Kyrgyz Republic: Sixth Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility and Request for New Three-Year PRGF Arrangement

The staff report for the Sixth Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility on the Kyrgyz Republic highlights the economic developments and policies. To ensure that the external debt ratios fall, the program introduces a new indicative target for concessional public borrowing. Low inflation and strong productivity growth to contain unit labor costs are crucial to set up favorable conditions for nongold exports. The key to boost productivity is higher private investment, and the program focuses on improving the investment climate.

Abstract

The staff report for the Sixth Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility on the Kyrgyz Republic highlights the economic developments and policies. To ensure that the external debt ratios fall, the program introduces a new indicative target for concessional public borrowing. Low inflation and strong productivity growth to contain unit labor costs are crucial to set up favorable conditions for nongold exports. The key to boost productivity is higher private investment, and the program focuses on improving the investment climate.

I. Introduction

1. Disciplined economic policies under the current PRGF arrangement led to a successful macroeconomic stabilization in 2001-03. Real GDP growth averaged 4 percent a year over this period and the poverty headcount index fell from 52 percent in 2000 to 41 percent in 2003. The 12-month rate of inflation was kept below 4 percent most of the time since 2001, with the nominal effective exchange rate remaining broadly stable. The real effective exchange rate depreciated slightly in 2001-03, maintaining a satisfactory competitiveness of Kyrgyz goods1. The balance of payments strengthened, and the import coverage of official gross reserves reached 4.1 months at end-2003. External debt indicators also began to improve. In most areas, outcomes were better than initially envisaged.

Selected Economic Indicators, 2000-03

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Source: Kyrgyz authorities and staff estimates.

Excluding Kumtor

2. In completing the last Article IV consultation on November 19, 2004, Executive Directors agreed with the main conclusions of the Ex Post Assessment of the Kyrgyz Longer-Term Use of Fund Resources prepared by an independent staff team. Directors noted that program ownership and policymaking capacity had strengthened considerably. The Government’s renewed fiscal discipline combined with sound monetary policy had been key factors behind the timely completion of all five program reviews in 2002–04. Looking forward, Directors stressed the importance of continued fiscal consolidation and further Paris Club debt relief to achieve external debt sustainability. They underscored the need to strengthen spending controls and the targeting of expenditure at high quality poverty reduction projects. Directors also urged the central bank to preserve a proper balance in accommodating remonetization while keeping inflation pressures at bay.

3. Executive Directors encouraged the authorities to approach structural reforms with renewed vigor. While overall progress had been satisfactory in recent years, reforms had slowed in certain areas, especially the energy sector. The importance of strengthening enforcement of legislative and regulatory initiatives was also emphasized. Directors thought that a low-access PRGF arrangement would be an appropriate means to continue assisting the Kyrgyz authorities in their reform efforts.

4. Parliamentary elections will be held on February 27, 2005, followed by the presidential election in October. EXR and MCD have proposed—and the authorities have agreed—that a seminar on medium-term economic policies will be organized for the new parliament this spring.

A. Recent Economic Developments and Performance Under the Program

5. Macroeconomic developments continued to be favorable in 2004. Real GDP growth for the year is estimated at 6 percent, and consumer price inflation remained low, at just 4 percent for the year. The solid growth performance and exchange rate stability helped increase per capita GDP to US$411 in 2004, for a total increase of 50 percent relative to 2000, resulting in a further reduction in the poverty rate to 35 percent.

uA01fig01

Exchange Rate Developments, 2000-04

(Index, 1995=100)

Citation: IMF Staff Country Reports 2005, 119; 10.5089/9781451821499.002.A001

Sources: Kyrgyz authorities, and staff estimates.1/ The US, Euro Area, Russia, and Kazakhstan, 25 percent weight each, (+, appreciation).
uA01fig02

Real GDP Growth and CPI Inflation

(In percent)

Citation: IMF Staff Country Reports 2005, 119; 10.5089/9781451821499.002.A001

Source: Kyrgyz authorities.

Kyrgyz Republic: Poverty Indicators, 1998–2004

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Sources: Kyrgyz authorities; World Bank; and Fund staff estimates.

National definition; based on per capita expenditure adjusted for household size.

6. The external current account deficit increased slightly to 3.2 percent of GDP in 2004, with both exports and imports growing at a fast pace. Gold exports in US dollar terms increased by 15 percent while nongold exports—particularly to CIS countries—grew even faster, by more than 30 percent. Energy imports, as well as other imports from CIS countries, also grew rapidly. International reserves rose sharply in 2004, owing largely to the partial sale of government shares in the Canadian-owned operator (Centerra) of the Kumtor gold mine. Continued fiscal consolidation led to a reduction of the external debt-to-GDP ratio to an estimated 92 percent by year’s end, from 96 percent in 2003.

7. Under the program, all the end-September 2004 performance criteria (PC) were observed (Table 1). The NBKR’s net domestic assets remained well below the program ceiling, and its net international reserves (NIR) increased by US$37 million to US$329 million by year’s end—significantly more than programmed.2 Cumulative state government tax collections exceeded the program target by som 500 million, or 0.6 percent of GDP, because of better tax administration and strong performance in VAT collections on imported goods. Payroll tax collections also surpassed the program’s target. The performance criterion on the fiscal deficit through end-September 2004 was observed with a small margin, and the quasi-fiscal deficit (QFD) of the electricity sector during the first half of 2004 was within the program’s indicative target.

Table 1.

Kyrgyz Republic: Third-Year Quantitative Program Targets

(in millions of soms, unless otherwise indicated; eop)

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

Valued at the program exchange rates specified in IMF Country Report No. 04/198 dt. July 2004.

8. On the structural front, the benchmarks for June-September 2004 were observed, although in certain cases with some delays (Table 2). The small business tax reform was submitted to the Economic Policy Council in September, and to Parliament in December with some amendments. The reform is expected to take effect in July 2005. In the financial sector, the audits of the Kyrgyz Agricultural Finance Corporation (KAFC) were completed as originally envisaged. Also, the government submitted proposals to parliament aimed at: (i) removing inconsistencies between banking and other legislation, and (ii) requiring future bills approved by parliament to incorporate all the amendments needed to assure conformity with other relevant legislation. Regarding governance in the mining sector, the authorities prepared a detailed template for reporting Kyrgyz Altyn’s financial data, in line with the Extractive Industries Transparency Initiative (EITI). They also issued the first semi-annual report in September, making the Kyrgyz Republic the most advanced country in implementing this initiative. The authorities also reorganized mining sector supervision in line with the World Bank recommendations, and completed a risk assurance and control audit of the state-owned mining company Kyrgyz Altyn in January 2005.

Table 2.

Kyrgyz Republic: Structural Conditionality in the Third Annual Program

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9. Although the electricity sector quasi-fiscal deficit declined in 2004, the government failed to raise power tariffs as required under the World Bank’s Consolidated Structural Adjustment Credit (CSAC). Also, parliament passed only part of the legislation allowing concession arrangements for state-owned power distribution companies. As a result, the CSAC operation was canceled. The conditionality under the Asian Development Bank’s Corporate Governance Loan and Customs Modernization project was observed.

B. Macroeconomic Performance in Comparison to Other CIS Countries

10. Improved policy implementation in 2001-04 underpins an economic performance that compares well with other CIS countries. Average consumer price inflation during this period was lower than in all but two CIS countries with the strong performance reflecting a prudent monetary stance during a period of rapid remonetization of the economy. There was also a strong turnaround in the fiscal position, which constituted the pillar of the country’s stabilization and debt strategy.

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CIS Countries: Recent Macroeconomic Performance 1/

Citation: IMF Staff Country Reports 2005, 119; 10.5089/9781451821499.002.A001

Source: World Economic Outlook.1/ 2004 figures are forecasts.

11. Recent economic growth rates, however, have lagged behind those experienced by most of the other CIS countries. Several CIS countries have benefited from sharp increases in earnings from oil and other natural resources, which were reflected in higher spending and growth rates. In the Kyrgyz Republic, rising revenues from gold exports, rather than spent, were used to reduce the Kumtor gold mine’s external debt. And flat growth in 2002—owing to an accident in the above-mentioned mine—affected the average growth rate for the period. In addition, the Kyrgyz economic circumstances differ in important ways from those of many other CIS countries, mainly because of the country’s distance from key markets and its difficulties in accessing markets in neighboring countries owing to trade restrictions. Although the pace of structural reforms has been relatively fast by regional standards, this has not been enough to offset the negative impact of these other factors.

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Transition Indicator Scores, 2004 1/

Citation: IMF Staff Country Reports 2005, 119; 10.5089/9781451821499.002.A001

Source: EBRD.1/ The chart reports simple unweighted averages for several reform areas.

II. Policy Discussions

12. The policy discussions on a new three-year economic program were conducted against the background of the recommendations arising from the last Article IV consultation and the Ex Post Assessment discussed by the Executive Board. The authorities were encouraged by the results achieved under the previous program, and indicated their intention to maintain the same policy strategy. Consistent with this approach, the new program seeks to consolidate the gains that have been made in recent years, with more emphasis on improving the investment climate and increasing labor market flexibility.

13. The authorities recognized that closing the “policy implementation gap” identified in the Ex Post Assessment was key to pursuing stronger macroeconomic and structural policies. In this regard, strengthening the government’s capacity to follow through on its commitments, including legislative and regulatory initiatives, was regarded as an important challenge of the new program. The authorities agreed that developing a professional civil service and improving public sector transparency and accountability were crucial to strengthen implementation capacity.

A. Macroeconomic Framework

14. The new program’s macroeconomic framework is broadly consistent with the authorities’ recent PRSP progress report (IMF Country Report No. 04/200 dt. July 2004). Sound macroeconomic policies and the effective implementation of structural reforms are expected to support real growth rates of 5–6 percent in the medium term (Table 3). Growth is projected to be led by private investment, with only a modest contribution from net exports, owing to a buoyant demand for imports of investment goods, especially in the gold sector. The program targets the primary fiscal deficit (before grants) to decline from 3¼ percent of GDP in 2004 to 3 percent in 2005, and further to 2¾ percent in 2007. Monetary policy will aim at containing annual inflation at 4 percent.

Table 3.

Kyrgyz Republic: Selected Economic Indicators, 2000-07

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

IMF Country Report No. 04/198.

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

Overall balance less interest payments.

Projections are based on program exchange rates specified in the TMU.

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.

Excluding Kumtor gold mine.

Excluding Kumtor gold mine, and accounting for Paris Club Debt relief up to 2004 only.

Key Projections, 2004-07

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15. The investment ratio is projected to increase from an average of 20 percent in 2001–04 to 23 percent in 2005–07. As productivity gains from higher capacity use and other catch-up efficiency improvements are gradually exhausted, higher investment would become the main factor supporting productivity growth. Debt-financed public investment would continue to decline over the program period and private investment would rise—in line with recent trends—from an average of 15 percent in 2001–04 to 18 percent in 2005–07. Higher national savings would reflect both continued fiscal consolidation and an increase in private savings as real incomes grow and the banking system becomes more trustworthy.

B. Policy Strategy

16. The high public external debt continues to be the main policy constraint affecting the Kyrgyz Republic. The authorities agreed that even with further Paris Club debt relief in 2005, fiscal consolidation would need to continue in the coming years in order to reduce the debt overhang. However, the pace of fiscal adjustment would be slower, as the privatization of the Kumtor gold mine would provide a new non-debt creating source of financing. A continued shift toward grant financing will also help reduce the debt burden. The program introduces new indicative limits on concessional borrowing to help ensure that external debt ratios remain on a declining path.

17. With gold production trending downward, export diversification is crucial for lasting growth and further poverty reduction. The authorities regarded low inflation and strong productivity growth as critical to contain unit labor costs and stimulate nongold exports, which have increased by an average 12 percent a year in U.S. dollar terms since 2001. The staff noted that real appreciation pressures in resource rich countries such as Kazakhstan and Russia provided a good opportunity for the Kyrgyz Republic to preserve its current advantage in labor costs. Increased focus on policies to promote labor market flexibility to keep real wage increases in line with productivity growth would also support this objective.

18. The staff fully agreed with the authorities that export diversification would be facilitated by a removal of trade restrictions by neighboring countries. The authorities indicated that, with the support of the international community, they would continue with their efforts to obtain a more liberal treatment of Kyrgyz exports, particularly in the Kazakh and Uzbek markets.

19. The authorities and the staff shared the view that the key to boost productivity was higher private investment. In this regard, reforms during the three-year program would focus on improving the investment climate in areas where the country lags behind its neighbors (Box 1). On taxation, these include reducing payroll tax rates, introducing a new tax code and a simplified tax system for small businesses, improving VAT reimbursements, and strengthening tax administration. At the same time, enhancing the availability of qualified personnel requires the adoption of measures aimed at promoting labor mobility, reducing skill mismatches, and streamlining hiring and firing regulations. In addition, creditor rights should be strengthened and reforms should be introduced in the judiciary to reduce corruption.

Investment climate: Kyrgyz Republic compared to the region: (Scale: Rating from -100 to +100, centered on the regional average)

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Source: Survey of investors in Kyrgyz Republic, “Investment Now,” Kyrgyz Republic, 2004

20. The authorities identified the large shadow economy as one of their main concerns. They closely linked the size of the informal sector to the tax system—including the high taxes on labor—and to excessive discretion in tax administration. The staff stressed that a less intrusive role of the state in the economy would provide an incentive for businesses to formalize their operations. The authorities committed to avoiding excessive government interference in private sector activities and making the regulatory framework more predictable to discourage informal activities.

C. Fiscal Policy

The medium-term fiscal framework

21. The authorities fully recognized the importance of further reducing the fiscal deficit in order to limit new borrowing. Following a strong revenue performance in 2001–04, the state tax revenue is programmed to rise modestly during the three-year program period from 15 percent of GDP in 2004 to 15.6 percent in 2007 (Tables 46). Solid economic growth, a gradual broadening of the tax base, and improved tax administration, would allow for reductions in certain tax rates. In particular, the authorities agreed on the need to lower the current payroll tax rate of 33 percent, which has discouraged formal hiring and full wage reporting. This tax rate will be reduced by 2 percentage points in 2005, and further cuts are foreseen later in the program by limiting pension increases to 2–3 percent a year in real terms.3 The authorities also pointed to a prospective increase in land tax rates as a step that would provide further scope for reducing labor taxation. Broadening the tax base by fully imposing the property tax would also help replace a number of distortive local taxes. With these policies, the general government tax revenue would remain broadly constant at 18½ percent of GDP during the program period.

Table 4.

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, grants and the foreign-financed PIP.

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

Table 5.

Kyrgyz Republic: State Government Finances, 2001-07

(In Millions of Soms)

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Sources: Kyrgyz authorities; and Fund staff estimates.

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 the foreign-financed PIP and foreign interest payments.

Primary balance excluding gold projects, grants and the foreign-financed PIP.

Table 5

(Concluded). Kyrgyz Republic: State Government Finances, 2001-07

(In Percent of GDP)

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Sources: Kyrgyz authorities; and Fund staff estimates.

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 the foreign-financed PIP and foreign interest payments.

Primary balance excluding gold projects, grants and the foreign-financed PIP.

Table 6.

Kyrgyz Republic: Social Fund Operations, 2001-07

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Sources: Kyrgyz authorities; and Fund staff estimates.

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