Kyrgyz Republic
Enhanced Initiative for Heavily Indebted Poor Countries: Preliminary Document

This paper presents a preliminary assessment of the Kyrgyz Republic’s eligibility for assistance under the Enhanced Heavily Indebted Poor Countries (HIPC) Initiative. It provides background information on the country’s eligibility under the enhanced HIPC Initiative. It summarizes the structure and performance of the economy as well as the poverty profile; analyzes the governance environment; and examines the policy track record and the unfinished reform agenda. This study discusses medium- to long-term macroeconomic projections and outlines the proposed timeline for preparation of the decision point document.

Abstract

This paper presents a preliminary assessment of the Kyrgyz Republic’s eligibility for assistance under the Enhanced Heavily Indebted Poor Countries (HIPC) Initiative. It provides background information on the country’s eligibility under the enhanced HIPC Initiative. It summarizes the structure and performance of the economy as well as the poverty profile; analyzes the governance environment; and examines the policy track record and the unfinished reform agenda. This study discusses medium- to long-term macroeconomic projections and outlines the proposed timeline for preparation of the decision point document.

I. Introduction

1. This paper presents a preliminary assessment of the Kyrgyz Republic’s eligibility for assistance under the enhanced Heavily Indebted Poor Countries (HIPC) Initiative. In consultation with the authorities, staffs of the IMF and IDA jointly conducted a preliminary debt sustainability analysis (DSA). The results show that the Kyrgyz Republic is eligible for debt relief under both the fiscal and the export criteria, since its NPV of external debt-to-central government revenues ratio (362 percent) and NPV of external debt-to-exports ratio (182 percent) at end-2004 exceeded the HIPC thresholds of 250 percent and 150 percent, respectively.1 The authorities recognize that debt relief under the initiative would provide a unique opportunity to free up resources for additional poverty reducing spending. They also recognize that, to enable the country to benefit from the resources made available for the overarching objectives of poverty reduction and economic growth, structural reforms initiated in critical areas, including governance and anti-corruption, need to be accelerated. Against this backdrop, the authorities formally communicated to the Fund and the World Bank (in a letter dated March 23, 2006) that they wished to initiate discussions on the possibility of debt relief under the HIPC Initiative and, subsequently, under the Multilateral Debt Relief Initiative (MDRI). During the August 2006 mission that conducted discussions for the 3rd PRGF review (which overlapped with a WB mission), the authorities consented to consideration of the preliminary document by the Boards of the Fund and the Bank.

2. Section II provides background information on the country’s eligibility under the enhanced HIPC Initiative. It summarizes the structure and performance of the economy as well as the poverty profile, analyzes the governance environment, and examines the policy track record and the unfinished reform agenda. Section III discusses medium- to long-term macroeconomic projections, while Section IV presents a preliminary DSA, incorporating possible assistance under the enhanced HIPC Initiative. Section V outlines the proposed timeline for preparation of the Decision Point document and key reform areas to be considered as possible Completion Point triggers, which are closely aligned with the government’s own programs and the Kyrgyz Country Development Strategy). It also gives a preliminary indication of how debt-service savings after the Decision Point could be used and tracked. Finally, Section VI presents issues for discussion by Executive Directors.

II. Background and Eligibility for HIPC Initiative Assistance

A. PRGF and IDA Status

3. In February 2005, the Executive Board of the IMF approved a new 3-year PRGF arrangement in an amount of SDR 8.88 million (10 percent of quota) to support the Kyrgyz Republic’s economic program. The Board completed the second review under the arrangement on a lapse-of-time basis in May 2006. The Kyrgyz Republic is an IDA-only country, with a per capita GDP of $473 in 2005. The World Bank’s Country Assistance Strategy (CAS) for 2003–06 expired in June 2006, and the World Bank together with the ADB, the Swiss Agency for Development and Cooperation (SDC/SECO), DFID, USAID, and UN agencies are preparing a Joint Country Support Strategy for FY 2007–10. Based on IDA’s Performance-Based Allocation (PBA) system, the Kyrgyz Republic is eligible for 100 percent grant funding under IDA 14 for FY06/07. Future eligibility for grants will depend upon the country remaining an IDA-only country at high-risk of debt distress, as evidenced by a debt sustainability analysis.

B. Economic Structure and Policy Track Record

4. The Kyrgyz Republic remains one of the poorest countries of the Commonwealth of Independent States (CIS), and following the collapse of the Soviet Union in 1991, it underwent a severe economic crisis, caused by a loss of transfers (about 13 percent of GDP) from the union’s budget and disruption of economic linkages with the former Soviet republics. The economy is dominated by agriculture, which accounts for about 36 percent of real GDP and over 50 percent of the labor force. In the early 1990’s, manufacturing industries (mainly machine building, metal processing, light industry and food processing) from the Soviet period were closed largely because they were unable to compete on price and quality with imported goods. They were replaced by services (particularly trade and transport), which now account for about 40 percent of value added, and, from 1997, by gold production, which makes up 8 percent of real GDP and 25 percent of exports. Fluctuations in gold prices and production have increased the volatility of GDP growth (Text Table 1). The power sector contributes about 4 percent to GDP, and energy supply is one of the key inputs for the development of other sectors. It is also a major potential source of revenues and exports.2 Governance problems and low electricity tariffs have resulted in large quasi fiscal deficits—around 9 percent of GDP in 2005—which pose a threat to macroeconomic stability.3

Text Table 1.

The Structure of Output and Growth, 1991–2005

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Sources: Kyrgyz authorities; and Fund staff calculations.

Gold growth rate refers to 1998-99 only. Gold output was zero in 1996 and increased to 6.4 percent of GDP in 1997.

Due to statistical problems, power sector output in 1991–95 was included in manufacturing and mining.

5. From 1991 to 1995, a 50 percent decline in GDP was accompanied by hyperinflation and large increases in unemployment and poverty. In response to this, the government implemented fundamental economic reforms and created the foundations for a market-oriented economy. Among the key reforms were the introduction of the national currency, price liberalization, land reform, small and medium-scale privatization, and trade liberalization. These reforms began to yield results from 1996, when the economy started to recover and recorded the first positive real GDP growth since independence.

6. Partly reflecting early reform efforts and a benign external environment, economic performance improved significantly in 1996–99 (Text Figure 1 and Text Table 2). Real GDP grew by an annual average of 5.5 percent,4 faster than in most CIS countries (whose average was 3.1 percent over the same period), and inflation declined from 32 percent in 1995 to below 10 percent in 2000. Growth was particularly strong in 1996 and 1997 (averaging 8 percent annually), driven mainly by strong agricultural growth as a result of agrarian reforms (distribution of land to farmers, price liberalization, restructuring of state-owned farms and, elimination of government regulation of product markets and of export duties) that led to increases in crop yields and increased production of high-value crops. In the aftermath of the Russian financial crisis in 1998, growth slowed to 2.9 percent in 1998–99. The domestic currency, the som, depreciated by almost 50 percent in real terms against the U.S. dollar in 1998, while it appreciated by 26 percent relative to the Russian ruble. The crisis led to a widening of the external current account deficit to 23 percent of GDP in 1998, from 8 percent in 1997, and it exposed the vulnerability of the economy to external shocks, partly reflecting the high level of geographical and commodity concentration of exports. The external current account deficit subsequently narrowed and the import coverage of official reserves increased. Nevertheless, banking sector problems intensified in the late 1990s, as nonperforming loans increased and banks failed to meet prudential requirements. These developments led to bank failures, and a specialized agency was established to handle bank liquidation.

Text Figure 1.
Text Figure 1.

Kyrgyz Republic: Macroeconomic Performance, 1993–2005

Citation: IMF Staff Country Reports 2006, 417; 10.5089/9781451821512.002.A001

Sources: Kyrgyz authorities; and Fund staff estimates.
Text Table 2.

Key Macroeconomic Indicators, 1991–2005

(In percent of GDP; unless otherwise indicated)

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Sources: Kyrgyz authorities; and Bank-Fund staff estimates.Notes: Data for 1991–96 are from the years with the best available data. Investment data for 2000–05 are estimates. The increase in FDI in 2004 is explained by a one-time transaction related to the Kumtor Gold Company.

7. As a result of fiscal laxity since independence, exacerbated by poor debt management and the shock from the 1998 Russian crisis (accompanied by a sharp depreciation of the som that depressed the country’s dollar GDP), the external debt burden began to swell (Text Figure 1 and Text Table 2). These problems were compounded by the low and often negative rates of return of many of the investments financed by the external debt accumulation, thereby undermining the debt repayment capacity. As a consequence by the early 2000s the external debt had risen to the equivalent of the country’s GDP, up from one-third of GDP in 1995, while the debt service burden rose to one-fourth of export receipts in 2000, from one-fifth in 1995.

8. During 2000–05, the country achieved broad macroeconomic stability, and prompted by a growing awareness of the problematic debt overhang, the authorities were able to stabilize the debt ratios, mainly through fiscal consolidation supported by enhanced coordination between the IFIs. In particular, the fiscal deficit was reduced to 4 percent of GDP in 2005, from 12 percent in 1999. Inflation declined steadily to about 4 percent and the exchange rate remained stable. Nongold GDP grew on average by about 4.5 percent per year in 2000–05, driven mainly by trade and other retail services,5 compared with 7.2 percent in other CIS countries. This suggests that, in contrast to its neighbors, the country failed to realize its full potential and sustain high rates of growth, once the impact of the early reforms dissipated.

9. While macroeconomic policy implementation in recent years has been adequate and the authorities have established a good record of implementation of successive PRGF-supported programs since 2001, progress on structural reforms has remained uneven. Macroeconomic stability and growth have been underpinned by a range of market-oriented structural reforms over the last decade, including price and trade liberalization and privatization of land and many state-owned enterprises (SOEs). The government phased out directed credits, sharply curtailed domestic financing of the budget deficit, and closed large loss-making state banks. It also made critical investments in essential telecommunications, energy, and irrigation infrastructure. Furthermore, it developed core economic legislation appropriate to a market-based economy and began the process of institutional reform and governance improvements that are critical to the effective implementation of such legislation. These efforts were supported with substantial assistance from the IMF, the World Bank, and other donors. The main areas of reform and results accomplished so far are summarized in Box 1 below.

Progress on Structural Reforms, 1995–2005

Anti-corruption and transparency in public administration: Numerous initiatives to address systemic corruption focused largely on (a) legal frameworks (adoption of a civil service law and procedures to promote professionalism of the service and approval of a law that requires income and asset declaration by key officials); and (b) formal institutional arrangements, including establishment of Councils of Good Governance (in 2003 and 2004) to advise on anti-corruption policy and an anti-corruption commission (2005) and a civil service agency to oversee appointments and promotion. Nevertheless, progress in implementing the legal frameworks has been slow and has not impacted corruption significantly.

Privatization and public enterprise management: Land privatization was largely carried out in the early 1990s—the land code, the law on land registration, and procedures for land-use rights and auctions were adopted—and about two-thirds of all land is now privately owned; but restrictions on land transfer remain. Efforts to accelerate and strengthen management of public utilities and state enterprises have been sporadic due to resistance from entrenched interests, resulting in weak management and continued lack of transparent practices and clear accountability mechanisms in SOEs.

Financial sector: The government established the Kyrgyz Agricultural Finance Corporation (KAFC) with World Bank funding in 1996 to provide financial services to the rural agricultural sector. The two-tier banking system established in 1997 led to entry of a large number of private banks. In the aftermath of the Russian financial crisis, which led to bank failures in the Kyrgyz Republic, the monetary authorities set up a debt and bank restructuring agency (DEBRA) in 2000 as the sole and exclusive liquidator of failed banks. The authorities recapitalized a systemically important bank, Kairat bank, in 2001 and placed four problem banks into liquidation. They also introduced improvements in banking supervision by adopting a regulatory response policy in 2001 aimed at (a) ensuring transparency and predictability of regulatory enforcement; (b) reducing political maneuvering to circumvent banking regulations; and (c) protecting the NBKR from accusations of discretion and arbitrariness. In early 2006, the authorities increased the minimum capital requirement on banks to $1.5 million, which will be raised further to $2.5 million by end-2007, and strengthened capital adequacy requirements. To enhance the payment system, the authorities developed bulk clearing facilities in 2005, and are implementing measures (with IMF and World Bank support) to further enhance financial intermediation. Despite these reforms, financial deepening remains slow and will depend on progress in legal judicial reforms and establishment of effective contract enforcement mechanisms.

Energy sector reforms: Enhancing efficiency of the sector—particularly in electricity—has been an important part of the authorities’ reform agenda, which has been supported since 2000 by the World Bank’s Consolidated Structural Adjustment Credit. The agenda includes (a) restructuring and subsequent privatization or concession of distribution companies; (b) transparency in accounting practices; and (c) tariff and regulatory changes. Progress has been thwarted by vested interests and lack of political will, resulting in physical and financial losses over the years; the quasifiscal deficit of the electricity sector is estimated at around 9 percent of GDP in 2005.

Mining sector transparency: The government endorsed the Extractive Industries Transparency Initiative (EITI) in July 2004, but compliance with commitments has been limited due in part to weak capacity. Deficiencies remain in mining sector legislation and continue to impede security of tenure (exemplified by the ongoing disputes on licenses for the Jerooy and Taldybulak gold mines) and flow of investments into the sector.

Public financial management (PFM): Basic elements of public financial management have been introduced, including a legal framework and procedures for budget management and a treasury system established in 1995. Due to weak capacity (stemming from lack of funds and technical assistance), the treasury system operates largely on a manual basis and has kept expenditure control less effective. Computerization of the treasury is supported by a World Bank credit approved in 2003 and is expected to be completed by 2008. The authorities are revising their budget classification system to enhance tracking of poverty related spending. PFM reforms have been supported by many donors, particularly the World Bank under its Public Sector Resource Management Adjustment Credit (PSRMAC) program (1997–99), the GSAC (since 2003), and the Programmatic Public Expenditure Review (PPER) (since 2005). Nevertheless, shortcomings remain, and the authorities have recently developed a focused plan with assistance of donors for strengthening the PFM reform that will ultimately help spending agencies implement their budgets in a predictable way under a solid internal control.

Tax and customs administration: Institutional fiscal reforms have focused on development of tax and customs administration along with procedures and codes. Reforms were introduced to reduce the tax burden on labor and capital—halving tax rates on labor and capital income (2005). Good progress is expected in reducing the payroll tax to a medium-term benchmark level of 25 percent. A revised tax code, which is aimed at simplifying filing procedures, reducing overly interference by tax officers in private business and boosting compliance is, however, yet to be approved by parliament. A simplified customs code was adopted in 2005 based on best international practice, but its implementation will require customs procedure amendments to reduce bureaucratic requirements. Improving customs administration will benefit from technical assistance and support from the Asian Development Bank (AsDB).

Public procurement: The public procurement law (PPL) supported by the World Bank under the Country Procurement Assessment Review provides for a fair, transparent and competitive procurement process. Nevertheless, the State Commission on Public Procurement and Material Reserves (SCPPMR) has so far failed to help public agencies organize themselves in accordance with the PPL, and it still participates in procurement processes, in contravention of the law. This has resulted in a large number of sole-source contracts and other symptoms of potential corruption in the procurement process.

Transport development and maintenance: During the past ten years, the focus in the transport sector has been on rehabilitating major international and national roads, financed largely by external donors. Maintenance has largely been neglected, and consequently much of the road network is in poor condition. Thus the key issue in transport is prioritization of expenditures—spending the limited funds on economic activities with the highest returns, including maintenance.

Agriculture: Land privatization and market liberalization have been the principal drivers of reform within this sector—only a quarter of cultivated land is currently state owned. Despite market-oriented reforms, the state continues to announce ad hoc interventions in commodity markets as a means of supporting agricultural producers, creating uncertainty and unrealistic expectations among market participants and stifling private initiative. A large agenda for further reforms would include developing capacity for appropriate and effective agricultural policy formulation, ensuring that all farm land holders have proper title to land and that the water code is implemented, as well as taking actions to increase market-based access to rural credit.

The business environment: Bills to streamline licensing and inspection procedures are pending approval by parliament, but serious problems of corruption remain and continue to hinder the development of a business-friendly environment.

Human development: Several initiatives in education and health care have been taken since independence. The Manas National Health Care Reform program (1996–2005) restructured service delivery and initiated a streamlined “patient-focused” and “primary-care oriented” health system. The joint donor-supported Health Sector Wide Approach (SWAp) since 2005. Pension reform (1997) supported by the World Bank’s Social Sector Adjustment Credit (SOSAC) converted social fund accounts to an accrual system.

C. Poverty and Social Development

10. Macroeconomic stability and growth have helped reduce poverty in the Kyrgyz Republic. Per capita incomes have almost doubled since their collapse in the early 1990s, and the capital city (Bishkek) and other urban areas have seen particularly strong reductions in poverty. The poverty level has declined to 46 percent in 2004, from 63 percent in 2000 (Box 2).

Kyrgyz Repblic: Poverty and Social Indicators

(In indicated units)

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Source: World Bank, Economic and Social Indicators.

This indicator exceeds 100 percent when enrolled pupils are in a grade that does not correspond to their age group.

11. Nevertheless, poverty—including its extreme manifestations—remains high, particularly in the rural areas, where three-quarters of the poor, or 1.8 million persons, live. Extreme poverty affects about 13 percent of the population. In addition, income inequality has worsened in recent years (the Gini index measured by per capita consumption increased to 32.8 percent in 2004, from 30.3 percent in 2000).

12. As shown in the World Bank’s 2003 Poverty Assessment Report on the Kyrgyz Republic, there is a strong correlation between poverty and employment status, with widespread poverty reflecting a large pool of unemployed and underemployed workers, many of whom rely on subsistence agriculture and informal street trade and are not included in the official unemployment rate of nearly 10 percent. Other determinants of poverty include the province of residence and family size, especially the number of young children. This pattern of poverty is similar to that seen in other countries in the Eastern Europe and Central Asia (ECA) region of the World Bank.

13. The Kyrgyz Republic, like other CIS countries, began the transition with exceptionally favorable social indicators (Box 2). These indicators remain markedly better than those of other countries at comparable income levels. Nonincome dimensions of deprivation are, however, gradually becoming a source of concern and, given resource constraints, the country faces the challenge of halting the deterioration of social indicators. Continued erosion of the quality of social services, combined with a decline in affordability, has excluded many poor households from benefiting from public interventions.

14. Protecting the poor and the vulnerable has been a policy priority of the government since the 1990s. Despite the low income level, the magnitude of resources channeled to social protection is remarkably high. In relative terms, spending on social protection is estimated at about 12 percent of GDP. Without these transfers, poverty would be clearly higher. However, even with such high spending, resources allocated for poverty reduction do not effectively reach the extremely poor, while entailing substantial leakage to the nonpoor.6

D. Recent Political Developments and Governance

15. The March 2005 “Tulip revolution,” which resulted in the overthrow of the government that had been in power for the previous 15 years reflected frustration with corruption and poor governance prevalent under the previous regime. The revolution opened up possibilities for significant reforms, and the new authorities have indicated their commitment to improving governance and transparency. However, lingering political tensions and the pervasive influence of vested interests have at times slowed progress.

16. The Kyrgyz Republic is characterized by relatively liberal legislation in many areas,7 low formal government interventions, and a formally deregulated business environment. This environment has created a basis for a steadily developing business community that, in turn, has helped stimulate a buoyant civil society, opening the way for increased voice and accountability. Following the revolution, civil society has consistently called on the authorities to fulfill their commitments to fight corruption and curb organized crime, and the authorities have, in turn, engaged in active dialogue with civil society. The mass media is freer now, and an environment of active political debate prevails.

17. Nevertheless, the country faces major challenges in providing good governance and reducing corruption.8 As a result of weak capacity and poorly defined institutional responsibilities, mechanisms to resolve conflicts over policy are underdeveloped and the ability of the government to effectively enforce policies and laws is limited. Within the civil service, extensive patronage networks, low pay and the legacy of the “nomenclatura” system have made it difficult to establish a professional merit-based civil service, unaffected by changes in ministerial portfolios. However, in recent months the importance of a merit-based civil service has been increasingly recognized and significant steps have been taken to implement reforms supported by the World Bank’s GSAC since 2003, particularly with regard to requirements for competitive selection of civil servants.

18. In 2005, the Corruption Perception Index (CPI)—an aggregate expert opinion indicator developed by Transparency International9—ranked the Kyrgyz Republic in the top half of the lowest quartile of countries included in the sample (130 out of 159 countries, Text Table 3). Among HIPC countries, the Kyrgyz Republic ranked 25 out of 36 countries included in the sample.10 Among CIS countries, the Kyrgyz Republic’s score is comparable to the other Central Asian countries and Georgia.

Text Table 3.

Corruption Perception Index, 2005

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Source: Transparency International, 2005.

Scores are on a scale of 1 to 10 (10 = least corrupt). The ranking covers 159 countries.

19. The EBRD-World Bank Business Environment and Enterprise Performance Survey (BEEPS) indicators for 2005, which capture the experience of corruption by enterprises as opposed to experts’ perceptions of corruption, and which are available only for countries in the ECA region of the World Bank, show that enterprises in the Kyrgyz Republic experience some of the worst problems of administrative corruption among ECA countries (Text Table 4).

Text Table 4.

Corruption as a Problem in Doing Business, 2005

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Source: World Bank BEEPS, 2005.

percent of firms reporting corruption to be a moderate or major obstacle to doing business.

20. Problems of corruption exist despite an apparently sound formal legal and regulatory framework as measured in the World Bank’s Doing Business Indicators. These indicators, based mainly on an assessment of the formal legal and regulatory framework, rank the Kyrgyz Republic slightly below the average for the world, among the top 6 performers out of 37 HIPC countries, and above most CIS countries in terms of ease of doing business (Text Figure 2).

Text Figure 2:
Text Figure 2:

Doing Business Indicators, 2006

(Comparing the Kyrgyz Republic and HIPC countries)

Citation: IMF Staff Country Reports 2006, 417; 10.5089/9781451821512.002.A001

Source: World Bank’s Doing Business, 2006.Note: The score on each item refers to the country’s rank among all countries surveyed in difficulty of doing business. Thus, a lower rank indicates a better business environment.

21. In sum, the level of corruption in the Kyrgyz Republic appears to be similar to that in many countries currently receiving assistance under the HIPC Initiative. However, the Kyrgyz Republic also appears to have a better legal framework, a more liberal political environment and freer media than most countries with comparable governance problems. The political events of March 2005 and a more open political environment support staffs’ view that sustained external assistance along with continued scrutiny from civil society could improve governance significantly.

E. The Structural Reform Agenda

22. Given the country’s low income and high poverty, sustained growth is the fundamental requirement for progress in poverty reduction. While the government has initiated wide-ranging reforms and achieved some tangible outcomes over the past decade, many of the reforms have not been completed. The key constraint has been poor governance, manifested through weak public administration and entrenched interests of public officials. Moving ahead with the unfinished reform agenda is critical to encouraging private sector development and ensuring that public resources are efficiently targeted at the most important priorities and the most vulnerable groups in the population. The new government recognizes the importance of decisive action to expedite reforms. It has recently begun to show its commitment through implementation of competitive processes for civil service appointments, publication of declarations of income and assets of the president, the prime minister, deputy prime ministers, ministers, members of parliament and senior judges,, and introduction of a new series of public finance reforms.

23. The HIPC process is expected to help the government implement the unfinished reform agenda in a well-sequenced and prioritized manner, with a focus on strengthening governance. The reform agenda draws on the authorities’ own stated commitments and priorities, now explicitly articulated in the new poverty reduction strategy (renamed the Country Development Strategy). It has also been supported by years of donor engagement, dialogue, and analytical work. The governance reform agenda is also supported by the population, with civil society actively demanding better governance and reduced corruption, and a relatively free media helping to reinforce these demands for government accountability. The government will need to steadfastly implement the reform agenda and demonstrate its ability to deal with corruption, by reducing rent-seeking opportunities among public officials and changing perceptions about what is tolerated in society. In particular, it will need to address challenges in key areas identified below.

24. Enhancing transparency and accountability in the civil service: In recent months, the authorities have begun to implement the new legal framework for competitive and merit-based appointments to the civil service. One of the key tasks going forward will be to ensure that due process is followed in all appointments and dismissals. Another important step forward in promoting accountability of public officials has been the publication of income and asset declarations by high state officials on the internet and in the mass media. Considerable efforts, supported by the external community, are still needed to strengthen ownership of reforms and the capacity of agencies to ensure development of a professional and accountable public service.

25. Improving public enterprise management: A key issue is to address poor corporate governance structures in SOEs and lack of managerial accountability. A strategy for managing all public enterprises, including a definition of management and accounting standards along with explicit procedures for appointing directors is a necessary first step towards more accountable and market-oriented SOEs, and would provide a basis for supporting government plans for privatization of some of these enterprises where feasible and appropriate. In addition, mechanisms are required to ensure that agencies responsible for managing SOEs report on compliance with audit reports. As in the case of public service reform, capacity building and external support are needed, along with political leadership and ownership of these reforms.

26. Regulatory reform and transparency in the energy and mining sectors: The challenges comprise creating transparent tariff structures and financing arrangements, consistent with cost-recovery, along with good corporate governance to attract private capital. In the mining sector, it is necessary to enact new legislation and a fiscal regime consistent with international norms and standards, and publish audited financial reports of state revenues originating from the mining sector in accordance with the country’s commitments under the Extractive Industries Transparency Initiative (EITI).

27. Strengthening public financial management (PFM): The main challenge will be to implement the recently developed action plan and show clear improvements in annual budget execution. In addition to fostering convergence to best practices, the reforms must also curtail rent-seeking within the budget process and bolster the credibility of budget agencies. The authorities will also need to help the major procuring entities organize themselves and begin to establish capacity to implement the law on public procurement. Implementation of the new law on the Chamber of Accounts will require extensive training for its auditors in modern international audit practices.

28. Fostering a business-friendly regulatory environment: The main challenges will be to adopt and implement a new tax code that removes ambiguities and contradictions, together with a tax administration strategy that moves towards risk-based assessment and away from excessively intrusive inspections. Similarly, implementation of the customs code will require introduction of selective risk-based inspections, proper systems of data exchange, and swift procedures to facilitate trade in line with international best practices, while safeguarding revenue collection. The authorities will need to implement existing legislation aimed at reducing the number of technical regulations and mandatory standards, and introduce limits in the number and duration of inspections without jeopardizing tax enforcement. Finally, it will be necessary to streamline licensing procedures and introduce mechanisms for reviewing new regulations that affect the business environment.

29. Improving human development outcomes on a sustained basis: The ultimate objective of good governance is to create the basis for sustained growth and poverty reduction. Efficient and effective provision of health, education and social protection services is critical to achieving that end. A key challenge in all three sectors is to secure adequate budget resources. Health sector reforms need to focus also on providing adequate primary care and ensuring transparent and predictable budgets for the sector. Flexible education financing arrangements are required to enhance basic education in rural areas. Further, the social protection system needs to be better targeted to ensure fiscal sustainability, while providing adequate protection to pensioners.

III. Medium- to Long-Term Macroeconomic Framework

30. Macroeconomic projections in this paper have been prepared jointly with the authorities (Tables 1 and 2) and are consistent with the policy strategy outlined in their PRGF-supported economic program for 2006 (IMF Country Report No. 6/235). The main parameters and objectives underlying these projections include (a) average medium-term output growth of 5½ percent; and (b) inflation of 5.7 percent in 2006, declining to 4 percent in the medium term. Achieving rapid growth will require increasing private sector investment, a rebound of the gold sector, and diversification of production and exports. The government will need to maintain fiscal prudence, while seeking to increase domestic resource mobilization and concessional external assistance to create fiscal space for further poverty reducing spending, consistent with its debt-reduction strategy. In addition, the macroeconomic framework assumes that supporting structural reforms, such as those outlined in section V, are carried out. In the absence of such a program, the projected productivity and investment growth required for the medium-term growth of 5¼ percent may not be attained, and there is a serious risk that the economy could find itself trapped at a significantly lower growth rate.

Table 1.

Kyrgyz Republic: Selected Economic Indicators, 2003–07

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

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

Projections are based on program exchange rates specified in the Technical Memorandum of Understanding.

12-month GDP over end-period broad money.

Weighted average interest rate on som denominated loans.

Table 2.

Kyrgyz Republic: Selected Long-term Macroeconomic Indicators, 2005–24.

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

31. Achieving strong productivity gains is also crucial to spur output growth and nongold exports. Productivity growth, stemming from improvements in resource efficiency and accompanied by declines in rent-seeking activities by key public officials, is expected to contribute about 2⅔ percentage points per year to output growth in 2006–15 and about 2⅓ percentage points per year in 2016–24. In the absence of shocks, this should safeguard external competitiveness and allow moderate but steady growth in real wages. Unemployment is expected to decline as growth picks up, supporting poverty reduction.

32. To foster private sector development, which is essential to underpin pro-poor growth, the government is committed to creating an enabling business environment and gradually reducing tax rates on labor. One of the constraints to further development of manufacturing and services is the unfavorable business environment for small and medium enterprises. The number of SMEs and their employment and output levels have remained broadly unchanged in recent years. To reduce the tax burden on labor and encourage employment and tax compliance, the 2006 budget introduced a flat 10 percent personal and corporate income tax rate (eliminating the 20 percent personal income tax bracket and halving the corporate tax rate) and lowered the payroll tax rate by 2 percentage points to 29 percent as a step toward the authorities’ objective of a 25 percent payroll tax rate. In addition, the authorities have announced their intention to reduce corruption and improve efficiency of public services, including in tax and customs administration, in order to broaden the tax base. In this connection, the new tax code currently being discussed by parliament aims at eliminating legislation burdensome to private sector operations, while clarifying taxpayer obligations and rights. In all, the investment-to-GDP ratio is expected to increase to an average 24 percent in 2006–14, from 20½ percent in 2000–05. This would come almost entirely from the private sector, as public investment would increase slightly. This outlook is also consistent with the move to limit external debt funding of the Public Investment Program (PIP).

33. Fiscal consolidation and a prudent debt management strategy should underpin macroeconomic stability. To secure a gradual decline in the fiscal deficit, tax revenues are expected to increase as the tax code is streamlined and tax and customs administration are enhanced to encourage compliance, while expenditures would increase at a moderate pace. In addition, it will be important to realign public expenditure towards social and capital spending. In line with the poverty reduction strategy, social spending will increase by 1 percentage point of GDP, to almost 16 percent of GDP from 2005 to 2008, and stabilize around 17 percent in 2015–24, while capital spending will increase by ½ a percentage point of GDP in the medium term. In addition, continued prudence in debt management will require contracting only highly concessional loans.

34. The external current account deficit is expected to decline in the medium term, in response to strong growth in gold mining and efficiency gains in the rest of the economy (on the assumption that the business environment and the energy situation improve). Supported by continuing close relations with major CIS partners and a gradual removal of transport bottlenecks, merchandise exports are expected to grow rapidly, while a well-educated labor force and rising employment opportunities should facilitate export diversification. In the long run, the external current account deficit is expected to stabilize at 5½–6 percent of GDP (Table 2).

IV. Debt Sustainability Analysis and Possible Assistance under the HIPC Initiative

A. Debt Reconciliation Status

35. The DSA presented below was jointly prepared by the staffs of the IMF and IDA in consultation with the authorities.11 It is based on loan-by-loan data provided by the authorities on debt outstanding and disbursed as of end-2004.12, 13 The exchange and discount rates used in calculating the nominal stock of debt and the NPV of debt as of end-2004 are presented in Table 8. Debt estimates and NPV calculations are preliminary, pending completion of debt reconciliation with creditors (all multilateral debt, and four-fifths of bilateral debt data have already been reconciled).

Table 3.

Kyrgyz Republic: Nominal Stock and Net Present Value of Debt at end-2004 by Creditor Groups

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Sources: Kyrgyz authorities and staff estimates.

Includes a stock-of-debt operation on Naples terms at end-2004 and at least comparable action by other official bilateral and commercial creditors on eligible debt (pre-cutoff and non-ODA).

Revenues are defined as central government revenues, excluding grants.

Based on the three-year backward looking average of exports of goods and services, excluding transit goods (2002-04).

Table 4.

Kyrgyz Republic Assistance Levels Under a Proportional Burden-Sharing Approach 1/

(In millions of U.S. dollars in end-2004 NPV terms; unless otherwise indicated) 2/

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Sources: Kyrgyz authorities and staff estimates and projections.

Assumes proportional burden-sharing as described in “Estimated Costs and Burden-Sharing Approaches,” that is, after full application of traditional debt relief mechanisms.

Using six-month backward-looking discount rates at end-2004, and end-2004 exchange rates.

Each creditor’s NPV reduction in percent of its exposure at end-2004 (after hypothetical stock-of-debt operation on Naples terms at the end-2004).

After a hypothetical stock-of-debt operation on Naples terms based on end-2004 data with comparable treatment from non-Paris club creditors.

Revenues are defined as central government revenues, excluding grants.

Based on the three-year backward looking average of exports of goods and services, excluding transit goods (2002–04).

Table 5.

Kyrgyz Republic: Net Present Value of External Debt, 2004–24 1/

(In millions of U.S. dollars: unless otherwise indicated)

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Sources: Kyrgyz authorities and staff estimates and projections.

Refers to public and publicly guaranteed external debt only and is discounted on the basis of the average commercial interest reference rate for the respective currency derived over the six-month period prior to the latest date for which actual data are available (December 2004).

NPV of debt in percent of three-year average of exports of goods and nonfactor services, excluding transit goods.

NPV of debt in percent of central government revenues, excluding grants.

Assumes a stock-of-debt operation on Naples terms (67 percent NPV reduction) as of end-2004 and at least comparable action by other official bilateral and commercial creditors.

For the bilateral creditors, assumes the implementation of 2005 Paris Club agreement for Paris Club creditors, then a Cologne flow operation during the interim period (December 2006–December 2008) followed by a Cologne stock operation at the completion point. Multilateral creditors are assumed to provide debt relief as of the decision point, except for the NDF and IFAD, for which the delivery would start at the completion point.

NPV of the debt shows the results of the (hypothetical) unconditional commitment and delivery of enhanced HIPC assistance at end-2004.

As defined in IMF, Balance of Payments Manual, 5th edition, 1993. Excludes transit goods.

Three-year backward looking average of exports of goods and nonfactor services, excluding transit goods.