Kyrgyz Republic
Fourth Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility and Request for Modification of Quantitative Performance Criteria: Staff Report; Staff Statement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for the Kyrgyz Republic
Author: International Monetary Fund
Publication Date:
08 Jun 2007
eISBN:
9781451821550
Language:
English
Keywords:
ISCR; CR; growth facility; Kyrgyz authorities; Three-Year arrangement; government; government's decision; exchange rate; debt management; government ownership
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The paper discusses key findings of the Fourth Review Under the Poverty Reduction and Growth Facility (PRGF) for the Kyrgyz Republic. Output is rebounding and inflation remains subdued. However, most end-December 2006 and end-March 2007 structural benchmarks have been missed, partly because of political tensions that slowed the legislature. The 2007 program, which targets 6½ percent output growth and 5 percent inflation, caps the fiscal deficit at 3.1 percent of GDP and maintains a prudent monetary policy. The government plans to implement delayed structural measures under the program, and strengthen external debt management.

Abstract

The paper discusses key findings of the Fourth Review Under the Poverty Reduction and Growth Facility (PRGF) for the Kyrgyz Republic. Output is rebounding and inflation remains subdued. However, most end-December 2006 and end-March 2007 structural benchmarks have been missed, partly because of political tensions that slowed the legislature. The 2007 program, which targets 6½ percent output growth and 5 percent inflation, caps the fiscal deficit at 3.1 percent of GDP and maintains a prudent monetary policy. The government plans to implement delayed structural measures under the program, and strengthen external debt management.

I. Recent Developments and Performance Under the Program

1. The authorities have continued to maintain macroeconomic discipline and the PRGF-supported program remains on track. All end-December 2006 quantitative performance criteria (PCs) were met, in most cases by wide margins (Table 1). However, as tensions between the government and parliament delayed passage of important legislation, most structural benchmarks for end-December 2006 and end-March 2007 were missed (including, those on enhancing the NBKR’s autonomy, preparing for privatization of the Kyrgyz Agricultural Finance Corporation (KAFC), and securing passage of a new tax code) (Table 2).

Table 1.

Kyrgyz Republic: Quantitative Program Targets for 2005–07 1/

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

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

Definitions are provided in the TMU.

New concessional loans during the year.

Table 2.

Kyrgyz Republic: Structural Conditionality

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2. Activity started to rebound in 2006, after a slight contraction in 2005, with nongold output growth of 5.1 percent. Total output only grew by 2.7 percent, dampened by a gold mine accident. Despite a rapid increase in monetary aggregates stemming from large NBKR unsterilized intervention, inflation has remained subdued due to continued remonetization—with a rise in consumer prices by 5.1 percent during 2006 (compared with the program’s 5.7 percent target) and by 4 percent during the 12 months to March 2007 (Figure 1). Reserve money grew by 47.5 percent in 2006 and 44.5 percent in the 12 months to March 2007. Credit to the private sector has also been rising rapidly (56 percent year-on-year in February 2007), albeit from a low base, thus far without a significant worsening in the quality of loan portfolios (Figure 2).

Figure 1.
Figure 1.

Real GDP Growth and CPI Inflation, 2001–07

Citation: IMF Staff Country Reports 2007, 195; 10.5089/9781451821550.002.A001

Source: Kyrgyz authorities; and Fund staff projections.
Figure 2.
Figure 2.

Credit Growth and Bank Performance, 2006:

(In percent)

Citation: IMF Staff Country Reports 2007, 195; 10.5089/9781451821550.002.A001

Source: Kyrgyz authorities.

3. Despite the NBKR’s intervention, the som appreciated by 8 percent against the U.S. dollar during the year, but the real effective appreciation has been modest, partly because of a strengthening of the currencies of major trading partners, such as Kazakhstan and Russia (Figure 3). Owing to rising imports and an accident-related shortfall in gold exports, the external current account deficit widened to 16¾ percent of GDP in 2006. Nevertheless, sizable short-term capital inflows (including errors & omissions that partly reflect unrecorded remittances and shuttle trade re-exports) led to a faster-than-expected buildup in foreign reserves. At end-March 2007, gross reserves amounted to $816 million, or 3.5 months of projected 2008 imports of goods and services.

Figure 3.
Figure 3.

Exchange Rate Developments

Citation: IMF Staff Country Reports 2007, 195; 10.5089/9781451821550.002.A001

Source: INS database.1/Against 20 major trading partners. Increase indicates appreciation.
uA01fig03

Net International Reserves and Nominal Exchange Rate

Citation: IMF Staff Country Reports 2007, 195; 10.5089/9781451821550.002.A001

Source: Kyrgyz authorities.

4. The overall general government deficit (2.3 percent of GDP) and the primary balance before grants (2.2 percent) were lower than projected in 2006. This reflected strong revenue gains despite a 2 percentage-point cut in the rate of social security contributions during the year. The strong revenue performance and shortfalls in capital expenditure more than offset overruns in current outlays in 2006, and tax receipts during the first quarter of 2007 have remained buoyant. The indicative limit on the electricity sector’s quasi-fiscal deficit (QFD) in 2006 was also met.

5. Political tensions over the past several months have distracted the authorities, delayed passage of key legislation and prompted the government’s decision to forego HIPC/MDRI debt relief. Moreover, recent changes in the structure of government, including a shift of some Finance Ministry responsibilities to a new Ministry of Economy and Trade, have complicated policy coordination. The country has undergone two constitutional reforms, and tensions between the government and parliament have sparked demonstrations by the opposition and two cabinet reshuffles, the latest one involving the appointment in March 2007 of a new cabinet led by Prime Minister Almaz Atambaev. After the mission’s departure, parliament reduced the retirement age (overturning an earlier presidential veto) and introduced a bill proposing nationalization of the mining industry.

II. Report on the Discussions

A. Overview

6. Policy discussions took place in the wake of the country’s decision to forego HIPC/MDRI debt relief. The government has updated the Country Development Strategy (CDS) to address the diminished longer-term resource envelope, while seeking to spur private sector-led growth through new initiatives (e.g., fostering SME development; expediting privatization; and attracting FDI and loans from regional creditors to develop manufacturing and natural resource-based projects).1 Moreover, the authorities sent to parliament a capital amnesty bill, hoping to foster capital repatriation and a one-off spike in tax receipts.

7. The economic program for 2007 targets 6½ percent output growth, driven by the industrial and construction sectors and a rebound in gold production. The program seeks to keep inflation around 5 percent and secure a foreign reserve gain to maintain end-year reserve coverage at 4 months of projected 2008 imports. The external current account deficit would narrow to 12½ percent of GDP from 16¾ percent in 2006, on the back of a recovery in gold exports and buoyant nongold exports and remittances. Fiscal and monetary prudence will continue to underpin macroeconomic stability, and the government is committed to implementing further reforms to foster financial deepening and enhance public financial management (Box 1).

Public Financial Management (PFM) Reforms

The authorities recognize the need for improvements in PFM to facilitate economic growth and poverty reduction. In particular, frequent and nontransparent budget revisions make budget execution at the sectoral level unpredictable, while accountability for use of resources is weakened by lack of robust internal controls and a modern accounting framework.

The authorities are implementing a PFM reform action plan supported by major donors, which includes (i) government ownership; (ii) coordinated donor support; and (iii) benchmarking and measurement of progress based on the Public Expenditure and Financial Accountability (PEFA) indicators. The priority is to address basic obstacles to the implementation of budgets in a predictable way and with a solid internal control framework. Progress will depend on the ability to reinforce ownership, retain qualified Finance Ministry staff, and upgrade managerial and technical capacity.

Going forward, the focus within the PFM action plan will be to (i) enhance tracking and reporting of poverty related expenditure; (ii) submit to parliament amendments to the basic budget law, to clearly define and limit changes to the budget during execution, and to ensure prior parliamentary approval of all supplementary budgets; (iii) introduce a chart of accounts and accounting standards for all public agencies consistent with international public sector accounting standards; and (iv) develop general standards, methodology and an appropriate institutional framework for internal controls, consistent with international internal audit standards. The authorities plan to issue an updated Medium-Term Budgetary framework in May 2007 that will include economic, functional and administrative summaries of expenditures, and will be better aligned with the annual budget process and PRSP priorities.

B. Fiscal and Quasi-Fiscal Issues

8. The overall government deficit will be capped at 3.1 percent of GDP in 2007, and will be financed mostly from external sources and privatization receipts (Table 4). The budget is premised on further revenue gains to keep the tax-to-GDP ratio broadly unchanged, despite an additional 2 percentage-point reduction in the rate of social fund contributions, to 27 percent. The medium-term revenue effort will be underpinned by introduction of a new tax code and further improvements in tax and customs administration. The authorities plan to phase out gradually the cascading and distortionary Road and Emergency Fund taxes from 2008, but they may advance this if revenue performance significantly exceeds expectations.

Table 3.

Kyrgyz Republic: Selected Economic Indicators, 2004–08

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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 (TMU).

12-month GDP over end-period broad money.

Weighted average interest rate on som-denominated loans.

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

Excludes obligations of Kumtor gold mine.

Table 4.

Kyrgyz Republic: Summary of General Government Fiscal Operations, 2005-07

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

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

Excludes transfers to the Social Fund.

Starting in 2006, interest and amortization reflect bilateral agreements signed following the March 2005 Paris Club agreement.

Mainly privatization proceeds.

9. On the expenditure side, the budget envisages no general wage increase, but includes wage hikes of 50 percent for Interior Ministry and corrections personnel and 30 percent for cultural and social sector employees. The increases would raise the wage bill to 7.6 percent of GDP—a relatively high level compared to other CIS countries in the region. The authorities plan to launch a civil service reform (CSR) that could check the wage bill drift over time, although allowing further selective increases to senior staff and specialized professionals. However, they have yet to develop their CSR strategy and indicated that no significant retrenchments are expected in the immediate future, owing to the increase in positions associated with the recent creation of new ministries and agencies.

Wage Bill in CIS Countries, 2007:

(General Government; in percent of GDP)

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Source: Country authorities and Fund staff estimates.

10. The budget also includes a 15 percent increase in pensions, bringing the cumulative increase over the past three years to 44 percent by year’s-end (a 24 percent increase in real terms, albeit from a low base). After the mission’s departure, parliament reduced the retirement age by three years, to 60 years for males and 55 years for females, reversing an earlier presidential veto. The authorities have indicated that this measure will be phased in over a three-year period and could cost 0.3 percent of GDP in 2007, with additional longer-term costs yet to be clarified. They noted that they are reviewing possible short-term offsetting measures, such as an effort to raise the remuneration of social fund deposits; sale of social fund assets; and intensification of the fund’s revenue effort. The authorities also plan to secure minor savings in transportation outlays for senior officials and other non-essential current spending. Staff encouraged the authorities to formulate a comprehensive blueprint for pension reform (with World Bank assistance) to put the social fund finances on a sound footing and foster development of domestic capital markets, possibly by creating voluntary private pension funds. The fiscal cost of transitioning to this mixed system and offsetting measures to safeguard overall fiscal stability should be incorporated into the Medium-Term Budgetary Framework (MTBF).

11. In line with the fiscal decentralization mandated by parliament, the 2007 budget introduces a two-tier system comprising the center and municipalities (Box 2). The authorities are taking precautionary steps to forestall a loss of fiscal control, but recognize that effective fiscal decentralization hinges on capacity building and clear demarcation of each tier’s fiscal competencies. Meanwhile, they are introducing reforms in public financial management and refining the fledgling MTBF (MEP,¶9).

Fiscal Decentralization

Parliament passed a law in 2003 mandating far-reaching fiscal decentralization, which the government is starting to implement. Under the new system, comprising the center and municipalities, resources available to the latter will comprise their actual own revenues, as well as categorical grants earmarked to education and formula-based equalization grants. By contrast, under the previous four-tier system the central government, together with provincial (oblast) and regional (rayon) administrations, essentially framed municipal budgets. After the new system is fully developed, municipalities should be able to prepare their own budgets and transparently execute them, subject to a few basic rules, and the size of each municipality’s equalization grant will be determined through a transparent formula.

The authorities have indicated that extensive capacity building will be required at the center and municipal levels (external donors have provided limited training to municipalities in generic budget issues), and that conceptual and operational issues remain to be clarified before the system becomes fully operational. In particular, they need to specify (i) the scope and criteria for municipal requests for unforeseen changes in quarterly equalization grant allocations; (ii) sanctions on the Finance Ministry untimely or incomplete allocation of equalization grants; (iii) accountability for the use of funds and safeguards to forestall the accumulation of local government arrears; and (iv) each tier’s responsibilities for service delivery. To maintain macro economic stability, some of the local government economic and financial bodies will remain under the Finance Ministry’s supervision until local capacity is built.

12. The government is contemplating creation of a Development Fund (DF) that would on-lend resources to the financial system and be fully integrated into the budget (MEP, ¶ 6). Loanable resources could include the public sector’s shares in the Centerra mining conglomerate (which operates Kumtor, the principal gold mine), and other privatization receipts. Staff advised the authorities to carefully weigh the risks of directed credits, and to minimize them by introducing appropriate fiduciary safeguards and fully integrating the DF (if passed by parliament) into the annual macroeconomic programs. Meanwhile, the status of this proposal is uncertain, in light of differences of views within the cabinet and the recent tabling of a bill by an opposition MP that would effectively nationalize the country’s gold mines.

13. The government has discussed an energy sector action plan with World Bank staff, which envisages phased power tariff hikes to cost-recovery levels by 2010 (after a de facto tariff freeze since 2002), accompanied by social safety nets (MEP, ¶ 10). Meanwhile, pending final government approval of the plan, the authorities have targeted a decline in the electricity sector’s quasi-fiscal deficit (an indicative program target) to under 5½ percent of GDP in 2007.

C. Monetary and Financial Sector Issues

14. The monetary program, premised on further remonetization of the economy, sets limits on the NBKR’s net domestic assets consistent with reserve money growth of 25 percent and broad money growth of 30 percent. To strengthen liquidity management, the NBKR will further enhance its current indirect monetary control instruments (repos, deposit auctions and central bank notes), drawing on the recommendations of an upcoming MCM TA mission. The authorities also plan to maintain the managed exchange rate float regime—essentially smoothing exchange rate fluctuations and reducing recourse to unsterilized intervention. Staff also advised the authorities to stand ready to raise policy interest rates (which have declined somewhat since end-2006) as needed, to keep liquidity expansion in check (Figure 4).

Figure 4.
Figure 4.

Policy Interest Rates, 2006–07

Citation: IMF Staff Country Reports 2007, 195; 10.5089/9781451821550.002.A001

Source: Kyrgyz authorities.

15. The authorities plan to deepen financial sector reforms.2 They will step up supervision; introduce a mandatory deposit insurance scheme for small depositors in 2008; enhance the payment system; and create a sound framework to foster term lending and capital market development (Box 3 and MEP, ¶ 12–14). The authorities reiterated their intention to eventually privatize the former KAFC, but they are now reviewing the company’s privatization strategy in consultation with the World Bank and the EBRD. The NBKR expected the independent review of its internal audit function to be completed shortly (MEP, ¶ 11). Staff underlined the importance of securing passage of pending legislation to strengthen the central bank’s autonomy, although the authorities noted that parliamentary support for this bill was weak.

Financial Sector Reforms

I. Strengthening the legal framework and central bank independence

  • A bill before parliament would amend the central bank’s charter to enhance its autonomy.

  • To underpin finality of bank resolution, the NBKR has proposed further amendments to the bank bankruptcy law. The authorities have also amended the civil code and the collateral law to facilitate use and seizure of collateral.

  • Following passage of new AML/CFT legislation, the NBKR, the Service for Supervision and Regulation of Financial Market (SSRFM) and the Financial Intelligence Unit have developed regulations for bank reporting under the law and enabling amendments to the criminal code.

II. Stepping up financial sector supervision

  • The NBKR and the SSRFM continue to strengthen supervision. The NBKR has introduced regulations for consolidated supervision in line with Basel Core Principles for Effective Banking Supervision, and tightened on-and off-site assessments of prudential requirements. It has also developed a framework for assessing market, country and transfer risks of banks, and instructed banks to closely track these risks and maintain adequate capital to cover them.

  • The NBKR increased minimum capital requirements on existing banks to som 60 million ($1.5 million) in 2006, to be further increased to som 100 million in 2008. The floor for new banks remains at som 300 million.

  • The NBKR has started to develop a supervision framework for Islamic banking.

III. Bolstering indirect monetary control instruments and enhancing the payment system

  • The NBKR introduced deposit auctions as a new monetary control instrument (besides repos and central bank notes) in 2006. It plans to take further steps to enhance liquidity management, drawing on recommendations of the upcoming MCM TA mission and the ongoing MCM regional TA on debt management and securities market development.

  • The NBKR has maintained a trading platform and acted as a depository for government securities, and initiated payment of salaries and utilities through the banks. It will launch a Real-Time Gross Settlement system in 2008.

  • The NBKR is poised to introduce mandatory deposit insurance for small depositors in 2008.

  • The NBKR will sponsor legislation to facilitate the use of bank accounts (including demand deposits) for settlement purposes by legal entities and individuals.

D. Other Issues

16. The authorities hope to lessen the external debt burden in the coming years by maintaining prudent macroeconomic policies, promoting rapid economic growth, and further strengthening external debt management. They pointed to the latest joint Fund/Bank debt sustainability analysis (LIC DSA) presented last fall (Country Report No. 07/135), which suggests that these mutually reinforcing policies would gradually put the debt ratios on a downward and more sustainable path. They hoped that, by end-2007, all the critical NPV of debt ratios would already show a significant decline, as a result of the economic recovery and further tax revenue gains. Furthermore, they noted that their updated external debt management strategy (which is expected to be implemented shortly) would maintain the 45 percent minimum grant element on any new public borrowing, strengthen risk assessment of external loans, and tighten supervision of external borrowing by public enterprises. While commending the authorities for their commitment to prudent policies and enhanced debt management, staff cautioned that the country would remain at a high risk of debt distress, unless the vulnerability to exogenous shocks and policy reversals was lessened by economic diversification and broader internal political support for economic reform.

17. The authorities are requesting small modifications to the end-June 2007 program limits on the central bank’s NIR and NDA and the floor on tax collections, as well as to the indicative limit on reserve money. To better align the fiscal stance with the goal of securing debt sustainability, they also wish to treat the overall general government deficit (instead of the general government primary deficit before grants) as the fiscal indicator to be monitored henceforth as a performance criterion under the program.

III. Staff Appraisal

18. Macroeconomic performance under the PRGF-supported program in 2006 and the year-to-date has been good. Real GDP growth last year was dampened by an accident in a major gold mine, but the recovery in other sectors has gained momentum. Moreover, despite a turbulent political environment, the authorities have maintained fiscal discipline and kept inflation subdued. All end-December 2006 quantitative PCs have been met comfortably, and preliminary data suggest that the end-March 2007 indicative targets have also been met.

19. Nevertheless, tense government relations with parliament and civil society have hampered the implementation of the reform agenda, as evidenced by nonobservance of six structural benchmarks. Moreover, the government backed off under political pressure from its earlier decision to request HIPC and MDRI debt relief, which would have helped secure debt sustainability and create fiscal space for pro-poor spending. Some initiatives with potentially serious economic downsides have recently been passed or tabled in parliament, including a reduction in the retirement age.

20. Against this backdrop, the authorities’ updated economic program for 2007 seeks to underpin macroeconomic stability by continued fiscal and monetary prudence. Inflation is targeted at 5 percent and real GDP growth at 6½ percent, and a further reserve gain would keep gross reserve coverage at a comfortable level. To achieve these goals, the overall fiscal deficit will be capped at 3.1 percent of GDP.

21. In the fiscal area, the government needs to forestall an upward drift in current spending by refraining from further wage and pension hikes and retrenching redundant personnel. There is also a need to bolster expenditure controls and the Medium-Term Budgetary Framework, and to deepen other public financial management reforms. In the face of expenditure pressures, it will be particularly important to further strengthen tax administration, especially by securing prompt passage of the new tax code and resisting pressures to dismantle the Large Taxpayers Unit.

22. Safeguarding fiscal stability also hinges on limiting the fallout from the recent reduction in the retirement age. The authorities’ decision to phase in the provisions of the new law over a three-year period is a welcome first step, which needs to be accompanied by offsetting actions to keep the programmed fiscal path on course. Moreover, the government should rally broad support for a comprehensive pension reform geared at securing long-term financial viability of the pension system.

23. To keep inflation in check, the central bank needs to moderate the increase in monetary aggregates, by largely refraining from unsterilized intervention, continuing to enhance indirect monetary control instruments, and raising policy interest rates. Staff commends the authorities for the important steps taken thus far to bolster supervision and modernize the financial system. Going forward, staff advised the authorities to consolidate these reforms and to implement expeditiously the delayed measures envisaged in the program—especially enhancing the NBKR’s autonomy and privatizing KAFC.

24. While the administration has an impressive record of macroeconomic discipline, much remains to be done to achieve the rapid sustained growth required to raise living standards and ease the debt burden. These challenges are compounded by the diminished resource envelope as a result of the decision taken early this year to forego HIPC/MDRI debt relief. In these circumstances, the reform blueprint discussed with donors in late 2006 (as possible HIPC conditionality) continues to serve as a solid springboard for action. The authorities would now be advised to fully develop their reform agenda in advance of a Development Forum (including senior government officials, parliamentarians, donors and NGOs), which they plan to host in Bishkek at end-May. In particular, the authorities should focus on enhancing the business climate (including by resisting pressures to nationalize the mining industry); fostering good governance and transparency in public sector operations; rehabilitating the energy sector and implementing the long delayed increases in electricity tariffs; and improving the targeting and delivery of social services. In addition, the authorities need to refine the external debt management framework and persevere in building central and local government capacity.

25. Periodic clashes between the government and the opposition, which have distracted the authorities’ attention, highlight the urgency of resolving these tensions and rallying internal support for reforms. The country’s vulnerability to external shocks also poses a risk that could be further exacerbated by populist initiatives to increase state intervention in the economy—including in the key mining sector. In the staff’s views, these risks remain manageable and will be mitigated by continued engagement of the Fund and other donors in support of the government’s adjustment effort. On this basis, staff recommends completion of the fourth review under the PRGF arrangement.

Table 5.

Kyrgyz Republic: General Government Finances, 2005–07

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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.

Excludes transfers to the Social Fund.

Mainly privatization proceeds.

Table 6.

Kyrgyz Republic: State Government Finances, 2005–07:

(In millions of soms)

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

In 2005, the VAT and customs revenues were reclassified, leading to lower VAT and higher customs duty collections.

Mainly mineral resource tax and motor vehicle tax.

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

Includes carry-forward expenditure from previous fiscal year (som 994 million in 2004, som 945 million in 2005, and som 480 million in 2006).

Mainly privatization proceeds.

Table 7.

Kyrgyz Republic: Social Fund Operations, 2005–07

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

Includes payments to compensate vulnerable households for electricity tariff increases introduced in June 2002. GDP

Table 8.

Kyrgyz Republic: Medium-Term Expenditure Framework for General Government by Functional Classification, 2005-09:

(In percent of GDP)

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

Including PIP and net lending.

Excluding net transfers to the Social Fund, but including the contingency item for social compensation in case of electricity tariff increases.

Social Fund operations net of transfers to other funds.