Concluding Statement of the IMF Mission to the Kyrgyz Republic (in the Context of the 2004 Article IV Consultation)

Bishkek, August 25, 2004

1.             An IMF mission visited Bishkek during August 13-25 for discussions under the IMF’s Article IV consultation process. Topics included recent and prospective economic developments, policy options for sustained growth and stability, and internal and external risks. The mission also assisted the government in the preparation of the 2005 draft state budget.

2.             The Kyrgyz Republic is enjoying strong economic performance, reflecting a generally favorable external economic environment and several years of prudent fiscal and monetary policies. With appropriate policies, the mission believes annual growth rates of 5 to 6 percent can be achieved over the next several years, with a further reduction of poverty. However, several challenges loom ahead: an anticipated sharp decline in gold exports; a heavy external debt burden; weaknesses in governance; and the fight against corruption.

3.             Strong macroeconomic performance has contributed to a sharp decline in poverty rates, from 55 percent in 1999 to 41 percent in 2003. Outside of the volatile gold and energy sectors, real GDP growth averaged nearly 4½ percent during 2000-03, underpinned by improved productivity. Inflation was brought below 10 percent in 2001 and has remained below 5 percent since 2002. External current account deficits have been moderate in recent years and the exchange rate of the som has gained strength. Continued strong performance so far in 2004—including real growth of 9 percent in the first half of the year—led this mission to raise its 2004 growth projection by 1 percentage point to 5½ percent, despite an anticipated decline in gold exports in the second half of 2004.

4.             Rapid remonetization of the economy is among the main recent macroeconomic achievements. The expansion of real money demand by some 20 percent on average during 2002-03 has been met by balance of payments inflows, rather than by an expansion of the domestic component of money supply. Indeed, the NBKR’s gross official reserves rose to a comfortable level equivalent to 4.7 months of imports by June 2004. Rapid growth of private sector credit is supporting investment, although the ratios of private sector credit and broad money to GDP remain low by international standards. Financial sector soundness indicators suggest an improving banking system, albeit at a slow pace.

5.             The mission welcomes the recent sale of state-held Kyrgyz Altyn shares in Centerra and the reduction of the government role in the mining sector, and looks forward to the imminent and complete transfer of proceeds from this sale to a government account with the NBKR. After payment of fees and other costs incurred in the process, this transfer will amount to about $78 million, with part of the proceeds to be used by the state budget for additional spending equivalent to 0.3 percent of GDP annually in 2005-07 on investments in health and education, and to address existing obligations to depositors of failed banks.

Medium-term outlook and risks

6.             The mission’s 2004-07 baseline macroeconomic scenario assumes continued sound financial policies and ambitious implementation of structural reforms. The external environment is expected to be supportive, with growth rates averaging 7 percent in the country’s key export markets of China, Kazakhstan, and Russia. Despite projected favorable gold prices, high oil prices may cause a modest deterioration in the terms of trade, although additional export demand from Kazakhstan and Russia would mitigate this impact. The baseline scenario foresees a decline in gold exports restraining growth to 5 percent in 2005, but real growth rates of 5-6 percent for several years thereafter. Growth will depend critically on new gold projects coming on stream and on policies to ensure a favorable business climate, especially for small and medium-size enterprises.

7.             The baseline scenario also assumes balance of payments financing by donors to fill annual financing gaps of 2½ to 3 percent of GDP in 2005-07 and somewhat smaller gaps thereafter. This financing could include further debt relief from the Paris Club—to be considered in early 2005—and financial support from the IMF, World Bank, and Asian Development Bank.

8.             The mission discussed with the authorities key risks to this macroeconomic scenario, which fall into four broad areas: (1) a substantial negative shock to the terms of trade, such as a protracted period of high oil prices or a drop in gold prices; (2) a sharp slowdown in partner countries’ import demand; (3) a decline in remittances from Kyrgyz working abroad, which are now estimated at least at the equivalent of 5 percent of GDP; and (4) a loss of confidence in the banking system, such as could result if high rates of private sector credit growth lead to weak loan portfolios. Although the mission and authorities were of the view that each such risk at present had low probability, it was important to prepare contingency plans in the event there are signs they begin to materialize.

9.             The mission supports the government’s intention to reduce the state government cash fiscal deficit to 4.4 percent of GDP (4.0 billion soms) in 2004, compared to the 2003 outcome of 5.2 percent of GDP, and to further reduce the deficit to below 3½ percent of GDP by 2007. State government tax revenues have risen from 12.4 percent of GDP in 2001 to a projected 14.7 percent this year, and achieving the intended pace of fiscal consolidation will require generating an additional ½ percentage point increase by 2007. The recent good tax revenue performance is due to rapidly growing VAT collections on imports as a result of both improved customs administration and strong import growth. The revenue effort must now be extended to other state tax collections, which have performed below targeted levels. The agricultural VAT and the real property tax adopted in early 2004 have been implemented reluctantly, with predictable results for revenues, and the government has not yet presented credible alternatives to these measures.

10.         The mission supports the process underway to revise the tax code and to improve the efficiency of small business taxation. Revisions to the tax code should aim to remove inconsistencies and ambiguities in tax laws and to broaden the coverage of the code. They should also substantially simplify small business taxation, taking into account the need to realign the VAT and small business tax thresholds, and eliminate the present patent tax system. The mission recommends that procedures for VAT refunds be streamlined to address one of the key concerns of the Kyrgyz business community.

11.         The mission identified scope for reducing the payroll tax rate beginning in 2005 in order to address excessive labor taxation, reduce incentives for misreporting income, and attract more economic activity into the formal sector. In the mission’s assessment, pensions could nevertheless grow in 2005 by several percentage points more than inflation (although less than in 2003 and 2004) while maintaining state budget transfers to the Social Fund at broadly unchanged levels in 2005.

12.         Achieving the fiscal deficit consolidation path articulated by the government also requires containing state government expenditures while ensuring adequate public investment and spending on poverty-reducing social programs. Expenditures should not exceed programmed levels and the government should ensure expenditure discipline as elections draw nearer. A sustained improvement calls for developing adequate controls over expenditure commitments and strong public institutions.

13.         Budget plans should target a reduction in the ratio of state government expenditures to GDP, from a projected 23½ percent in 2004 to 22½ percent by 2007. Continued streamlining of the foreign-financed PIP component is critical to the external debt strategy. The mission would support higher foreign-financed expenditures in the event that grants can be found to finance valuable projects. Overall investment spending should nonetheless be maintained at around 4½ percent of GDP through faster growth in domestically-financed investment spending. This would partly be achieved by the allocation of receipts from the sale of Centerra shares to investment projects in the health and education sectors. In the mission’s view, the 2005 budget should have a strong poverty reduction and social emphasis. More analysis is needed in the coming months to precisely define the scope for, and allocation of, government wage and social expenditure increases. At the same time, an action plan should be prepared for a medium-term government wage to ensure that a professional civil service has a competitive remuneration mechanism to prevent a deterioration of the quality of the civil service.

14.         Macroeconomic forecasting should be conducted in the Ministry of Finance, where it has traditionally been located and where it can best be integrated into budget projections and budget management.

15.         The NBKR’s monetary policy implementation has been a key factor behind the country’s sustained macroeconomic stability. The mission and authorities shared the view that the present managed float exchange rate arrangement is appropriate. Price stability should remain the main objective of monetary policy also in the coming years. Competitiveness has been maintained by productivity growth and low inflation relative to that of key trading partners. Projected high levels of NBKR official reserves allow some scope for de-emphasizing further reserves accumulation in the medium term. In the event of emerging inflation pressures, however, the NBKR should limit its intervention in the foreign exchange market to smoothing temporary variations in the nominal exchange rate and tighten monetary policy through open-market operations. We encourage the NBKR to continue its work modernizing the payments system and recommend that the NBKR and MINFIN jointly explore paying government wages through the banking system.

16.         Despite recent rapid credit growth, financial soundness indicators do not indicate any immediate banking vulnerabilities. Stress tests undertaken by the mission suggest that credit risk remains important. Growing foreign ownership and sustained macroeconomic stability are helping to strengthen the Kyrgyz banking system. Foreign banks, many with high-quality staff and a well-developed product base, are expected to enhance competition in the sector and broaden the available range of banking services. However, the large foreign ownership presence presents challenges to the supervisory framework of the NBKR, which needs to develop its relationships with home country supervisors and revise its regulatory framework for sharing financial and other relevant information.

17.         Excessive credit growth in the future could threaten banking system stability and the mission encourages the authorities to closely monitor credit developments and their impact on the quality of banks’ loan portfolios, and to be ready to act quickly in the event that pressures emerge. In this context, the mission and authorities discussed means to deepen the government securities market as a means to provide banks with alternative investment opportunities that could help moderate rates of credit growth. Forthcoming technical assistance from the IMF’s Monetary and Financial Department will be timely in this respect.

18.         The mission welcomes the smooth privatization process regarding Kairat Bank. The mission reviewed the financial situation of KAFC and believes that a further assessment of the policy options for KAFC’s future—including options such as its privatization and  the issuance of a banking license—could be explored and decided in the coming months. Progress was made in discussions on a prospective deposit insurance scheme, including the specific conditions that should precede the introduction of such a scheme. These discussions will be resumed in the context of the upcoming review under the PRGF-supported program.

19.         Recent debt simulations by the IMF staff indicate that further Paris Club debt relief is necessary for a return to external debt sustainability. To be successful, however, such debt relief must be accompanied by prudent macroeconomic policies, as outlined above, with further fiscal consolidation needed to bring about a decline in external borrowing requirements. The mission discussed with the authorities the debt thresholds appropriate for the country, taking into account the country’s institutional capacity and the quality of its policies, as reflected in the World Bank’s CPIA ratings and other indicators.

20.         The mission applauds the liberal trade regime maintained by the Kyrgyz Republic and believes that liberal trade policies are in the country’s best interest. It welcomes recent agreements with Kazakhstan that serve to liberalize transit of Kyrgyz goods through Kazakh territory—a critical step for Kyrgyz exports to Russia and other markets; however, more work is needed to make these measures truly effective. The mission welcomes indications that the external tariff of the Eurasian Economic Community (EAEC) remains subject to further changes and  urges the authorities to work with their EAEC partners to ensure that the Kyrgyz Republic continues to abide by its existing WTO commitments.

Structural policies

21.         Structural reform areas key to investment and growth prospects include governance, the electricity sector quasi-fiscal deficit, and oversight and governance of the mining sector. The mission encourages the National Integrity Council to develop an action plan with objective, monitorable, and time-bound measures aimed at reducing corruption and improving governance. Large, sustained quasi-fiscal deficits in the electricity sector sharply reduce the scope for alternative fiscal policies and keep enterprises with weak financial discipline afloat. The mission urges the authorities to work closely with the World Bank and other experts to reduce the quasi-fiscal deficit to below 9 ½ percent of GDP this year, compared to over 11 percent in 2003. Regarding the mining sector, the mission looks forward to the first semi-annual report on Kyrgyz Altyn’s financial data and completion of a risk assurance and control audit of Kyrgyz Altyn’s 2002-03 accounts, both of which are expected by end-September. The upcoming reorganization of mining sector supervision in line with earlier World Bank recommendations would go far toward ensuring that licensing and other government actions in the sector are undertaken transparently.

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22.         The mission notes the strong cooperation received from the Kyrgyz authorities, who welcomed and were responsive to the mission’s recommendations. The mission would also like to express its appreciation for the authorities’ friendly hospitality.