments with emphasis on policy-making and streamlining budgetary processes (structural benchmark). In addition, the NBKR and the Ministry of Finance, with assistance from an MAE mission, concluded the regularization of their financial relations.10

14. The privatization of strategic state-owned enterprises is moving ahead. A tender for KyrgyzTelekom was issued on September 9, and closed on December 10, 2002: 13 offers were received, all from foreigners. In collaboration with the World Bank, the authorities are revising their strategy for energy distribution companies (DISCOs) and are considering giving at least one DISCO in concession to a foreign managing company. In April, 2002, the government also took steps to reduce the quasi-fiscal deficit by cutting the number of privileged users and increasing electricity tariff on households. The World Bank had projected that, as a result of these measures, the quasi-fiscal deficit would decline by two percentage points to 4.1 percent of GDP by end-2002. However, more recent data suggest that the increase in tariffs was in part offset by lower collection rates and increased “technical losses,” including theft.

IV. Report on the Discussions

15 The authorities’ draft National Poverty Reduction Strategy (NPRS) provided the basis for discussions on the medium-term strategy. The NPRS underlines that continuous poverty reduction can be achieved only with sustained economic growth. In 2003-2006 and beyond, real GDP is projected to increase on average by 5 percent a year mainly through productivity gains stemming from structural reforms and more efficient use of capital and labor (Figure 2).11 The authorities argued that this projection, which is the baseline scenario in their NPRS, represents a conservative estimate. The NPRS high-case scenario assumes that GDP could grow by 7 percent a year in the event that the authorities are successful in their efforts to attract more foreign direct investment. However, the effect of the 1998 Russian crisis, volatile energy exports, and the large impact of the recent landslide at the Kumtor gold mine underscore the vulnerability of the Kyrgyz economy and the need for caution in growth projections. Under any scenario, the medium-term strategy needs to aim at diversifying the economy by fostering export-led growth supported by small and medium-size enterprises.

Figure 2.
Figure 2.

Kyrgyz Republic. Baseline and Low-case Scenarios

Citation: IMF Staff Country Reports 2003, 051; 10.5089/9781451821352.002.A001

Source: Kyrgyz authorities, and Fund staff estimates.

A. Medium-Term Strategy

16. The strategy discussions focused on alternative policies to attain a 5 percent growth path under three constraints: the projected decline in gold production, the need to lower external debt, and low domestic savings because of high poverty. To achieve the growth objective, export volumes should grow 4.5 percent a year during the remainder of the decade. The negative impact of the declining gold production should be offset by other manufacturing enterprises, agriculture, and tourism. The authorities agreed that inflation should stabilize at 4 percent a year to allow a continued relative price adjustment of public utilities.

uA01fig05

Kyrz Rebpublic: Nominal and Real Effective Exchange Rate, 1995-2010

(Index, 1995 = 100)

Citation: IMF Staff Country Reports 2003, 051; 10.5089/9781451821352.002.A001

Source: Kyrgyz authorities; and Fund staff estimates1/ Based on unit lab cost relative to industrial countries, Kazakhistan, and Russian 2002-2010 are projections.

Strong productivity growth is critical to preserve cost competitiveness and boost nongold exports. Productivity growth in the tradable goods sector is expected to be about 2-3 percentage points higher than in the nontradable sector and—because of the low starting level—also higher than in competitor countries. This should, in the absence of external and domestic shocks, ensure a competitive real exchange rate.12 Real wages are expected to grow less than productivity because of high (hidden) unemployment.13 However, wage restraint is still necessary because of the current low profitability of the tradable goods sector. The authorities argued that their strategy hinges on open access to foreign markets of Kyrgyz exports. They stressed that tariff and nontariff barriers are currently hindering trade with Uzbekistan, Kazakhstan and Russia.14 Staff agreed with the need to reduce trade barriers, but noted that a strong cost competitiveness could in part compensate for the extra transport costs, and help Kyrgyz producers gain market shares. Nevertheless, staff advised the authorities to search the cooperation of neighboring countries to remove unofficial constraints in the context of the CIS7 initiative and through WTO.

17. The debt strategy targets reducing the net present value of external debt from 213 percent of exports in 2001 to below 150 percent by 2007. To achieve this target, it will be critical to reduce the fiscal deficit, promote export growth, and be cautious in external borrowing. To lower the public external debt to the targeted level requires decreasing the primary fiscal deficit from an average of 7½ percent in 1996–2000, to below 1 percent by 2006. This could be achieved mainly through streamlining the Public Investment Program and improving tax collection.15 Such an ambitious fiscal adjustment is consistent with an average current account deficit of about 4.3 percent of GDP in 2003–2006. Assuming an increase in FDI inflows, low interest rates on loans relative to the targeted GDP growth, and some real appreciation of the som, debt dynamics suggest the NPV debt-to-GDP ratio would decline to around 50 percent by 2007 from 81 percent in 2001. Assuming a debt stock relief from Paris Club creditors after a successful implementation of the current PRGF-supported program, this ratio would be consistent with the NPV public debt-to-exports ratio of about 145 percent.

18. The agreed medium-term strategy (2003-2006) is consistent with the original program’s saving-investment analysis (Table 4). The investment ratio is projected to increase to 23.5 percent in 2006 from 19.4 percent in 2002. This is consistent with a 5 percent growth rate even if the efficiency of investment would decline somewhat from its average 1996–2001 level. Private investment should drive capital accumulation as the externally financed Public Investment Program will be streamlined from 5.1 percent of GDP in 2002 to 3 percent by 2006 and kept at that level from then on. For private investment including FDI, the business climate needs to improve significantly which calls for a comprehensive governance reform to reduce corruption and state capture. The increase in national savings by 2.9 percentage points of GDP over 2002-2006 would reflect the fiscal adjustment and improved enterprise profitability through productivity gains. To promote private savings and improve the efficiency of financial intermediation, the reform of the banking system is important. The use of foreign savings to finance investment could increase by 1.3 percentage point of GDP between 2002 and 2006 as a somewhat higher current account deficit, supported by foreign direct investments,16 is consistent with the debt sustainability target.

19. The authorities are aware that poverty reduction objectives and parliamentary and presidential elections in 2005 are likely to increase pressures for higher fiscal spending. These pressures and the difficult task of reducing corruption and state capture are the main risks for the success of the strategy. Renewed fiscal slippages and a failure to improve business climate could trigger macroeconomic imbalances through rekindling inflation and depreciating nominal exchange rate. Inflation could rise to 7-8 percent and undermine competitiveness. Such policy slippages would lead to the low-case scenario of Figure 2. In this scenario real GDP would grow on average by only 2½ percent a year with export volumes rising only by 2 percent a year in 2003–2010. External debt ratios would start growing rapidly again in 2006 even with the debt stock relief from the Paris Club.

20. Given the weak financial position of the government, the authorities count mainly on economic growth to reduce poverty. According to World Bank estimates, for every 1 percent growth in per capita consumption, the headcount index of poverty declines by 0.8 percentage points. Therefore, even without changes in income distribution, the baseline scenario would result in a decline of poverty by 15 percentage points by 2006. To generate more room for social spending, the authorities aim at improving tax collection and reallocating public resources from nonproductive uses to social purposes. The staff stressed that because of the narrow room for maneuver in macroeconomic policies, the authorities should avoid higher fiscal deficits to finance social spending but instead seek grants to help finance specific poverty reduction programs. At the same time, they should be cautious not to establish unsustainable spending mechanisms with temporary foreign aid

B. Policy Mix for the Second-Year Program

21. The key macroeconomic objectives for the second-year program are a return to a higher growth path while continuing with low inflation. With the recovery of production at the Kumtor gold mine, the staff believes that the authorities’ growth projection of 5.2 percent is feasible. The targeted 12-month rate of inflation of 4.4 percent incorporates a onetime increase in prices because of extending VAT17 to large agricultural producers in April 2003 and implies a 3 percent underlying inflation.

22. Tax reform was the most difficult topic in program discussions. The mission pushed strongly for introducing significant but politically sensitive measures to broaden the tax base—the extension of the VAT to large agricultural producers, VAT on utilities and higher electricity tariffs, and higher land tax rates. After difficult and lengthy discussions, the authorities agreed to present to parliament a proposal to extend the VAT to large agricultural producers.18 This measure is expected to generate 0.3 percentage point of GDP in additional tax revenue in 2003, and more than one percentage point over the medium term. On power tariffs, the authorities requested more time to study the poverty implications and consult with the World Bank staff.19 The mission also proposed a 20 percent increase in the land tax rate to strengthen local governments’ revenue base and increase Social Fund payroll contributions from the agricultural sector.20 The authorities were not, however, in favor of this proposal given the present sensitive political situation.21 The mission also discussed the authorities’ proposal to reduce excise taxes on gasoline. It pointed out the revenue-reducing impact of such a measure, and the authorities decided to set up a working group to study this matter compensate for the likely price impact of introducing the VAT on large agricultural producers, the 2003 budget provides for a 20 percent increase in key social benefits starting from April 2003. In addition, an 8 percent pension increase was tentatively included in the 2003 budget awaiting the results of an updated assessment of the Social Fund’s financial position during the February 2003 mission.

23. Several other factors will help raise revenue collection in 2003. In particular, revenue is expected to increase once the Kumtor gold mine resumes normal operations and as several of its tax holidays expired in the second quarter of 2002.22 In addition, the full-year effect of the recent elimination of various VAT exemptions, the introduction of the excise tax on jet fuel, and the removal of the VAT exemption on PIP imports are expected to improve revenue collection next year. In the 2003 budget proposal, the authorities also introduced a new property tax, a higher excise tax on liquor, and higher presumptive tax rates. Based on the work of the FAD environmental mission, a unified environmental tax will be introduced to replace the existing various fees.23 Overall, the general government tax-to-GDP ratio is expected to increase to 18.0 percent of GDP in 2003 from the projected 16.9 percent in 2002 (Box 1).

2003 Tax Policy Package

article image
Source: Staff estimates.

24. Expenditure policy will support the NPRS‘s poverty alleviation objectives. As regards government wages, the 2003 budget allows for an average increase of 8 percent. When applied selectively, this would help address the low wage level of key civil servants and support efforts to fight petty corruption. In line with the authorities’ poverty reduction objectives, spending on education and health could increase by 5 percent in real terms. To compensate for the likely price impact of introducing the VAT on large agricultural producers, the 2003 budget provides for a 20 percent increase in key social benefits starting from April 2003. In addition, an 8 percent pension increase was tentatively included in the 2003 budget awaiting the results of an updated assessment of the Social Fund’s financial position during the February 2003 mission.

25. The economic strategy calls for a cautious monetary policy to keep inflation low and ensure cost competitiveness of Kyrgyz exports. In 2002, the strong growth of monetary aggregates reflected an increase in the demand for som-denominated assets, mainly for transaction purposes.24 Som broad money would grow less in 2003, by 15 percent, consolidating recent gains in monetization. Demand for som real balances is projected to grow by 6 percent during 2003 compared to a preliminary estimate of a 22 percent increase in 2002. Financial deepening is expected to continue also based on further banking sector reforms supporting the recovery of the private sector. Against this background, the end-March 2003 NIR target aims at increasing foreign reserves by $24 million from the end-September 2002 level of $81 million. The program’s NDA target for end-March 2003 reflects an increase in government deposits in the central bank to help sterilize the monetary impact of the expected capital inflows.

26. The authorities shared the staff’s concern that the recent rapid money growth could raise inflation expectations. They assured that any signs of rekindling inflation would prompt them to tighten monetary conditions. The staff pointed out that instead of foreign exchange interventions, this would require more active sales of NBKR or treasury bills. The NBKR’s capacity to influence monetary conditions through open market operations has improved as, in addition to its own bills, the stock of T-bills recently doubled with the issuance to the NBKR of interest bearing short-term government securities.

27. The mission recommended that the NBKR continue its exchange rate policy of managed floating. The authorities agreed that, in general, the NBKR should intervene in the foreign exchange market only to smooth temporary variations of the nominal exchange rate and strengthen the official reserve position. Leaning against a nominal appreciation, as has been done during 2002, was considered justified because of the need to increase reserves while preserving the tradable good sector’s competitiveness. To reduce its operating costs, the NBKR requested Fund support in moving from quarterly to annual audits of its foreign reserves as auditors have not found any weaknesses in reserves management in the past three-year period of quarterly audits.

28. On trade policy, staff stressed the need to preserve a liberal and low-tariff trade regime. The authorities should refrain from introducing new seasonal tariffs (such as the temporary duties imposed on Kazakh wheat this harvest season) or nontariff barriers on agricultural or other imports. The authorities intend to approach neighboring countries with specific proposals to reduce regional trade restrictions, such as transit fees and other nontariff barriers to market access. The exchange regime remains free of restrictions. In accordance with WTO commitments, the tariff structure has been simplified to comprise 4 bands, with an average rate of 5.1 percent.

29. The staff and the authorities noted that the debt-reduction strategy was on track. Foreign borrowing has declined and any further contracting of public or publicly-guaranteed debt has been restricted to loans with a grant element of at least 45 percent. Negotiations with Paris club creditors have been completed. Of non-Paris Club creditors, only Uzbekistan, Pakistan, and the Kuwait Fund have not yet rescheduled their claims on comparable terms. An updated debt sustainability analysis suggest that if the PRGF-supported program is implemented successfully, and a stock of debt relief is granted, the Kyrgyz Republic’s external debt could reach manageable levels in the second half of the decade (Box 2).

Debt Sustainability

The updated debt sustainability analysis is based on the baseline scenario summarized in Figure 2. The weakening of the indicators between the approval of the program and the first review was mainly due to the reduction in the applied discount rate. New simulations suggest that the external debt could become sustainable in 2007 when assessed by the NPV of debt-to-exports and debt service-to-fiscal revenue ratios. In part, the more favorable outcome than projected at the time of the approval of the PRGF arrangement is due to a lower starting level of the external debt reflecting lower-than-expected current account deficit in 2001-2002. In addition, exports of services are projected to be stronger because of increased tourism and higher spending of the international military base. Also, the latest simulations take account of the donors’ pledges for increased concessional financial support.

Naturally, the outcome of these simulations is sensitive to several factors. In particular, with lower growth of exports and weaker fiscal adjustment, the debt dynamics would be significantly less favorable. As indicated in the low-case scenario of Figure 2, and discussed in paragraph 20, a 2-3 percentage points lower growth of output and exports would not only keep the external debt at unsustainable levels throughout the decade, but even lead to increasing debt ratios.

uA01fig06
Source: Ministry of Finance and staff calculations.

C. Structural Reform Agenda

30. Discussions on structural reforms focused on two issues: a banking sector reform and governance. Despite the progress made in recent years towards consolidation and stabilization, the banking sector remains small and financial intermediation is low even by CIS standards. The high proportion of cash to deposits highlights the poor confidence in banks. The authorities recognized the need for strict enforcement of prudential regulations to reduce bank vulnerabilities and improve public trust in banks. Discussions on the banking reform were closely coordinated with the staffs of the World Bank, the Asian Development Bank (AsDB), and the EBRD. Based on the recommendations of the recent FSAP missions (Box 2) a detailed banking sector reform program was designed. It aims at stronger bank supervision, better regulatory framework, divestiture of the state-owned banks, strengthened debt recovery, and improved payments system (see Second-year Memorandum of Economic Policies (SMEP), Box 1). The second year program identifies one performance criterion and three benchmarks that are most critical for the success of the program (see SMEP, Box 3).

uA01fig07

Financial Deeping

(average of 2001 and 2002 data)

Citation: IMF Staff Country Reports 2003, 051; 10.5089/9781451821352.002.A001

Source: Staff estimates.

Main Recommendations of the Financial Sector Assessment Program

Bank governance and the banking system need strengthening. To encourage strategic investors, the government should cancel the 15 percent ownership limit for legal entities. The NBKR should gradually raise Minimum Tier 1 capital, and place increasingly rigorous restrictions on specialized banks. Resolution plans for Kairat and the Savings and Settlement Corporation need to be finalized and implemented. Banking supervision needs further improvement. The Banking Law should be the sole legal source for bank licensing; moreover accounting practices need to improve as well as the regulatory framework for risk management. Measures that may take longer to carry out include providing legal protection for NBKR employees and third parties doing work for the NBKR; and empowering the NBKR to oppose the appointment of, or require replacing, external auditors.

Weaknesses in the judicial and legal system, which constitute an important barrier to financial sector development, need to be addressed urgently. The government needs to make the judicial system more efficient, effective, independent and accountable. Lawmaking should become more efficient and transparent. The payment system is slow and inefficient, but it does not pose a systemic risk. The authorities are finalizing plans for modernizing the system to bring it up to international standards. Implementation will, however, require much resources and management time.

Authorities should press ahead with efforts to address the current weak legal framework against money laundering and terrorism financing. The parliament should pass the draft AML/CFT law in the near term, and the NBKR should arrange enough resources and training to ensure effective implementation. Law enforcement bodies should develop an understanding of relevant banking issues and fully implement criminal investigative and prosecutorial measures.

Transparency practices in monetary policy, banking supervision, and payment system oversight are generally good, but could be improved. Changes might include explaining changes in monetary policy on a more systematic and timely basis; regularly reporting on internal governance procedures; and introducing a more formal approach to seeking public comments on proposed changes NBKR policies.

31. The authorities recognized that a governance reform was necessary for better business climate and foreign investments. According to recent surveys, enterprises, households, and public officials perceive basic public institutions as corrupt. The authorities acknowledged that this undermined the legitimacy of the government and helped vested interest capture the state. In particular, they were concerned that mainly small and medium-size enterprises—the engine of growth in transition economies—were negatively affected in this environment. Staff noted that good governance was also necessary to attract foreign direct investment and to boost productivity growth.

uA01fig08

Governance and FDI

Citation: IMF Staff Country Reports 2003, 051; 10.5089/9781451821352.002.A001

Source: World Bank, and staff estimates.

32. The President reiterated his support for a concerted action plan to tackle the governance problem. The second-year program includes a comprehensive governance reform detailed in Box 2 of the SMEP. This initiative combines the main features of the work under the PRGF-supported program, the AsDB’s Corporate Governance and Enterprise Reforms Program, the AsDB’s Custom Modernization Project, and the World Bank’s forthcoming Governance Structural Adjustment Credit. The focus is on: (i) setting up a stakeholder institution for good governance; (ii) promoting public awareness; (iii) improving efficiency in public administration; (iv) strengthening corporate governance; and (v) reforming the judiciary. Of these measures, the authorities chose one performance criterion and two structural benchmarks for the first half of the second-year program. Further benchmarks will be set out for the midyear review of the second-year program (see SMEP, Box 2).

33. On privatization, as mentioned before, a tender for KyrgyzTelekom was issued, but the other enterprises will need essential restructuring before privatization.25 KyrgyzAir’s debt restructuring negotiations with the government are underway. Privatizing the distribution companies of the former Kyrgyz Energo and of KyrgyzGas will take more time than envisaged in the original program. The authorities are working with the World Bank staff to review the reform agenda in this area. The World Bank staff is considering concession arrangements and foreign management contracts instead of privatization to improve efficiency in the energy sector. The staff concurred with the authorities that no conditionalities should be introduced on privatizing these companies at this stage.

D. Statistical Issues

34. The authorities have been working with international financial institutions (IFIs) and bilateral donors to improve national account statistics. The National Statistics Committee (NSC) is expanding the use of household surveys to improve the quality of the data. The current focus is on discrete quarterly GDP data, and on wages and unemployment. As regards GDP, the particular problems include monthly data for the construction sector and for spending on capital goods, both of which systematically understate true values. The estimates are corrected only in the last quarter of the year, or later. As for prices, the PPI coverage has expanded which improved its reliability but the calculation of the GDP deflator needs improvement. The NSC is preparing a report on the 2002 agriculture census. It will provide a better and much needed review of the largest sector of the economy. The recent data ROSC ascertained the need for training and updating procedures.

E. Program Financing and Monitoring

35. The second year program is fully financed. Paris Club debt rescheduling will complement disbursements by the World Bank and the IMF. Gross reserves are expected to be slightly higher—at 4.7 months of imports—by the end of 2003 than in 2002. This level was considered appropriate in view of the Kyrgyz economy’s vulnerability to external shocks and high external debt.

36. Proposed prior actions, quantitative and structural performance criteria, and structural benchmarks are specified in the authorities’ SMEP, Table 1 and Box 3. To better monitor the collection of the social security contributions, a floor on payroll tax collections in cash is now proposed as an additional performance criterion. Another new performance criterion would cover outstanding arrears of Social Fund transfers to the Medical Insurance Fund to help finance the World Bank and USAID sponsored health sector reform. Amendments to the July 2002 TMU clarify the definition of external arrears to encompass claims from overdue commercial obligations. Discussions with staff for the third review are expected to take place in May 2003. The review will focus mainly on progress made in governance reform.

V. Staff Appraisal

37. The authorities’ candid assessment of their performance under the previous IMF-supported programs is welcome. The current emphasis on realism and pragmatism bodes well given the challenges ahead. The fact that the fiscal program and debt reduction strategy are on track suggests that the lessons from the past have been learned.

38. Given the ambitious medium-term strategy of the authorities, the need for strict policy discipline is critical. Poverty reduction, the projected decline in gold production, and the high external debt are constraints that put the economy on a narrow path where slippages could easily lead to a vicious cycle. Expansion of nongold exports is the key to reach the medium growth objective and this requires strong commitment to foster productivity growth and contain inflation. The staff is pleased to note that the authorities share the understanding of the importance of maintaining, or even improving, the current level of cost competitiveness and realize that this calls for a wage policy based on real wages increasing only through productivity growth.

39. Under the current PRGF-supported program, the Kyrgyz authorities are to be commended for their good policy performance. Price stabilization continued in 2002, and the dip in real GDP is expected to be reversed this year. However, the temporary output decline underscores the need to diversify the economy and to work with neighboring countries and the international community to reduce trade restrictions in the region.

40. The observance of all fiscal targets was a commendable achievement in view of the shortfall of revenue from Kumtor. However, the good performance in 2002 is unlikely to be sustained without further reforms in tax administration and broadening the tax base. The government’s commitment to extend VAT to large agricultural producers in the current politically sensitive environment deserves appreciation. Staff also welcomes the new action plan for the LTU since it addresses the basic structural weakness in the Kyrgyz tax administration. If fully carried out, this reform would go a long way to reduce the scope for corruption. The impact on prices of the VAT extension has been considered and compensatory measures for the poor are included in the 2003 budget. The staff supports this approach.

41. Monetary policy has been successful in containing inflation while allowing remonetization of the economy. Recent purchases of foreign currency have accommodated the increased demand for local currency, and prevented excessive nominal appreciation, with harmful effects to competitiveness, which is deemed satisfactory at its present level. Against this backdrop, the policy of managed floating of the exchange rate has been appropriate. If there are any signs of accelerating inflation, however, the central bank should react promptly by tightening monetary conditions through open market operations using government securities and its own bills.

42. Staff notes with satisfaction that the external debt strategy is on track. In the coming two years, the authorities must carefully follow this strategy placing emphasis on further fiscal consolidation and avoiding slippages especially prior to the forthcoming elections in 2005. The Ministry of Finance has done a good job in completing all bilateral reschedulings with the Paris Club creditors. It is important that all non-Paris Club creditors also agree on comparable terms.

43. After ten years of transition, the agenda for structural reforms remains to be completed. At the present stage the greatest need is in the areas of governance and banking sector reforms. The civil society’s perception of the legitimacy of the government is low and vested interests and state capture undermine the opportunities of small and medium size enterprises. Strong support from the highest level of the government is essential to guarantee the success of the governance and banking sector reforms. If these reforms are not pursued with vigor, private sector investment and growth will be undermined

44. Looking ahead, the main downside risks are financial instability and, over the medium term, a low-growth trap. The high external debt leaves no room at all for policy failures. Fiscal slippages would be particularly dangerous. In such a scenario, the Paris Club concessional stock rescheduling would be unlikely and the targeted gains in poverty reduction elusive. The staff notes that political factors may cause the authorities to be cautious in introducing strong measures when the 2005 elections approach. The cost of any delays must, however, be also factored in as weak policies would only increase the need for adjustments later on.

45. While the program faces risks, the staff believes that they are manageable. The good track record in 2001-2002 proves that the Kyrgyz authorities have the capacity to succeed in a difficult environment. As the policies are on track, and the breach of the performance criterion was small and has been corrected, the staff supports the authorities request for a waiver and the completion of the second review under the PRGF. Also, the staff supports the NBKR’s intention to move to an annual cycle in auditing its foreign reserve management.

46. Is it expected that the next Article IV consultation with the Kyrgyz Republic will be held in accordance with the provisions of the decision on consultation cycles approved on July 15, 2002.

Table 1.

Kyrgyz Republic: Quantitative Program Targets 1/

(In millions of soms, unless otherwise indicated, eop)

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Sources: Data provided by the Kyrgyz authorities; and) Fund staff estimates and projections

Until September 2002, foreign exchange components valued at the exchange rate US$1 - sum 49, gold holdings valued at US$265 per ounce, SDR valued at SDR 1 = US$3.259. Starting December 2002, foreign exchange components valued at the exchange rate US$1 = sum 47, gold holdings valued at US$322.4 per ounce, SDR valued at SDR 1 = US$13186. Targets exclude claims and liabilities to BRO countries.

As defined in the Technical Memorandum of Understanding (TMU), excludes, among others, swaps and international reserves of the NBKR that are pledged or blocked.

As defined in the TMU, excludes, among others, the counterpart of the loan by the Eximbank of Turkey and the EBRD/IDA enterprise loan which are channeled through the NBKR.

As defined in the TMU, state government comprises central and local governments. For March 2003, cumulative begins on October 1, 2002. For December 2003, cumulative begins on October 1, 2003.

The deficit for the fourth quarter of 2001 is adjusted for interest payments rescheduled by the Paris Club (sum 172 million).

As defined in the TMU, includes, among others, collection of tax arrears but excludes, among others, tax offsets. For March 2003 cumulative begins on October 1, 2002. For December 2003 cumulative begins on October 1, 2003.

As defined in the TMU, central government budget arrears comprise, among others, wages, payroll contributions and mandatory transfers to the Social Fund, categorical grants, payments to KyrgyzEnergo, and allowances to poor families from September 2002 onwards.

For March 2003, cumulative begins an October 1, 2002. For December 2003, cumulative begins on October 1, 2003.

External debt is defined in the TMU as in Executive Board’s Decision no. 12274 (00/85) of August 24, 2000. Includes loans, leases, suppliers’ credits and other instruments giving rise to external debt.

On a continuous basis.

As defined in the TMU, a debt is classified as concessional if its grant element is at least 45 percent, calculated using a discount rate based on the 10-year average of OECD commercial interest reference rates (CIRR), for debts of maturity greater than 15 years debts of maturity 15 years or less, the discount rate should be based on the six month average of the OECD CIRR. The ceilings include loans, leases, supplier’s credits and other instrument giving rise to external debt on nonconcessional terms. IMF lending is excluded from the ceiling on new nonconcessional borrowing.

Adjustons1. The floor on net international reserves of the NBKR will be adjusted; (i) upward/downward by 100 percent for excess/shortfalls of the use of net foreign financing of the state government budget and cash grants; (ii) upward/downward by 100 percent for excess/shortfall of cash privatization receipts. The adjustment for shortfalls in adjustors (i)and (ii) is limited to US$ 15 million each, valued at the program exchange rate. In the case of a release of the NBKR’S pledged foreign reserves, the NIR floor will be adjusted upward by 100 percent of the net effect of the releases and related amortization payments.2. The ceiling on net domestic assets of the NBKR will be adjusted: (i) downward/upward by 100 percent for excesses/shortfalls of the use of net foreign financing of the state government budget and cash grants; (ii) downward/upward by 100 percent for excess/shortfall of cash privatization cash privatization receipts. The adjustment for shortfalls in adjustors (i) and (ii) is limited to US$,15 million each, valued at the program exchange rate, excluding the amortization payments for the release of the NBKR’s pledged foreign reserves.
Table 2.

Kyrgyz Republic: Prior Action, Structural Performance Criteria, and Benchmarks Through end-September 2002

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Table 3.

Kyrgyz Republic: Selected Economic Indicators, 1999-2006

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Sources: Kyrgyz authorities; and Fund staff estimates and projections,

Overall balance less accrued interest payments.

Projections use program exchange rate.

For 1997-2000, annualized quarterly GDP/end-of-period broad money, for 2001-2003, 12-month GDP/average broad money for last two quarters.

Gross reserves exclude international reserves of NBKR that are pledged or blocked

Excluding Kumtor.

Table 4.

Kyrgyz Republic: Medium Term Projections, 1999-2006

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Sources: Data provided by the Kyrgyz authorities; and Fund staff estimates and projections.
Table 5.

Kyrgyz Republic General Government Finances

(In millions of soms, unless otherwise indicated, eop)

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Sourcs: Ministry of Finance and Fund staff projections.

Excluding government contributions.

It includes interest rescheduled for bilatera loan bilateral loans in 2000. From 2001. from 2001 onwards debt rescheduling operations are classified within external financing.

including the new bond billatcra loans the guarantee of the Jhibet: Zhiilu loan in the amount of US$23 million dollars.

Refers to the new bond issuance for guarantee on the Zhibek loan.

In the electricty sector.

Table 5.1.

Kyrgyz Republic: State Government Finances

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Sources: Krgyz authorities: and Fund saff estimates and

The following offset transactions were carried due in 2000, but were included in the budget in kind grants worth Som 244 million were received, of which Som 160 million were granted as allowances to the poor, and new housing facilitics, Som 84 million were granted to the milian shown in Q3, 2001, Includes subsidies and transfer to the social Fund.

Includes interest rescheduled for bilateral loans in From 2001 onwards, debt rescheduling opertions are classified within external financing.

The different between the financing gap in the BOP and the fiscal tables for 2005-06 reflect potential IMF disbursements.

Includes the social fund until end-June 2002 (when the general government was introduced).

The amount in 2001 refers to the redemption or the Jibek Jolou bonds The amounts after 2003 forms part of the NBKR’s imputed dividend provision to the budget in the context of regularizaton of the financial relationship between the MOF and the NBKR.

Includes the Social Fund.

Refers to the new bond issuance for the guarantee on the Zhibek Zholu loan.

Excluding Kumtor, and debt services by the NBKR and by the state-owned enterprises.