Kyrgyz Republic
First Review Under the Three-Year Arrangement Under the Extended Credit Facility and Request for Modification of Performance Criteria: Staff Report; Staff Statement and Supplement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Kyrgyz Republic.
Author: International Monetary Fund
Publication Date:
14 Dec 2011
eISBN:
9781463929213
Language:
English
Keywords:
ISCR; CR; Three-Year arrangement; program adjustor; Three-Year; Kyrgyz authority; staff appraisal; Kyrgyz authorities; state government; broad money; debt service; current account; banking system
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The Kyrgyz Republic is emerging from a deep political crisis. In April 2010, a popular uprising toppled the previous regime and internal ethnic conflict in June 2010 exacerbated the already difficult political situation. The crisis has adversely affected economic activity and near-term growth prospects, straining the government’s financial position, which has been worsened further by critical reconciliation, recovery, and reconstruction needs. Continued growth in Russia and Kazakhstan, combined with high gold prices, contributed to an expansion in remittances and gold exports by 33 percent and 74 percent, respectively.

Abstract

The Kyrgyz Republic is emerging from a deep political crisis. In April 2010, a popular uprising toppled the previous regime and internal ethnic conflict in June 2010 exacerbated the already difficult political situation. The crisis has adversely affected economic activity and near-term growth prospects, straining the government’s financial position, which has been worsened further by critical reconciliation, recovery, and reconstruction needs. Continued growth in Russia and Kazakhstan, combined with high gold prices, contributed to an expansion in remittances and gold exports by 33 percent and 74 percent, respectively.

I. Recent Developments and Outlook

A. Political Context

1. The Kyrgyz Republic is emerging from a deep political crisis. In April 2010, a popular uprising toppled the previous regime and internal ethnic conflict in June 2010 exacerbated the already difficult political situation. The crisis adversely affected economic activity and near-term growth prospects, straining the government’s financial position, which was further worsened by critical reconciliation, recovery, and reconstruction needs. Parliamentary elections took place in October 2010 and a new coalition government took office in December 2010. Presidential elections took place on October 30, 2011 with the incumbent prime minister receiving over 63 percent of the votes. He is expected to serve a six-year term.1 Following the inauguration, which could be as early as December 1, 2011, all members of the cabinet will be acting until confirmed or replaced as a result of coalition talks. However, because the president-elect was instrumental in negotiating the ECF arrangement in his capacity as prime minister, staff expects no disruptions in program implementation.

B. Economic Developments and Program Implementation

2. The Kyrgyz economy is recovering strongly, while inflation is declining rapidly.2

  • Following the economic contraction in 2010, real GDP grew by 8.7 percent (year-on-year) in the first nine months of the year and is projected at 7 percent in 2011.3 Growth was broad-based and was driven by mining, manufacturing, and services. Despite this strong growth, however, unemployment remains a problem, especially among the youth (see Appendix).

  • Timely tightening of monetary policy, a rebound in agriculture, and retreating global food prices have helped to ease inflationary pressures.4 Inflation declined significantly from above 20 percent in July 2011 to 9.5 percent in October and is projected at about 7.5 percent at end-2011.5

  • Fiscal performance was strong during the first nine months of 2011. Tax revenue collections have increased by 30 percent compared to the same period of last year, partly because of a buoyant economy and high gold prices, but also because of administrative measures and improved customs valuation supported by the program. On the expenditure side, absorptive capacity constraints and uncertainty regarding the availability of financing led to a moderation in nonpriority spending, primarily on capital and goods and services outlays. As a result the end-June and end-September 2011 fiscal deficits were better than programmed: Som -0.2 billion at end-June 2011 versus programmed Som 4.0 billion and Som 4.0 billion at end-September 2011 versus the indicative target of Som 6.9 billion.

3. A favorable external environment helped to strengthen the current account during the first nine months of the year.

  • Continued growth in Russia and Kazakhstan, combined with high gold prices, contributed to an expansion in remittances and gold exports by 33 percent and 74 percent, respectively.

  • These developments combined with the tighter monetary policy stance led to appreciation pressures beginning in the second quarter of 2011 with the Kyrgyz som, strengthening by more than 6 percent against the U.S. dollar. In line with the NBKR’s exchange rate policy to smooth short-term volatility, the NBKR accumulated international reserves. However, appreciation pressures subsided subsequently mainly because of seasonal effects (the tourism season ends in the fall) and higher wages and pensions.

4. Financial sector performance is improving and problem bank resolution is progressing in line with program commitments.

  • The banking sector shows signs of revival with year-on-year credit and deposit growth of 16 percent and 17 percent, respectively, as of September 2011.

  • After reaching almost 17 percent in January 2011, nonperforming loans have declined to 11.4 percent in September, 2011, while capital adequacy remains sound and profitability indicators returned to their precrisis levels.

  • The external audit confirmed the solvency of Zalkar bank and its sale is progressing. Ongoing litigations due to weaknesses in the bank resolution framework impede a timely resolution of the four banks remaining under conservatorship.

5. Program performance has been strong. All quantitative performance criteria and indicative targets for end-June and end-September 2011 were met. All structural benchmarks for end-September and end-October 2011 were also observed (see Table 13).

Figure.
Figure.

Kyrgyz Republic: Macroeconomic Developments

Citation: IMF Staff Country Reports 2011, 354; 10.5089/9781463929213.002.A001

Source: Kyrgyz authorities, and Fund staff estimates and projections.

C. Medium-Term Outlook and Risks

6. Political stability and a broadly supportive external environment would allow the Kyrgyz economy to continue to grow in 2012.

  • GDP is projected to grow by 5.5 percent in 2012 and average about 5 percent in 2013–14, somewhat slower than previously projected to reflect recent developments in partner economies including Russia. Domestic demand fuelled by growing remittance inflows and a gradual recovery in private sector credit will underpin private sector-led growth, while ongoing structural reforms should help to foster more inclusive growth than in the past. External demand is expected to support nongold exports and the planned increase in gold output will provide an additional impetus to growth. Prudent fiscal and prudent monetary policies will help contain inflation to 6–8 percent in the medium term.

  • The current account balance is expected to improve. Exports are expected to continue to rebound with domestic stability and continued high gold prices, while remittances are likely to remain strong. However, imports will continue to grow, primarily as a result of strong economic growth and remittances, and because of large energy and mining related imports.

7. Nonetheless, risks to the outlook remain. Failure of the new government to demonstrate visible progress to reform governance and to achieve inclusive growth could destabilize the political situation. Slippages, including on fiscal policy and in the financial sector, are another source of vulnerability. The Kyrgyz economy also remains vulnerable to adverse terms of trade shocks, but could be partly insulated from a global downturn if that were to be accompanied by a sharp fall in oil prices (see the Box) or higher gold prices.

Global Uncertainties and Other Risks—How is the Kyrgyz Republic Affected?

The global economy has entered a dangerous new phase with risks elevated. While a deepening of the European crisis would have limited direct contagion effects, the Kyrgyz Republic would be exposed to possible second round effects of a slowdown in Europe/Russia/Kazakhstan growth and remittances. Unemployment and social tensions remain high in the aftermath of last year’s events, and policy buffers have been run down. However, while a global economic downturn will cause disruptions to the Kyrgyz economy, the negative impact is expected to be manageable.

Key assumptions:

  • A permanent external shock is assumed to bring oil prices down sharply to US$55 per barrel in 2012, increase to US$70 per barrel in 2013, and stay there in real terms for the remainder of the forecast (2016).

  • Growth in Russia is assumed to decline to -2 percent in 2012 with a slow recovery starting in 2013, in line with the scenario presented in the recent Article IV report (IMF Country Report 11/294).

  • Average gold prices are assumed to remain constant at the 2011 level of US$1582 per ounce, while gold exports (volume) remain unchanged from the baseline.

How would a global downturn affect the Kyrgyz economy?

  • The decline in remittances and exports would lead to a gradual depreciation of the som under the flexible exchange rate regime, with the central bank selling foreign exchange to mitigate large-scale downward pressure on the exchange rate. Inflation would also fall and the real effective exchange rate would depreciate, improving competitiveness.

  • Consumer and investor confidence is likely to take a hit and banks are expected to become more risk averse, prompting aggregate demand, including for imports, to shrink and economic activity to slow. Nonetheless, growth would likely remain positive at about 3 percent. Nonperforming loans in the banking system would rise by 2–3 percentage points. However, developments in Europe could affect confidence in local subsidiaries.

  • Lower oil prices would help improve the external position, and result in faster accumulation of foreign exchange reserves.

  • The pace of fiscal consolidation will be disrupted through lower revenues associated with lower growth and inflation. While some spending adjustment could take place, the room for maneuver will be limited in 2012, as commitments for 2012 have already been made and large wage and pension increases implemented this year have increased the share of nondiscretionary spending. Assuming no further revenue measures, more drastic expenditure adjustments would be needed from 2013, including on wages, to maintain fiscal sustainability.

uA01fig02

Growth

(In percent)

Citation: IMF Staff Country Reports 2011, 354; 10.5089/9781463929213.002.A001

uA01fig03

Current Account Deficit (in percent of GDP) and Reserves Cover (in months of imports)

Citation: IMF Staff Country Reports 2011, 354; 10.5089/9781463929213.002.A001

uA01fig04

Overall Fiscal Balance Excluding Energy Projects

(In percent)

Citation: IMF Staff Country Reports 2011, 354; 10.5089/9781463929213.002.A001

Impact of potential gold price volatility

  • As a gold exporter, the Kyrgyz Republic would be adversely affected if the global downturn was also accompanied by a sharp drop in gold prices (compared to the constant prices assumed above). For example, if gold were to lose one-third of its 2011 value in 2012 and through the medium term, the current account deficit would reach 6½ percent of GDP, reserves would deteriorate to 3.4 months of imports, and the overall deficit excluding energy projects would be about 3.6 percent of GDP in 2016.

Stand-alone financial sector stress testing

  • Stress tests conducted on the August 2011 banking sector data suggest that under a severe shock in which the NPL ratio deteriorates further to 35 percent (reflecting a peak observed across countries in past crises), the capital adequacy ratio of the banking system would decline to 13 percent.1 While at the system level this is still above the minimum capital adequacy ratio of 12 percent, a few banks would fall below this minimum and would require recapitalization of about 1 percent of GDP.

Overall, the prospects of another global crisis highlight the importance of rebuilding policy buffers, which would enable the Kyrgyz Republic to more easily absorb any adverse shocks.

1The stress-testing assumptions are as follows: credit risk—one category migration of nonperforming loans and one category migration of 100 percent of watch loans and 50 percent of satisfactory loans; foreign exchange risk—direct impact of the 15 percent depreciation and indirect impact of 30 percent of foreign currency loans becoming nonperforming; and interest rate risk—600 basis points increase on local currency and 250 basis points increase on foreign currency.

II. Policy Discussions

A. Fiscal Policy

8. The revised 2011 budget and the 2012 budget are appropriate. The overall deficit excluding foreign-financed energy infrastructure projects is unchanged compared to the program for 2011 and 0.8 percentage points of GDP lower than programmed for 2012.6 Strong growth, tax and customs measures, and high gold prices have allowed the authorities to increase spending, partly reflecting pre-election pressures, including an additional 20 percent increase in pensions from October 2011. This has brought the average pension to about 85 percent of the nationwide minimum subsistence level.7 However, some grant financed spending was delayed until the next year. Despite the pension increase, current expenditures are projected to be lower than programmed for 2011–12. Financing remains under pressure. The authorities have delayed the planned large-scale privatizations until next year to maximize sales proceeds and substituted the shortfall by drawing down government deposits at the NBKR. After repeated delays, the disbursement from the EURASEC Anti-Crisis Fund (ACF) in the amount of US$106.7 million is expected by the end-2011 (see LOI ¶5).

Text Table 1.

Kyrgyz Republic: General Government Budget, 2010–14

(In percent of GDP)

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Sources: Kyrgyz authorities, and Fund staff estimates.

Foreign financed energy infrastructure projects have been reclassified from net lending to capital expenditures (PIP loans).

9. Recognizing downside risks and in light of the stronger recovery, staff has urged the authorities to accelerate medium-term fiscal consolidation. This will help to rebuild fiscal policy buffers, which proved important to cushion the effects of previous adverse shocks. The tax policy reform and continued efforts to strengthen tax and customs administration will boost tax revenues. While the full-year impact of the recent pension increase will raise expenditures by about 1 percentage point of GDP in the medium term, adjustments in other areas including civil service reform are expected to more than offset this increase. Subsequently, the bulk of the adjustment will be in current spending, while capital expenditures financed from domestic sources will be maintained.8 As a result of faster fiscal consolidation and a successful renegotiation of the borrowing terms on the first phase of the foreign-financed energy infrastructure project, the debt outlook is expected to continue to improve.9

10. Invigorating Public Financial Management (PFM) reforms will strengthen fiscal governance and transparency and aid in the process of fiscal consolidation. The PFM reform will largely draw on the recently completed FAD technical assistance mission’s recommendations and cover measures to revitalize public financial management reform by strengthening the ministry of finance’s role in this process, revamp its organizational structure and reform treasury operations (see structural benchmarks, LOI ¶7).

B. Monetary Policy

11. Staff and authorities agreed that the tight monetary stance needs to be maintained until underlying inflation pressures subside. It will help to ensure that the concentration of fiscal spending in the remainder of 2011 does not create a large monetary overhang. In 2012, monetary policy should keep inflation in single digits. The authorities agreed that while headline inflation has been declining, supported by subsiding global food prices, continued strong remittance inflows and higher government spending and increased outlays on pensions and salaries will continue exerting upward pressure on core inflation. At the same time, the NBKR will continue to intervene in the foreign exchange market only to smooth excessive volatility. The ministry of finance and the NBKR have been closely coordinating their policies and this cooperation will need to be continued (see LOI ¶10).

C. Financial Sector Policies

12. On the back of improving system-wide financial stability indicators, the authorities’ actions will focus on resolving problem banks and addressing vulnerabilities going forward. In line with the agreed resolution plan, the authorities have initiated a sales procedure for Zalkar bank, which was found to be solvent. The second largest state-owned bank, Settlement and Saving Company (SSC), has expanded its balance sheet by 225 percent over the last 20 months, because many former Asia Universal Bank customers have moved to SSC and the government launched directed lending operations through this bank to support agriculture and business in the south that suffered damages during last year’s events. However, the pace of expansion and the directed lending have raised concerns as to whether lending standards have slipped. The NBKR has agreed to step up monitoring of SSC and take appropriate supervisory actions, as needed. Limiting capital injections for the purpose of extending such directed loans is important to constrain the bank’s overall asset growth (see LOI ¶11). To address regulatory shortcomings revealed in the aftermath of the 2010 crisis, the legal reforms envisaged under the ECF-supported program are under way. Moreover, the (Swiss) State Secretariat for Economic Affairs (SECO) will fund a Legal Resident Advisor who will assist in codifying 5–6 banking laws and advising the authorities on improving basic legal operations of the NBKR.

D. Other Structural Reforms

13. In line with their program commitment to prepare a poverty reduction strategy paper (PRSP), the authorities have recently presented the first draft of the Medium-Term Development Program (MTDP) (see LOI ¶3). The final document, together with the Joint Staff Advisory Note (JSAN) will be presented to the Board together with the second review, expected in early May of next year.

14. While the Kyrgyz government expressed an interest in joining the Belarus-Kazakhstan-Russia customs union, timing of accession remains uncertain. Kyrgyz authorities have expressed concern that premature accession to the customs union may entail job losses in the trade sector, which employs a significant share of the local population. In the format of working level meetings with the customs union secretariat, both procedural issues related to the Kyrgyz Republic’s WTO membership and options for mitigation of economic consequences from the accession are being discussed.

15. The authorities are contemplating the establishment of a development bank to encourage the development of underserved sectors of the economy. The authorities have committed to consult closely with Fund staff and other development partners once a proposal is available and will ensure that any such institution is in line with their program commitments (see LOI ¶9).

III. Program Issues

16. Program design and modification of performance criteria. The review schedule and phasing of disbursements is outlined in Table 10. New quantitative performance criteria (QPC) and indicative targets for end-June and indicative targets for end-September and end-December 2012 have been proposed (see LOI Table 1). The authorities are requesting an upward modification of the QPC on the NBKR’s net international reserves for end-December 2011 reflecting higher-than-expected foreign-exchange inflows with the subsequent modifications in the QPC on the NBKR’s net domestic assets. In addition, they are requesting an upward modification of the QPC on the general government overall deficit targets for end-December 2011 to reflect the advancement of the foreign-financed energy infrastructure project. Moreover, in light of the successful renegotiation of the borrowing terms on the first phase of this project (in the amount of US$208 million), the authorities are requesting a downward modification of the ceiling on contracting or guaranteeing of new nonconcessional external debt by the public sector. The structural conditionality—existing and proposed—is summarized in LOI Table 2. The new structural benchmarks aim to support the authorities’ PFM reform efforts.

17. Program monitoring will continue to be performed on a semi-annual basis. The second review will be based on continuous and end-December 2011 QPC and the third review on continuous and end-June 2012 QPC. Structural conditionality will focus on macro-critical areas, particularly public financial management reform, public debt management, completion of problem bank resolution, and strengthening bank resolution legal framework and safeguards (see LOI Tables 1 and 2).

18. Financing. The program is fully financed for 2011 and 2012. The ECF will fill the residual balance of payments gap. As requested by the authorities and envisaged at the approval of the arrangement, the second disbursement will be directed to the budget.

Text Table 2.

Kyrgyz Republic: Balance of Payment Financing Gaps, 2011–14

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Source: Kyrgyz authorities, and Fund staff estimates.

19. The recently completed safeguards assessment update highlighted some areas for improvement in NBKR operations. The update with respect to the new ECF was completed on October 28, 2011. The assessment concluded that the NBKR has established important safeguards in financial reporting, external and internal audits. While the chairperson is accountable to parliament, governance arrangements need to be strengthened by establishing independent board oversight and more effective reporting by the audit committee that became operational following the 2009 assessment. The proposed new Banking Code also presents an opportunity to strengthen institutional autonomy and giving the NBKR sole responsibility for the governance of official foreign exchange reserves. Based on the assessment’s recommendations, amendments to the law on NBKR, which will be prepared as part of the ongoing work on the new Banking Code, will include provisions on establishing the NBKR’s sole authority to hold and manage official foreign reserves and an extended term of engagement for the NBKR external auditors (see structural benchmarks, LOI ¶12).

IV. Staff Appraisal

20. Strong adherence to the policies agreed under the Fund-supported program has played a pivotal role in achieving post-conflict economic recovery and macroeconomic stabilization. Real growth was close to 9 percent in the first nine months of 2011, broad-based, and one of the highest in the Commonwealth of Independent States (CIS), albeit starting from a low base. As a result, fiscal revenues have improved markedly. Inflation, which exceeded 20 percent for a few months and was the highest in the region, has declined to 9.5 percent as of October 2011. Moreover, financial sector indicators have been improving gradually and the banking sector has resumed growth.

21. Better governance and institutions are essential for a continued strong economic performance in the medium term. Combating corruption and creating a vibrant public service, ensuring compliance with the regulatory framework, and building strong key public institutions will remove significant barriers to growth. Staff stands ready to discuss with the authorities the creation of a development bank, to ensure that any such institution is in line with the ECF-supported program and will not jeopardize macro-financial stability. The setup of the development bank should be in line with international best practice to avoid recent negative experience with similar development vehicles.

22. The 2011 budget reflects election year priorities; going forward, fiscal consolidation should ensure restraint in current spending. Large increases in wages and pensions this year have helped to mitigate social tensions and contributed to fostering political stability. In the medium term, the authorities will need to withstand popular pressures and limit current spending, while beefing up investments in public infrastructure, which have long-term growth effects. Moreover, given the uncertain global economic outlook employing conservative budgeting principles is needed to ensure fiscal sustainability. Such an approach will allow the authorities to avoid painful spending adjustment later in the event that external risks materialize. This will also help maintain sufficient flexibility to respond to adverse shocks.

23. Tight monetary policy is warranted to counteract this year’s pre-election spending and strong remittance inflows. Although headline inflation is on a firm downward trajectory, the NBKR needs to avoid excessive money growth prompted by fiscal spending and foreign exchange inflows. Moreover, close coordination between the monetary and fiscal authorities will be important to ensure a smooth implementation of monetary targets.

24. Bank supervision needs to be strengthened and heightened vigilance is needed to monitor potentially vulnerable banks. This in particular refers to the state-owned SSC bank, whose assets continue to grow rapidly due in part to the directed lending to the south following last year’s events, but closer monitoring of other systemically important banks, including those with foreign ownership, is also needed. Resolution of Zalkar bank in line with program commitments is an important test to restore credibility in the system and improve investor confidence. The planned legal reforms will help to remove shortcomings in the bank resolution framework. Banking supervision capacity needs to be strengthened through increased resources and training.

25. The Kyrgyz Republic maintains a multiple currency practice (MCP), which predates the arrangement, arising from the use of the official exchange rate for government transactions. The official rate may differ by more than 2 percent from market rates because it is based on the average transaction weighted rate of the preceding day. In practice, the official and market rates have never differed by more than 2 percent. Staff does not recommend approval of this MCP.

26. Staff recommends completion of the first review and approval of the request for modification of the performance criteria for end-December 2011. Policies for the remainder of 2011 and 2012 are appropriate to achieve the program’s objectives.

Table 1.

Kyrgyz Republic: Selected Economic Indicators, 2009–16

article image
Sources: Kyrgyz authorities, and Fund staff estimates and projections.

General government comprises State Government, Social Fund and Development Fund (starting from September 2009) finances. State government comprises central and local governments.

Calculated at end-period exchange rates.

12-month GDP over end-period broad money.

Interest rate on 3-month treasury bills.

Table 2.

Kyrgyz Republic: Balance of Payments, 2009–16

(In millions of U.S. dollars)

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

Projected budget support is included in the financing gap.

Includes return of KRDF investments abroad.

Public and publicly-guaranteed debt.

Net of rescheduling.

Valued at end-period exchange rates. The discrepancy between the difference in year-end stocks and the change in reserves under financing is caused by movements in prices and exchange rates.

Table 3.

Kyrgyz Republic: NBKR Accounts, 2009–12

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Source: Kyrgyz authorities, and Fund staff estimates and projections.

Contribution is defined as change of asset stock relative to previous end-year reserve money stock (in percent).

Table 4.

Kyrgyz Republic: Monetary Survey, 2009–12

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

Contribution is defined as change of asset stock relative to previous end-year broad money stock (in percent).

12-month GDP over end-period broad money.

Table 5.

Kyrgyz Republic: General Government Finances, 2009–14

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

In 2009, the road, emergency and retail taxes have been abolished, the VAT tax rate reduced from 20 to 12 percent, and a new turnover tax introduced. Median turnover tax rate was reduced from 2.5 percent to 2 percent from January 1, 2010.

Foreign financed energy infrastructure projects have been reclassified from net lending to PIP loans.

Includes costs of SSC bank capitalization of KGS 400 million in 2011.

Negative numbers indicate outflow of assets overseas.