Kyrgyz Republic: Staff Report for the 2004 Article IV Consultation and Request to Extend the PRGF Arrangement

The staff report for the combined 2004 Article IV Consultation on the Kyrgyz Republic highlights the economic developments and external policies. The Kyrgyz Republic’s good economic performance owes much to its macroeconomic policies. Fiscal consolidation has helped to stabilize external debt, particularly by containing the externally financed public investment program. The anticipated decline in gold exports calls for actions to diversify exports and preserve cost competitiveness through low inflation and structural reforms to boost productivity growth.


The staff report for the combined 2004 Article IV Consultation on the Kyrgyz Republic highlights the economic developments and external policies. The Kyrgyz Republic’s good economic performance owes much to its macroeconomic policies. Fiscal consolidation has helped to stabilize external debt, particularly by containing the externally financed public investment program. The anticipated decline in gold exports calls for actions to diversify exports and preserve cost competitiveness through low inflation and structural reforms to boost productivity growth.

I. Recent Economic Developments

1. The Kyrgyz Republic faced severe macroeconomic imbalances following the 1998 Russian financial crisis. In 1998-99, growth slowed, exports contracted by a quarter, and the som depreciated by 60 percent against the U.S. dollar, exposing vulnerabilities stemming from the rapid external borrowing begun in the 1990s. After an initially inadequate policy response, macroeconomic policies and performance began to improve; however, the sharp increase in the ratio of debt service to fiscal revenues—from 14 percent in 1997 to over a third in 2000—strained the budget and brought to the forefront concerns over external debt sustainability.1

2. Disciplined economic policies during the current PRGF arrangement underpin the successful macroeconomic stabilization in 2001-03. Program ownership and policymaking capacity strengthened, as reflected in the timely completion of all program reviews so far.2 The lynchpin of the strategy (IMF Country Report No. 01/223) was the recognition that the debt overhang fundamentally constrained policies and required a multi-year fiscal consolidation. This was to be achieved principally by strengthening tax collection and streamlining the externally financed public investment program (PIP).


Real GDP Growth and CPI Inflation, 2000-04

(In percent)

Citation: IMF Staff Country Reports 2005, 047; 10.5089/9781451821482.002.A001

Source: Kyrgyz authorities. Figures for 2004 are projections.

Exchange Rate Developments, 2000-04

Citation: IMF Staff Country Reports 2005, 047; 10.5089/9781451821482.002.A001

Source: Kyrgyz authorities, and staff estimates.1/ US, Euro Area, Russia, and Kazakhstan, 25 percent weight each, (+, appreciation).

Monetary policy contained inflation to 4 percent on average in 2001-03—compared to 21 percent in 1998-2000—helping to stabilize the nominal and real effective exchange rates while fostering an environment more conducive to private investment. In 2003, per capita GDP was 36 percent higher than in 2000 and the poverty rate had declined from 52 to 41 percent. In key areas, outcomes were better than envisaged when the PRGF-supported program was approved.

Selected Economic Indicators, 2000-03

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Source: Kyrgyz authorities and staff estimates.

Excluding Kumtor

3. Growth has become more broad-based. Real growth outside the volatile gold and energy sectors has averaged 5 percent since 2000, with strong growth in manufacturing industries such as food processing, textiles, and glass production. Productivity improvements (including greater capacity utilization) have contributed more to growth than has employment growth or capital accumulation. However, there are indications that new investment has been a significant factor supporting the 7 percent growth in January-September 2004.

Growth Performance, 1999-2004

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4. External current account deficits have moderated, despite recent rapid import growth.3 An improved external macroeconomic environment has contributed to an average 9 percent export volume growth in 2002-03. High growth in China, Kazakhstan, and Russia supported Kyrgyz exports, while gold exports recovered from the low 2002 levels that resulted from the Kumtor mine accident. In 2003, gold accounted for 14 percent of GDP and 44 percent of merchandise exports, partly reflecting higher world market prices. Electricity exports remained well below peak levels, but tourism and other services exports have been strong. High import volume growth mainly reflects strong domestic demand, but also increased oil prices and improved customs statistics.

5. During 2001-03, external public debt fell from 111 to 94 percent of GDP.4 Progress under the authorities’ external debt strategy owes much to fiscal consolidation. The general government fiscal deficit, which consistently had been above 9 percent of GDP from 1996-2000, was reduced to an average of 5 percent of GDP in 2001-2003. Tax revenue performance improved, owing mainly to better administration. State government collections rose 2½ percentage points during 2000-03, to 14.3 percent of GDP. At the same time, improved tax administration helped to maintain payroll tax collections despite a 4 percentage point rate reduction in 2002. The two tax steps taken in 2003—extending the VAT to agriculture and introducing a new real property tax—faced strong political resistance and their revenue impact remained marginal.

6. Expenditure policy contained total expenditures while gradually allocating higher shares to social and poverty-related areas. Social spending (including education, health, social security and welfare, and pensions) rose from an average 12 percent of GDP in 2000-01 to 14 percent in 2002-03. Overall pension increases outpaced nominal GDP growth during this period and much higher percentage increases were targeted at poor pensioners, helping to alleviate poverty among the elderly. The government wage bill rose from 5.1 percent of GDP in 2000 to 6.8 percent in 2003, mainly because of increases in the low-wage health and education sectors.

7. Progress was made in strengthening fiscal institutions. The annual rolling three-year fiscal framework has improved fiscal transparency, expenditure planning and expenditure execution, although weaknesses remain in the areas of commitment control and arrears tracking.5 The computerization of the treasury, with IMF and World Bank technical assistance, was begun in 2003 and is progressing broadly according to schedule. However, it is expected to help substantially improve public expenditure management only in 2007. The August 2003 restructuring of the large taxpayer unit is expected to strengthen implementation of self assessment and enforcement. Customs modernization and computerization was implemented in 2004, assisted by the AsDB and USAID, and a new Customs Code takes effect in January 2005.

Financial Sector Developments

8. Commercial banks continue to dominate financial intermediation. Following the Kairat Bank privatization in June 2004, the Savings and Settlement Company (SSC) (operating as a narrow bank) is the only state-owned bank among the 20 banks in the country. Recently, foreign investment has shaped the landscape of commercial banking. At end-June 2004, seven foreign-owned banks accounted for half of bank loans and deposits, compared to five banks with 2 percent of loans and 21 percent of deposits at end-2001.

9. The financial market remains shallow. Both money and credit relative to GDP are low, even by CIS standards. However, financial soundness indicators suggest a slowly improving banking system. This reflects macroeconomic stabilization, the entry of foreign banks, and reforms of the sector and its regulatory framework. On aggregate, banks have become profitable and highly liquid, while the ratio of non-performing to total loans has fallen gradually. Bank deposits have begun to grow and commercial banking has expanded at an average annual rate of 40 percent in 2003 and 2004. Most of the bank lending and deposit taking, however, continues to take place in foreign currencies—mainly U.S. dollars.

Kyrgyz Republic: Selected Financial Soundness Indicators, 2001–04

(In percent and end-of-period, unless otherwise indicated)

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Source: National Bank of the Kyrgyz Republic.

Net profits/net Tier 1 capital.


Financial Depth and Credit to Private Sector, 2002

Citation: IMF Staff Country Reports 2005, 047; 10.5089/9781451821482.002.A001

Source: IMF

II. Report on the Discussions

10. Discussions focused on the macroeconomic outlook and medium-term policy challenges and strategy. Specific attention was placed on external debt dynamics, conditions for private investment, and the ways and means of reducing the share of the shadow economy.

A. Economic Outlook

11. The staff’s medium-term baseline scenario assumes continued sound macroeconomic policies and continued implementation of structural reforms. This would support real growth rates of 5 to 6 percent in the medium-term, including in 2005 despite a decline in gold exports. The overall fiscal deficit would decline gradually, from 5 percent of GDP in 2003 to 3¾ percent in 2007, helping to reduce the external debt overhang. Monetary policy would contain inflation to about 4 percent.

12. A favorable external environment is envisaged for the next few years. Strong growth prospects among key trade partners6 and gradually improving market access for Kyrgyz goods and services is expected to underlie buoyant external demand. However, external current account deficits would increase until 2006, reflecting continued high domestic demand growth and new investments in gold projects. The scenario assumes that donors would fill the balance of payments financing gaps of 2½ to 3 percent of GDP beginning in 2005. This could include further Paris Club debt relief in early 2005. Overall, this baseline is broadly consistent with the authorities’ recent PRSP annual progress report (IMF Country Report No. 04/200). Beyond 2007 the economy faces significant uncertainty with the expected decline of gold exports, emphasizing the need for export diversification.

Key Projections 2004-07

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Source: Kyrgyz authorities; staff estimates.

13. Three key risks to this macroeconomic scenario were identified. First, a substantial negative terms of trade shock—such as from a protracted period of high oil prices or a drop in gold prices—could lead to lower growth and higher inflation. Second, a sharp slowdown in partner countries’ demand for Kyrgyz exports—apart from slowing growth—could weaken the exchange rate and external debt ratios. Third, a loss of confidence in the banking system—such as could result if high rates of credit growth lead to weak loan portfolios and individual bank failures—could worsen the investment climate and reverse the shift away from the shadow economy.

B. Ex Post Assessment

14. The Kyrgyz authorities assessed positively past cooperation with the Fund and welcomed the main conclusions of the EPA, but felt the EPA could have highlighted more the achievements of the 1990s. They stressed the Fund’s role in identifying a proper policy course and in building policymaking and technical capacity, including through technical assistance. Close cooperation with the Fund had helped to develop a consistent framework for macroeconomic policies and established a dialogue among key policy makers. The authorities recognized that a challenging reform agenda remains in front of them and agreed on the need to broaden support for their economic program, including by clearly articulating to the public the rationale for the government’s strategy. The EPA concludes that a low access PRGF arrangement would be an appropriate means of IMF involvement over the next few years. Other highlights of the EPA discussion are presented in Box 1.

15. The EPA concludes that Fund-provided technical assistance has been well received by the authorities. Nevertheless, more “hands-on” assistance and, in certain areas, more systematic follow-up and monitoring of TA recommendations would be desirable. In statistics, recent TA missions have noted substantial progress in implementing earlier recommendations. Other areas with strong progress include treasury and customs modernization (paragraph 7), external debt monitoring, and the restructuring of debt between the NBKR and the Ministry of Finance. Important steps have been taken in response to TA in the areas of tax policy and tax administration, although overall effectiveness in these areas has been mixed. For example, while the authorities recognized the quality of assistance on the agricultural VAT, that TA remains ineffective because of strong opposition to the policy.

C. Policy Challenges and the Strategy Ahead

16. The staff and the authorities agreed on the key aspects of the medium-term macroeconomic strategy. During the last few years, the strategy has faced three major challenges, which continue to shape the policy landscape. As noted also in the EPA, the first challenge has been the high level of public external debt, which called for continuous fiscal adjustment and more cautious foreign borrowing.7 Government net borrowing during 2001-03 amounted to $177 million compared to $404 million during the previous three-year period. The authorities agreed that even with further Paris Club debt relief in 2005, the fiscal consolidation would need to continue in order to ensure that debt sustainability is achieved during this decade. However, it was also recognized that the pace of fiscal adjustment could slow somewhat as the recent sale of part of the government ownership in the Kumtor gold mine provides new financing to support poverty reduction without increasing external debt.8

Highlights of the Ex Post Assessment (EPA)

The EPA draws attention to past policy implementation that often raised questions about program ownership. Successful periods were followed by relapses and, too often, reforms implemented on paper but not in practice. Tackling problems through issuance of presidential decrees, government resolutions, and legislative amendments does not bring results if enforcement is neglected, the EPA concludes. The authorities agreed that implementation had been a problem in the past, but the performance has improved and weaknesses in policy execution was a common feature in all CIS countries.

The key message of the EPA is the need to close this “implementation gap” to sustain success. A professional civil service that is granted the necessary authority while also being held accountable for its actions is critical to developing strong public administration. This will need to be accompanied by reductions in corruption—and in the public’s perception of corruption—to garner public support for reforms. Efforts to increase the transparency of government operations are important to help generate the dynamic investment climate needed for growth and poverty reduction. Interestingly, the authorities felt that, with the benefit of hindsight, governance reforms should have been included in donor-supported programs at an earlier stage.

The EPA underscores the vulnerability resulting from high external debt, concluding that a concessional bilateral debt restructuring would improve the prospects for medium-term sustainability. Ensuring debt sustainability would also require a continued shift toward grant financing. The government’s responsibility in this respect is to continue fiscal consolidation. Explicit limits on new concessional borrowing should be considered. In this context, the authorities stressed inadequate donor coordination as a factor contributing to external debt accumulation in the mid- to late-1990s. External borrowing from official sources sometimes overwhelmed the capacity for its effective, well-governed use.

The EPA concludes that a low access PRGF arrangement would be an appropriate means of IMF involvement over the next few years. It notes that although the country does not face a large balance of payments need, further Paris Club debt relief is essential to establishing debt sustainability, and that an IMF-supported program is an important complement to such debt relief.

17. The second challenge has been the prospect of declining gold production. The authorities agreed with the staff’s view that, under these circumstances, export diversification is crucial not only to offset the negative impact on real incomes but also to avoid the re-emergence of spiraling external debt ratios. It was noted with satisfaction that in 2002-03 non-gold, non-energy exports (in U.S. dollars) were about one third higher than in 2000-01 on average. The key for further broadening the export base is preserving external competitiveness through low inflation and strong productivity growth, to maintain competitive unit labor costs. The major trading partners—Kazakhstan and Russia—are resource rich countries and therefore likely to appreciate their real exchange rates in the medium term, allowing a good opportunity for the Kyrgyz Republic to preserve its current advantage in relative labor cost levels. To fully utilize this competitive edge, regional trade restrictions will need to be reduced further. To foster productivity growth, governance reform has to accelerate, corruption must be reduced, and the energy sector’s quasi-fiscal deficit has to decline significantly to accelerate enterprise restructuring.

18. The third challenge discussed was the constraint on domestic savings, and thus investment, caused by high poverty and weak institutions. Although private savings show some signs of recovery, to increase national savings requires higher public savings. Promoting private savings requires solid growth of real incomes, building up trust in banks, and reducing the size of the informal economy thus bringing about a more efficient use of funds currently under the mattresses. Regarding private investment, apart from macroeconomic stability, several structural reforms are needed to improve the investment climate as also forcefully pointed out in the staff’s EPA (Box 2).

19. In the discussions, the authorities stressed the large share of the shadow economy as the main development concern, which they linked to high taxation driving enterprises underground. The mission agreed and pointed out that the tax code reform under discussion should significantly simplify taxation to make it less intrusive. At the same time, some tax rates—notably the payroll tax rate—are highly punitive, and should be reduced. However, a significant reduction in the payroll tax rate requires compensating for the revenue loss by broadening the tax base, improving compliance, strengthening the performance of other taxes, and restraining expenditures, the staff emphasized.

20. The staff noted that corruption and poor governance are also important contributing factors to the growth of the informal economy (Box 3). Recent research provides ample evidence of the strong link between the relative size of the shadow economy and poor governance. Tax and governance reforms would provide an incentive for businesses to formalize their operations. This would boost productivity as enterprises could better exploit economies of scale and draw on better functioning market institutions for more efficient services delivery. Thus, to reduce the size of the shadow economy—apart from taxation—future policies should reduce the regulatory burden, improve governance and lessen corruption.

Determinants of Private Investment

Strong and sustained economic growth in the Kyrgyz Republic requires higher private investment ratios in coming years. Private investment averaged 12 percent of GDP in 2002-03—well below other CIS countries. Continued macroeconomic stability will be critical to enhance growth and profit prospects and to reduce the cost of financing to stimulate private investment. This, however, must be complemented by reforms in the tax regime, the financial infrastructure, and governance. A simple tax system with minimal exemptions and clear rules can accelerate investment while ensuring tax compliance. Such a regime also limits tax inspectors’ discretion, reducing corruption and improving governance in general. The expected Tax Code revisions—the harmonization of existing laws and new small business taxation scheme—are important in this respect.

Further development of the financial infrastructure is needed to enhance access to financial services and mobilize savings for private investment. Despite the ongoing remonetization, the Kyrgyz financial system remains underdeveloped, with the ratio of private credit to GDP of only 4 percent—much lower than in other countries in the region. Recent entries of foreign banks are a positive development, but further financial sector reforms are necessary to improve access to finance. Examples of areas to be addressed include enterprise accounting reform, land registration and title, the development of auditing capacity, and the framework for property and creditor rights.

Good governance is at the center of a supportive investment climate. An efficient regulatory framework, control of corruption, strong corporate governance, transparency, and accountability of public administration are essential parts of a growth-enhancing investment environment. A proper regulatory framework calls for minimal interference in private business operations, simple business registration procedures, strong contract enforcement, effective property rights, and efficient bankruptcy procedures. Weak contract enforcement is among the most frequently cited investment obstacles in the Kyrgyz Republic. Debt dispute resolution requires over 492 days, compared to 304 days average for the region.1 The cost of debt resolution is also high at 48 percent of per capita income—compared to the 18 percent regional average.


Investment and Private Credit

Citation: IMF Staff Country Reports 2005, 047; 10.5089/9781451821482.002.A001

Source: Kyrgyz authorities, Fund staff estimates

Contract Enforcement Indicators

Citation: IMF Staff Country Reports 2005, 047; 10.5089/9781451821482.002.A001

Source: World Bank
1 Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, Moldova, Russia, Ukraine, Uzbekistan

The Kyrgyz Shadow Economy

The shadow economy consists of untaxed economic activity—legal and illegal—that would be taxable if reported. While difficult to measure, studies suggest that in 2000 the Kyrgyz shadow economy comprised about 40 percent of official GDP, about 5 percentage points higher than in the mid-1990s. As cash dominates informal transactions, the rapidly rising cash-to-GDP ratio since 2000 suggests that the shadow economy has expanded more rapidly than the formal economy in recent years, despite structural reforms and the successful macroeconomic stabilization. This suggests that official measures may underestimate economic growth in recent years.

Key factors affecting the size of the shadow economy are high taxes (especially payroll taxes), excessive government controls, and poor governance. These are all areas where international comparisons indicate that the Kyrgyz Republic could do better.


Cash-to-GDP Ratio, Kyrgyz Republic


Citation: IMF Staff Country Reports 2005, 047; 10.5089/9781451821482.002.A001

Source: Kyrgyz authorities, Fund staff estimates

Shadow economy, 1999/2000

(per cent GDP)

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Source: Schneider and Klinglmair, “Shadow Economies Around the World: What do we Know?” Institute for the Study of Labor Discussion Paper 1043, March 2004.

Fiscal Policy

21. The staff stressed that the medium-term fiscal strategy must balance the spending requirements of meeting the Millennium Development Goals against the constraints imposed by high external debt.9 This tradeoff has been at the crux of economic strategy for the past three years and the recent receipt of $84 million (4 percent of GDP) in proceeds from the Kumtor financial restructuring allows the objectives to be addressed more urgently while maintaining the previously envisaged debt path. The staff has suggested to increase annual spending (relative to the previous baseline) for the next five years, to be used for poverty related expenditures (mainly on health and education investments), and discussions on this issue continue.


Fiscal Deficit Measures, 2000-2007

State Government, in percent of GDP

Citation: IMF Staff Country Reports 2005, 047; 10.5089/9781451821482.002.A001

Sources: Kyrgyz authorities; and Fund staff estimates and projections.1/ Overall balance excluding foreign financed PIP and foreign interests.

22. While there was broad agreement on the desired pace of fiscal consolidation, views on some tax policy issues diverged within the government. Both the staff and authorities felt that, following the rapid improvement in 2001-03, the ratio of general government tax revenues to GDP could remain at about 18 percent over the next few years. However, the staff stressed that an additional revenue effort could free further resources for poverty reduction and help to reduce the ratio of debt to tax revenue, an important indicator of debt sustainability. A gradual broadening of the tax base and improved tax administration would allow the reduction of certain tax rates. The broadening of the tax base would include fully implementing the personal property tax and the application of the normal VAT regime to large-scale agriculture—measures adopted by parliament in 2003 that remain ineffective. The staff and the Ministry of Finance favored gradually eliminating distortionary production taxes and cutting several percentage points from the payroll tax—which, at 33 percent, provides disincentives to formal hiring and full wage reporting. Social Fund officials, however, opposed reducing the payroll tax. Also, deep-rooted opposition has developed in some agencies and parliament to the personal property tax and the removal of the VAT exemption for agriculture.

23. The staff supported efforts underway to remove tax code inconsistencies and ambiguities developed as a result of successive tax code revisions over the past several years. The authorities began a review of the tax code in early 2004 that drew on expertise from both inside and outside the government, including the IMF Legal Department, USAID, and the Moscow-based Institute for Economies in Transition. The staff also supported the authorities’ work in revamping small business taxation and recommended eliminating the present patent taxes and the realignment of the VAT and small business tax thresholds. These reforms, and particularly the small business tax reform, are intended to reduce discretion and discrimination in the tax system as a means to limit the scope for corruption.

24. Achieving the fiscal consolidation path articulated by the Government also requires containing state government expenditures while ensuring adequate public investment and social spending. The authorities welcomed staff suggestions to continue reorienting spending toward durable reductions in poverty, in line with the PRSP and MTFF. Increased social spending in recent years has been driven by current spending (e.g., wages and pensions), while capital spending was held to more moderate levels. Looking forward, this reorientation would be reflected partly in higher health and education investments and other poverty-related spending of ¾ percent of GDP annually. However, staff stressed that this additional spending should not lead to permanent expenditure increases and that budget planning must take account of the recurrent maintenance costs associated with higher investment. Key officials also emphasized a need for further increases in the overall public sector wage bill, citing the need to strengthen the quality of public services and reduce incentives for corruption. The staff saw merit in further, appropriately targeted increases and encouraged the Government to reform, in the medium-term, the civil service and its pay structure so that key personnel can be provided with merit-based and more competitive salaries. Following such a catch-up, real wage increases could be modest—below the real GDP growth rate—leading to a gradual decline in the wage bill relative to GDP. Continued streamlining of the foreign-financed public investment program was seen as important, both because of the external debt strategy and to help control recurrent maintenance costs, where bottlenecks have appeared. On pension policy, the staff recommended that real benefits increase by 2-3 percent a year. Key Social Fund officials considered this insufficient.

The 2005 Budget

25. The authorities were committed to minimizing the influence of election-related pressures on the 2005 budget. The staff noted that sales proceeds from the sale of Centerra shares turned out higher than anticipated. This windfall gain provided some room for fiscal flexibility without increasing external debt provided that sales receipt will be allocated to investments and one-time projects to avoid permanent expenditure increases. The government will submit to parliament revisions to the 2005 budget in early November and is in discussions with the staff regarding the size of the 2005 deficit. The key issue is whether—in light of the higher sales receipt from Centerra shares—the state budget fiscal deficit could be kept at the 2004 level (4.4 percent of GDP) instead of 4.0 percent as recommended during the August mission. In any event, the government intends to reduce the use of foreign borrowing to finance the budget from 4.9 percent of GDP to 3.5 percent, as targeted earlier.

26. The staff broadly supported the President’s call for a socially-oriented budget and encouraged the authorities to draw on their PRSP update and medium-term fiscal framework. Higher health and education sector wages (a 15 percent increase in 2005) and investments were a component of this vision. These wage increases are another open issue under discussion with the staff. A supplement to this staff report will be issued before the Board meeting on the results of these discussions.

D. Monetary and Exchange Rate Policies

27. Rapid remonetization of the economy is among the main recent macroeconomic achievements. With steady economic growth and low inflation, real money demand expanded by 20 percent on average in 2002-03, a trend that has continued so far in 2004. Higher money demand has been met primarily by balance of payments inflows, rather than by expanding the domestic component of the money supply.10 Indeed, the NBKR’s gross official reserves rose to the equivalent of 4.7 months of imports at end-June 2004, from 3.8 months at end-2001.

28. The authorities were satisfied with the managed float exchange rate regime. The staff agreed and emphasized that price stability should remain the main objective of monetary policy and, in this context, noted that the NBKR should be more willing to let the nominal exchange rate appreciate.11 The authorities also expressed interest in moving to inflation-targeting in the medium-term. This was a reasonable goal, in the staff’s view, but the preconditions for such a regime remained distant, given unstable monetary transmission mechanisms and the current macroeconomic modeling capacity. There was broad agreement that the level of international reserves provided scope to de-emphasize the further buildup of reserves in the medium-term. The staff observed that financial intermediation remained relatively shallow, making it difficult for the NBKR to manage banking system liquidity. With a view to facilitating monetary management, the staff and authorities explored means of deepening the government securities market.12

29. The staff saw the high rate of private sector credit growth and its potential impact on loan portfolios as a key medium-term risk facing the financial sector. The authorities emphasized that the stock of credit was relatively low, but they recognized the need for increased vigilance and effective monitoring of individual banks. The authorities and staff shared the view to a large extent that high credit growth reflected the desired remonetization of the economy. Recent experience in many other transition economies with high credit growth was instructive in this respect. However, it was agreed that the NBKR should strengthen bank supervision to safeguard against the vulnerabilities presented by the rapid credit growth. In this context the staff stressed the importance of strengthening the independence of the NBKR and its bank supervision department and encouraged the Government and parliament to fully support these efforts. The staff welcomed the authorities’ openness to foreign participation in the banking system, which was bringing additional competition and expertise and had resulted in a broader range of banking services and lower interest rates. Nevertheless, extensive foreign participation presented a new challenge to the supervisory authorities, and the staff recommended they seek close cooperation with their counterpart foreign supervisors.13

E. External Policies

30. The staff presented various debt scenarios that indicate a need for further Paris Club debt relief (Annex I). Staff simulations suggest that an improvement in debt indicators to sustainable levels is feasible, although external obligations will remain burdensome. Paris Club debt relief on Houston terms would temporarily alleviate the debt problem, but only a concessional restructuring would improve debt indicators permanently. As suggested by the stress tests, however, debt sustainability would remain vulnerable to shocks.

31. The staff welcomed the Kyrgyz Republic’s liberal trade regime, marked by few non-tariff barriers, low import tariffs, and comprehensive WTO tariff bindings.14 The authorities noted that the Eurasian Economic Community (EAEC) provided for a common external tariff (CET) by 2005, but that provisions allowed EAEC members to postpone implementation. About one-third of Kyrgyz MFN tariff rates were in line with the present CET, with about half below. Some counterparts expected that the CET may need to change prior to the WTO accession of Russia and other EAEC members. The authorities appreciated that the Fund’s bilateral and multilateral surveillance had begun highlighting the negative impact of industrial countries’ trade restrictions on low-income countries and urged the Fund to do more in this respect.

32. The authorities welcomed recent steps by neighboring countries to improve market access and the transit of Kyrgyz goods. However, they stressed that important restrictions remained, including local taxes and fees imposed in Kazakhstan on road transit and the uncertainty of an agreement on rail transit.

F. Structural Policies

33. A comprehensive structural reform agenda is being implemented mainly under the lending programs of the Fund, World Bank, and AsDB.15 In addition to fiscal and banking sector reforms, the discussions focused on the electricity sector quasi-fiscal deficit (QFD), which was 12 percent of GDP in 2002, and governance.16 On the former, the authorities noted that they had met their 2003 and June 2004 QFD reduction targets, mainly through improved collections. They reiterated their commitment to broadly halve the electricity sector QFD by 2006 and supported the present Fund monitoring framework and the use of semi-annual QFD targets. The staff urged the authorities to work closely with the World Bank in devising and implementing the specific tariff, bill collection, and management measures needed to meet this goal. The planned further reduction of the QFD by about 3 percentage points of GDP would accelerate enterprise restructuring and improve financial discipline more generally, yielding important macroeconomic benefits.17

34. In the financial sector, the authorities were satisfied that most 2003 FSAP recommendations on legal and regulatory reforms have been implemented. They regretted, however, that amendments proposed by the NBKR on the legislative framework for anti-money laundering and combating the financing of terrorism (AML/CFT), with IMF technical assistance, had not yet passed parliament. Aspects of the June 2003 Financial Action Task Force (FATF) recommendations are reflected in the AML law that was submitted to parliament during 2004. Legislative amendments have been drafted that aim to remove conflicts between banking and other legislation and to avoid the introduction of such inconsistencies in the future. A new Law on Bank Bankruptcy and Conservatorship has taken effect, but amendments to certain other laws are needed before it can be implemented effectively.

35. Regarding governance, the staff regretted that establishment of the National Integrity Council in 2003 has not yet led to concrete governance reforms. Initial efforts to develop the agenda lacked tangible measures and a clear time schedule. On the other hand, a major step in the mining sector is the increased transparency resulting from the adoption of the Extractive Industries Transparency Initiative (EITI), spearheaded under the Fund-supported program and being implemented with World Bank and DFID assistance. More generally, the staff noted that many specific governance policies were outside the Fund’s competence and that further steps would need to be taken under the guidance of the World Bank and other development institutions and donors. The Fund would focus on fiscal and financial sector reforms, and in other areas only if they had a significant macroeconomic impact (e.g., electricity sector QFD). The authorities, however, urged that the Fund remain engaged on a broad front, noting that the public attached particular significance to the Fund’s endorsement of and engagement with the reforms.

G. Statistical and Other Issues

36. The Kyrgyz Republic’s economic statistics are adequate for effective surveillance. The authorities subscribed to the Fund’s SDDS effective February 2004 and a Data ROSC module was published in November 2003. Nevertheless, methodological improvements are ongoing. The NBKR’s official balance of payments is being revised to incorporate newly available data on migrants’ transfers, estimated at 5 percent of GDP in 2003, and the staff has revised its BOP estimates accordingly.

37. The authorities are requesting an extension of the PRGF arrangement (Attachment II) to allow for the disbursement of rephased amounts that would follow the completion of the sixth review under the PRGF.

III. Staff Appraisal

38. The Kyrgyz Republic has achieved strong economic performance over the past few years, reflecting a generally favorable external economic environment and prudent fiscal and monetary policies. Economic growth has begun to broaden, inflation has remained low, and the balance of payments has strengthened. This performance has contributed to strong real income growth and declining poverty. With continued prudent macroeconomic policies and further structural reform, the country’s medium-term economic outlook is positive. Nevertheless—as the accompanying Ex Post Assessment stresses—a successor PRGF arrangement and further Paris Club debt relief are needed to continue the recent favorable developments.

39. Economic policymaking strengthened under the present three-year PRGF arrangement. The staff notes the authorities’ good record of responding to Fund policy advice, particularly regarding improved fiscal discipline. Strengthened administration has led to better tax compliance, while expenditure growth has been contained and spending has increasingly focused on social priorities. Steady improvements in the three-year medium-term fiscal frameworks underlie strengthened fiscal planning and discipline and have helped line ministries to better understand budgetary tradeoffs. However, spending controls require further attention, as government decisions have sometimes overruled the Ministry of Finance efforts to keep expenditures on the budgeted track.

40. The staff supports the authorities’ revised spending plans to address urgent social needs. These plans mainly reflect higher-than-anticipated receipts from the sale of Centerra gold company shares. Under the revised spending plans, fiscal deficits over the next few years would be somewhat higher than previously foreseen, but without implying additional borrowing. The authorities should work closely with the World Bank to ensure that additional spending is targeted at high quality social sector investments and one-time poverty alleviation projects because of the temporary nature of Centerra proceeds. While there is some risk that the receipts would be inefficiently used or inappropriately targeted, on balance the staff feels that the urgency of spending needs and the authorities’ improving capacity to plan and efficiently implement spending justify accepting this risk. External budget financing should be contained in the future and consideration given to setting explicit limits also on concessional borrowing.

41. With the size of the shadow economy a growing concern, payroll tax rate reductions should begin with the 2005 budget. The staff welcomes the steps toward overhauling the tax code and, in particular, small business taxation. The authorities should swiftly complete the process, in line with staff recommendations, and bring the changes into effect with the 2005 budget. In light of the external debt burden and social spending priorities, the authorities should view the projected path of tax revenues as a minimum. The staff urges additional efforts to broaden the tax base and improve tax administration, leading to a gradual rise in the ratio of tax revenues to GDP.

42. The NBKR’s sound monetary policy is a key factor behind the country’s sustained macroeconomic stability, having facilitated the rapid remonetization of the economy while achieving price stability. Nevertheless, high rates of private sector credit growth—albeit from a low level—need to be monitored carefully for their impact on the quality of banks’ loan portfolios. Financial sector indicators do not indicate any immediate banking vulnerabilities at present, but the NBKR must be prepared to act quickly should pressures emerge. Therefore, further strengthening of bank supervision will be important and the Government and Parliament should support the NBKR’s effective independence in this respect. The increasing role of foreign banks is an overall benefit to the economy but presents additional challenges to banking supervision, requiring enhanced cooperation with foreign counterparts.

43. The Kyrgyz Republic’s managed float exchange rate regime remains appropriate. Facing strong demand, the som has strengthened but, as inflation continues to be several percentage points below that in partner countries, the real effective exchange rate has remained stable. Other indicators such as unit labor costs also suggest that competitiveness remains adequate.

44. The authorities should approach structural reforms with renewed vigor. The period leading up to the 2005 elections has been marked by increasing reluctance to implement reforms despite earlier commitments, in particular in the energy sector restructuring. Governance measures should be more concrete. At the same time, all public policy decisions must consider the implications for corruption and governance, minimizing opportunities for public officials to exercise undue discretion. This includes areas such as tax policy, tax administration, public procurement, economic regulation, privatization, and the management of public enterprises. These are critical concerns of domestic and foreign investors.

45. The staff believes that a robust successor PRGF program is needed to support the government’s reform effort. It would provide the basis for further Paris Club debt relief and help mobilize the grants needed to meet poverty alleviation goals, while moving toward debt sustainability. A low-access PRGF appears to be the most appropriate vehicle for close IMF involvement over the next few years as the country, because of its recent macroeconomic achievements, does not face a large balance of payments need. The Fund’s major role would be to help ensure that the government continues with recent policies conducive to consolidation of a stable macroeconomic environment. At the same time, such involvement would reassure the international community and foreign investors that the country is on the right track.

46. The staff supports the authorities’ request to extend the PRGF arrangement and welcomes their consent to publish this Article IV staff report and related documents. It is recommended that the next Article IV consultation be held in accordance with the July 2002 decision on consultation cycles.

Table 1.

Kyrgyz Republic: Selected Economic Indicators, 2000-07

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IMF Country Report No. 04/16.

IMF Country Report No. 04/198.

General government comprises state government and Social Fund finances. State government comprises central and local governments.

Overall balance less interest payments.

Projections use program exchange rate.

12 month GDP over average quarterly broad money.

Weighted average interest rate on som denominated loans.

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

Public and publicly guaranteed debt (excluding Kumtor)

Table 2.

Kyrgyz Republic: General Government Finances, 2001-07

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

Includes payroll tax revenue (contribution to the Social Fund), net of the government contribution to the Social Fund.

Mainly privatization proceeds. For revised 2004 projection, includes som 3,589 million related to the Kumtor mine restructuring.

Primary balance excluding gold projects, grant and foreign financed PIP.

Overall balance (in cash) excluding foreign financed PIP and foreign interest payments.

Table 3.

Kyrgyz Republic: State Government Finances, 2001-07

(In Millions of Soms)

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

Mainly mineral resource tax and real property tax.

Excludes transfer to Social Fund (columns for original program include transfer to Social Fund).

Includes carry-forward expenditure from previous fiscal year (Som 1,022 million in 2004 and 539 million in 2005).

Mainly privatization proceeds. For revised 2004 projection, includes som 3,589 million related to the Kumtor mine restructuring.

Overall balance (in cash) excluding foreign financed PIP and foreign interest payments.

Primary balance excluding gold projects, grant and foreign financed PIP.

Table 4.

Kyrgyz Republic: State Government Finances, 2001-07

(In Percent of GDP)

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

Mainly mineral resource tax and real property tax.

Excludes transfer to Social Fund (columns for original program include transfer to Social Fund).

Includes carry-forward expenditure from previous fiscal year (1.1 percent of GDP in 2004 and 0.5 percent of GDP in 2005).

Mainly privatization proceeds. For revised 2004 projection, includes som 3,589 million related to the Kumtor mine restructuring.

Overall balance (in cash) excluding foreign financed PIP and foreign interest payments.

Primary balance excluding gold projects, grant and foreign financed PIP.

Table 5.

Kyrgyz Republic: Social Fund Operations, 2001-07

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

Includes payments to compensate for electricity tariff increase introduced in June 2002.