Statement by Mr. Heller, Executive Director on Kyrgyz Republic, and Mr. Imashov, Advisor to the Executive Director, June 17, 2016

External shocks continue to shape both the outlook and policies. A weaker-than-expected external environment is hurting growth, straining the budget, and raising public debt and banking sector vulnerabilities. The authorities' response to shocks has focused on exchange rate flexibility and unorthodox stimulus measures, although the budget deficit in 2015 was well within the program target. For 2016, the authorities are undertaking additional efforts to adhere to the program's fiscal commitments. Financial sector vulnerabilities and risks are high and rising. Slow progress toward passing the Banking Law that aims to introduce a modern bank resolution system and increase the independence of the National Bank of the Kyrgyz Republic remains a concern. The change in the cabinet just six months after the elections underlines the fluidity of the country's political situation.

Abstract

External shocks continue to shape both the outlook and policies. A weaker-than-expected external environment is hurting growth, straining the budget, and raising public debt and banking sector vulnerabilities. The authorities' response to shocks has focused on exchange rate flexibility and unorthodox stimulus measures, although the budget deficit in 2015 was well within the program target. For 2016, the authorities are undertaking additional efforts to adhere to the program's fiscal commitments. Financial sector vulnerabilities and risks are high and rising. Slow progress toward passing the Banking Law that aims to introduce a modern bank resolution system and increase the independence of the National Bank of the Kyrgyz Republic remains a concern. The change in the cabinet just six months after the elections underlines the fluidity of the country's political situation.

On behalf of our Kyrgyz authorities, we would like to thank staff for the high quality reports, and Executive Directors and Management for their continued support to the Kyrgyz Republic. The authorities are highly appreciative of the Fund’s continued engagement with them and agree with staff’s analysis and recommendations. Despite the challenging external environment, the authorities have stayed the course on their reform agenda. All end-December quantitative targets were met, and all but two structural benchmarks were also met. Going forward, the authorities remain fully committed to the policies and objectives of the arrangement under the Extended Credit Facility. On the basis of this satisfactory performance and continued commitment to the program, the authorities request the completion of the second review, as well as the modification of performance criteria given the weaker macroeconomic outlook.

Recent economic developments

Adverse external shocks continue to strongly impact the Kyrgyz economy, with the regional environment weaker than anticipated at the end of last year. While oil and other commodity prices have been recovering somewhat recently, albeit from a low base, weaker growth and currencies in key trading partners have continued to weigh significantly on the economy. Output growth in the Kyrgyz Republic has slowed down further in this challenging external environment. From strong growth of 10.2 percent in 2013, growth slowed down in 2014 and 2015, while remaining positive in the turbulent regional context. Real output grew by 3.5 percent in 2015, with nongold growth better than expected at 4.5 percent, helped by construction, trade, and agriculture.

The National Bank of the Kyrgyz Republic (NBKR) kept monetary policy on a tight stance to contain inflation and alleviate exchange rate volatility. Exchange rate flexibility was instrumental in mitigating the impact of external shocks on the Kyrgyz economy. The policy rate was raised to 10 percent and the NBKR undertook necessary interventions to smooth excessive exchange rate volatility in the last quarter of 2015. Since the beginning of 2016, the impact of the rebound of oil prices in major trading partners, together with the prudent monetary policy measures, allowed the som to appreciate by 7.7 percent between January and March. As a result, the NBKR could lower the policy rate to 8 percent at the end of March, and further to 6 percent at the end of May, and start rebuilding reserve buffers by purchasing U.S. dollars on the foreign exchange market. Following its large depreciation in 2015, the real effective exchange rate is assessed to be broadly in line with fundamentals. The overall fiscal deficit for 2015 reached 1.2 percent of GDP, well below the program’s target of 3.5 percent of GDP. Nonpriority spending was partially postponed to 2016 due to delays in donor support, while revenues were higher than expected. In the first five months of 2016, fiscal performance was better than anticipated, with higher tax and grants revenues and lower current and development expenditures.

The current account deficit narrowed to 10.4 percent of GDP in 2015, largely driven by a significant drop in imports, which more than compensated the fall in remittances. While falling by 25 percent in dollar terms last year, remittances have started to recover recently, with positive growth in ruble terms, notably due to the more favorable treatment of migrant workers from the Kyrgyz Republic in the Russian Federation, and the appreciation of the som against the U.S. dollar in the latest few months. Between October 2015 and April 2016, remittances increased by 19 percent in ruble terms and the number of registered Kyrgyz workers in the Russian Federation increased by 10 percent.

Fiscal policy: a matching goal of consolidation of public finances and debt sustainability

In line with the commitment made at the time of the first review, the fiscal deficit target for 2016 remains unchanged at 4.5 percent of GDP. Despite adverse developments last year, the authorities remain committed to their deficit target and have reinforced their efforts to find new measures to reach this target. They are pursuing a balanced approach of enhancing tax revenue collection and rationalizing public expenditure. Earlier this year, work has started to prepare an action plan to mobilize additional revenues and continued to prioritize the investment budget and improve its efficiency. These measures brought down the deficit target substantially, but a gap of 1.5 percent of GDP still remained. More recently, therefore, further measures have been identified to close this gap. Should any shortfall emerge from these measures, the authorities will reduce expenditures in an equivalent amount in order to ensure that they meet their fiscal target.

On the revenue side, new measures include strengthening the VAT administration, reviewing the system of tax exemptions in order to streamline them, and in the meantime, refraining from extending expiring exemptions or granting new ones. Moreover, the authorities are harmonizing excise tax rates on alcohol and tobacco products with some EEU countries, considering introducing excise stamps for domestically produced goods, and considering the introduction of a luxury tax for properties. In addition, the authorities are requesting Fund technical assistance to review the taxation of natural resources and international legal entities to prevent illicit flows.

On the expenditure side, streamlining nonpriority current expenditures will continue, in particular for goods and services and domestically financed capital spending. For this purpose, a new e-procurement system was introduced, which will help to substantially rationalize nonpriority expenditures. The targeting of social benefits will be improved to raise pro-poor spending.

The authorities remain committed to gradually reducing the public wage bill to 8 percent of GDP by 2018. To this effect, an action plan for the reform of the public sector personnel and remuneration policy has been finalized. Next, the authorities will set up a comprehensive register of all public employees by March 2017. As a first step, the register will cover health and education employees. Then, the action plan will be further developed to undertake a functional review of the main sectors, including an assessment of staffing needs and remuneration policies.

The efficiency of public sector investment will be enhanced based on the recommendations of the recent PIMA. In this area, measures focus on strengthening the planning and prioritization of projects, upgrading the monitoring framework and improving budget practices to avoid projects being stalled or stranded. The government will modify by decree the decision-making process for the selection of public investment projects by formalizing the roles of the Ministry of Economy for the evaluation of projects, and the Ministry of Finance for the financing. The PIP guidelines will be updated accordingly and a standardized framework for project monitoring of physical and financial performance will be introduced for all projects exceeding KGS 50 million.

While debt remains at a moderate risk of debt distress, the depreciation of the som in 2015 has exacerbated debt vulnerabilities further. The authorities are cognizant of the need to ensure debt sustainability. To this end, they will refrain from nonconcessional borrowing, improve debt monitoring, and undertake remedial actions to maintain external public debt at a moderate risk of debt distress.

Monetary and exchange rate policies

Monetary policy will continue to focus on containing inflation within the NBKR’s targeted range of 5-7 percent. The NBKR will adjust the policy rate in line with emerging pressures and is, at present, balancing the need for policy relaxation stemming from the recent drop in headline inflation, the moderation of credit growth, and weaker growth prospects, against the potential of fiscal and exchange rate pressures. The NBKR and the Ministry of Finance will continue strengthening their coordination to improve liquidity management.

The authorities remain committed to further improving the operational framework for monetary policy and enhancing the transmission mechanism. In that context, the authorities will consider narrowing the corridor around the policy rate and make it more symmetric. At the same time, measures will be undertaken to deepen the interbank market by maintaining liquidity at a level that provides incentives for interbank trading, and allowing NBKR notes to be used as collateral in the interbank market.

Exchange rate flexibility has helped reduce external imbalances, enhance competitiveness, and prevent a rundown of external buffers. The NBKR stressed the need to balance the objectives of financial sector stability and exchange rate flexibility. At the same time, the NBKR remains committed to limit interventions in the foreign exchange market to only smoothing excessive fluctuations, along with introducing new monetary and hedging instruments. The authorities agree on the need to rebuild reserves to about four months of imports, given the country’s vulnerability to shocks and the high dollarization. In recent months, the NBKR has already made sizeable progress to this effect.

Financial sector

Financial sector developments will continue to be monitored for emerging risks associated with foreign exchange volatility, dollarization, and the economic slowdown. The monitoring of nonperforming loans will be improved by collecting additional information from banks. Moreover, additional measures will be undertaken to align legislation with international best practice. Further consideration will be given to the classification of the prolonged loans category, the differentiation between performing and nonperforming restructured loans and the introduction of a new category for loans issued to refinance NPLs.

A crisis preparedness framework will be set up, including establishing a high-level financial stability council (FSC). As a first step, an analysis will be performed of the tasks, functions and regulation of the FSC, consistent with Kyrgyz legislation. The key components of the framework include coordinating arrangements between relevant agencies, supervisory remedial actions, as well as an effective financial resolution system and depositor safety net. To test and possibly improve coordinating arrangements, a crisis simulation exercise will be conducted with the help of the World Bank.

The authorities are committed to strengthening and implementing an AML/CFT regime in line with international standards. A draft law on combating the legalization of proceeds from crime, financing of terrorist and extremist activities, which incorporates the main recommendations from IMF experts, is in the process of being submitted to parliament. Timely action through the adoption and publication of the law should contribute to a positive assessment by the Eurasian Group on Combating Money Laundering and Financing of Terrorism during 2016–17.

The audit of DEBRA and the insolvent banks under its management has been completed, albeit with a delay for reasons largely beyond the control of the authorities. The next step is to proceed according to the law with the liquidation of these banks.

Structural reforms to lift long-term growth

The authorities firmly believe that improving the business environment is key to withstanding external shocks, attracting investment and generating inclusive growth. In order to realize the full benefits from EEU membership, efforts will be continued to address weaknesses in the business environment.

A stable and predictable investment climate with proper contract enforcement, strong property rights, less red tape and corruption are essential for attracting investment and spurring private sector-led growth. Additionally, an anti-crisis action plan has been developed to address the weak outlook and external shocks.

Reforming the energy sector is essential to ensure better service delivery and putting it on a sound economic footing. To this effect, efforts will be pursued to improve the governance aspects of the sector by introducing a transparent cash settlement mechanisms monitored by the State Regulatory Agency for Fuel and Energy sector, and increasing the human and financial resources available to the Regulatory Agency to match them to the entity’s functions and ensure proper functioning of the regulatory framework, among other things.