Kyrgyz Republic and the IMF
1. The macroeconomic stabilization and structural adjustment efforts of the Kyrgyz authorities in recent years have been supported by the IMF, the World Bank, the Asian Development Bank (AsDB), the European Bank for Reconstruction and Development (EBRD), and a number of bilateral and other multilateral donors. This Policy Framework Paper (PFP) elaborates on an earlier draft in a number of key policy areas.1 It reviews progress under the first annual program under the Kyrgyz Republic's successor ESAF arrangement, forms the basis of the program to be supported under the second annual arrangement under the Poverty Reduction and Growth Facility, and outlines general objectives and adjustment policies for the period 2000-2002. Discussions on a second-year program started in May 1999, however, due to unforeseen developments finalization of the document was somewhat delayed.
2. Until the Russian economic and financial crisis, program implementation was broadly satisfactory. Since then, the crisis has exposed the vulnerability of the Kyrgyz economy to external shocks and at the same time, highlighted the deep-seated problems of a land-locked country that continues to depend heavily on its former trading partners, where the private sector remains relatively undeveloped, and where budgetary rigidities affect the allocation of scarce public resources. In the event, while real GDP growth is expected to remain modest at around 2 percent over the course of this year, a range of other indicators suggest a deterioration of economic performance more generally: inflation has picked up (now running at around 36 percent compared with 12 percent in 1998) in the face of a substantial depreciation of the som (by around 65 percent since a year earlier); the budget deficit on an cash basis is expected to decline only marginally this year and at around 12 percent of GDP it is still high; the current account deficit is projected to improve this year, albeit from 20 percent of GDP a year ago; and external debt is imposing a heavy burden.
3. The banking sector has experienced serious difficulties since late 1998, due to loan repayment problems of several borrowers following the depreciation of the som, and as a result of a number of banks' direct and indirect exposure to the troubled state gas company. Two banks were closed earlier this year and two additional (small) banks were placed under NBKR administration in August of this year. Consequently, public intervention has become necessary to protect depositors.
4. Several important structural policy measures were undertaken during 1998. First, there was a change to the constitution that allowed for full private ownership of land. The positive impact of this measure, however, will be delayed, due to a moratorium on land sales to allow time to implement changes to a number of land laws and to prevent speculation while the new owners (including farmers) become familiar with the benefits of private ownership. Second, the Kyrgyz Republic acceded to the World Trade Organization, becoming the only CIS country to do so thus far. Third, supported by the World Bank and other international donors, adjustments to the national pension scheme were undertaken to enhance its viability. Fourth, in early 1999, again in cooperation with international donors, the government adopted a comprehensive plan for the restructuring and reform of the financially troubled state-owned energy company, KyrgyzEnergo. The government also introduced a number of measures to bring Kyrgyz Airlines closer to cost recovery levels (airfares were increased, an airport fee for international flights was introduced, and a lease for two new airplanes was canceled); it began to review options on how to restructure and reform the gas sector; and an international tender for Kyrgyz Telecom was announced. More recently, although initiatives were taken to strengthen banking supervision and to reduce the burden of business licensing to promote private sector activity, overall progress in structural reform targeted under the proposed program has been slow. This lack of progress is associated with a number of factors, including financing issues and ongoing discussions with creditors and donors on the modalities of specific adjustment programs (particularly in public utilities and privatization) and the need to settle legal questions.
5. Given the adverse impact of the Russia crisis, a dramatic increase of external debt, and the relatively slow adjustment of the private sector to measures taken since independence in 1991, the main aim of the authorities is to achieve a sustained improvement in economic performance through deepening reform, coupled with efforts to improve living conditions of the poorest segments of the population. Over the medium term, important elements in this regard will cover policy measures that: encourage balanced growth, with a gradual reduction in the dependence on external financing (including through the Public Investment Program, PIP); improve the decision-making process both in the public and private sector; promote private sector development and structural change; and enhance the quality of life through fair and affordable social policies and investments in health and education.
6. While the private sector should be key for growth, the government recognizes that public investment will play an important role as well. However, there are limited domestic resources and implementation capacity in the country, which requires prioritization among the large and increasing number of PIP projects financed by the international donor community. Without prioritization, the implementation of these projects may go off-track, and the accumulation of foreign debt will become unsustainable. Within this context, the main challenge of the government will be to design and implement growth-enhancing and poverty-reducing policies.
7. Targeted improvement in the social indicators will be reached via better and more efficient use of budgetary resources and the achievement of the annual economic growth targets of about 4-5 percent over the medium term. To avoid unsustainably high domestic and external public debt ratios, the budget deficit needs to be reduced to below 6 percent of GDP in 2002, requiring a concerted effort at fiscal consolidation. The inflation rate is targeted to decrease gradually to around 7 percent in 2002, and in line with this, a tight monetary policy will be pursued. This will be combined with greater efforts to improve the banking sector, after the difficult period in 1999. This will be vital to further development of the private sector and the achievement of our goals. The NBKR will move quickly to improve banking supervision, and to initiate the introduction of a premium-based deposit insurance scheme. Foreign currency reserves are targeted to remain at about 4 months of imports during 2000-2002, and the current-account deficit is projected to decline to about 7 percent of GDP by 2002.
8. The overall aim of fiscal policy under the program will be to reduce gradually the fiscal deficit on a cash basis from about 11 percent of GDP in 1999 to below 6 percent by 2002. To achieve the overall deficit target, expenditures will have to be curtailed further, and the efficiency of government spending will have to be improved to allow essential public services to be provided, despite budget cuts. The strengthening of budgetary procedures, expenditure management, and greater transparency will be at the center of the government's policies to avoid the recurrence of expenditure arrears. To consolidate revenues, the government will focus on improvements in tax and customs administration, while limiting amendments to the tax code to a few key measures in order to maintain a stable legal basis for tax collection. Existing tax exemptions will be carefully reviewed with a view to eliminating those that are unwarranted, and the government will refrain from granting any new tax holidays and exemptions on a discretionary basis. To enhance revenues over time, the government will adopt the destination principle on VAT taxation for trade with all countries, including Russia, increase the contribution of agriculture to the overall tax base, and develop new revenue sources.
9. The entire stock of expenditure arrears (amounting to 1.7 percent of GDP at end-1998) will be repaid in the year 2000. The widespread problem of nonpayment in the economy has been partly fueled by the accumulation of expenditure arrears by the government. In order to break this vicious circle the government feels that it is essential that the privatization of public utilities be accelerated (see below), and that the budget meet all its obligations in this area. Moreover, the accumulation of budgetary expenditure arrears during the second half of 1998 and in early 1999 illustrates the inadequacy of the expenditure control system of the budget and efforts will be speeded up to improve them. This will include installing commitment controls, monthly financial planning and improved treasury cash management. The government will accordingly implement Minimum Standards on Fiscal Transparency and a number of measures aimed at improving budget execution.
10. As noted, in light of the large and increasing number of PIP projects financed by international donors, the government realizes the need to start prioritizing these projects. As a first step in this direction, the government will take stock of all ongoing investment projects in order to prioritize them, and fully incorporate the PIP into the 2000 and subsequent budgets.3 Further steps will comprise, among other things, the establishment of economic criteria for accepting new projects and ongoing monitoring of the impact of such investments.
11. The government will implement further elements of its pension reform, supported by the World Bank and a number of bilateral donors, in order to create a sustainable pension system and reduce budget subsidies to the Social Fund to zero in 2001. These elements will include increasing the retirement age according to the schedule agreed with the World Bank, reducing early retirement privileges and special pensions, and adopting a transparent indexation policy.
12. The National Bank of the Kyrgyz Republic (NBKR) will continue to pursue an ambitious inflation target and apply its monetary policy instruments accordingly in order to regain the confidence of the population in the currency. With the aim of strengthening and refining the conduct of monetary policy further, the NBKR and the Ministry of Finance (MoF) will collaborate to improve liquidity forecasting techniques by preparing weekly revenue and expenditure forecasts based on information from the treasury system and by coordinating the issuance of treasury bills. National Bank bills will be introduced by end-June 2000 to add another monetary policy instrument. Moreover, the flexibility, marketability and effectiveness of reverse repos will be enhanced by relying more on treasury bills.
13. Given the fragility of the banking sector, close supervision of the banking system will be imperative to avoid a further deterioration of asset quality and to prevent similar problems in the future. The NBKR will accordingly establish a program to conduct on-site inspections of all commercial banks at least once a year, and continue to improve its procedures in the payment system to reduce its exposure to commercial bank default. Likewise, the restructuring plans for problem banks will be further developed in line with Fund staff recommendations. Efforts will be stepped up to recover debts owed to the failed banks.
14. The exchange rate policy of the NBKR will continue to be consistent with a flexible exchange rate; the NBKR will limit interventions only to smooth temporary market fluctuations, and it will not resist a depreciation of the som should pressure on the currency fail to abate following an appropriate policy response. In case of unexpected capital inflows, it will strengthen reserves, unless a weak demand for money appears to undermine the inflation objective of the program.
15. The sharp depreciation of the som vis-à-vis the dollar since late 1998, the deterioration of the external balance, and the associated large increase in a number of external debt indicators underline the vulnerability of the country and the need for improvements in external debt management. In this context, the government will establish a comprehensive debt monitoring system accessible to both the NBKR and the MoF, and rely only on highly concessional external financing. As an element of the improvements in debt management, a new law on state debt will be drafted (including provisions on government guarantees) and will be submitted to parliament by mid-2000. The Free Economic Zones (FEZs) in Naryn and Karakul will be reduced in size and fenced-in, and the ban against retail trading will be strictly enforced. Moreover, the Kyrgyz Republic will continue to liberalize its trade regime by reducing the top tariff rate to 15 percent by end-2000, develop a schedule for the further reduction of tariff rates in compliance with its WTO obligations, and avoid implementing measures that distort economic activity, such as export tariffs.
16. In line with the overall reform strategy of the government focussed on growth and poverty alleviation, structural policies under the program will address a number of areas, most importantly: pushing forward with public sector reform; improving conditions for private sector development; directing privatization efforts toward large enterprises; and rationalization of public utilities.
17. The allocation of public resources in the Kyrgyz Republic both in terms of decision making and inefficient provision of both goods and services, needs further improvement. To address this situation, the government will embark on a comprehensive reform of the civil service taking a top-down approach--that is, beginning with a determination of the role of the public sector in both guiding and promoting economic activity. The major components of this program will comprise: (i) reorganizing government activities and reduce employment by reviewing and clarifying the functions of main ministries and agencies to eliminate duplication both at the central and local levels; (ii) strengthening of a number of departments and activities (such as those of the treasury, debt management, tax and customs collection); and (iii) improving the quality of civil service personnel through competitive compensation and employment practices.
18. Private sector activity in the Kyrgyz Republic continues to account for a relatively small share of value added and much less than what was expected after several years of structural reform and mass privatization. The government's strategy to further develop the private sector will proceed along several lines. First, to improve the business environment there will be a number of measures aimed at lessening the regulatory burden through reducing licensing, sub-licensing, inspections, and other administrative requirements, severely curtailing the authority to grant licenses, and removing conflict of interest in government agencies/enterprises that issue licenses and engage in competing commercial activities with the private sector. Second, a number of measures will be aimed at removing obstacles to the development of agriculture--which accounts for the largest share of output-based GDP--by limiting government intervention in input and output markets, the promotion of farm restructuring, and the lifting of the moratorium on land sales and sale of arable land placed in the Land Redistribution Fund (LRF). Third, efforts will be made to better implement existing legislation. In this context, the government recognizes the importance of a well-functioning, stable, and predictable judiciary system and will continue its training programs for judges and lawyers, supported by international donors. As part of the reform of the general legal system, the government will initiate a stocktaking exercise of laws, decrees, resolutions, and orders that would have a budget impact, but are not reflected in the budget, in order to cancel or postpone these laws. Furthermore, the bankruptcy law and the law regarding the main principles of budgetary legislation vis-à-vis conservatorship will be enforced in all cases of non-payment of budget loans, and the principles for on-lending will be reviewed.
19. Private sector development will also be strengthened by following through with the privatization program begun earlier. As part of the government's case-by-case approach, a majority of at least 50 enterprises will be turned over to the private sector, including: Bishkek Machine Engineering Plant, Kyrgyzneft Petroleum, Linoleum Company, Resort-Recreational Company. More enterprises will be added in the following years. Forty percent of Kyrgyz Telecom will be sold before September 2000. Implementation of international accounting, reporting, and disclosure standards will be further strengthened under the AsDB corporate governance program, and Kyrgyz Altin, Kyrgyz Airlines, KyrgyzGasMunaizat4 and KyrgyzEnergo will undergo international audits. The government will also implement its reform program for the transportation sector to bring it closer to cost recovery levels by, for example, removing special privileges.
20. An important part of the structural reform agenda will involve the rationalization of some public utilities, particularly in the energy sector, supported by international donors. The goal of these policy moves are threefold: to reduce energy use through price increases; bolster the financial health of the utility companies through better billing, tariff collection and cost recovery practices; and to restructure the energy sector through private sector participation and investment. At the same time, the authorities will put into place a strategy to protect the poorest segments of society against these energy prices increases, as agreed with the World Bank. With regard to electricity and heating, tariff increases will be scheduled in order to reach full cost recovery for the state-owned KyrgyzEnergo, by the end of 2000. The distribution sector of the electricity market will be restructured, with at least one of the five power distribution companies offered for sale in the near term, with the others following somewhat later. With regard to gas, the market will be restructured according to the 1999-2000 Action Plan, which covers provisions for compliance with cash collection targets, a loss reduction plan, and the requirement to install meters. The state gas company, Kyrgyzgas will also be prepared for privatization.
21. The government is aware of the need to arrest and then reverse the continued worsening of social indicators, and in this context it will begin discussions with the Fund and the World Bank to develop a Poverty Reduction Strategy Paper to be completed by March 2001. The overall objective will be to halve the current poverty level in the Kyrgyz Republic, in line with the goals set by the international community. In the interim, adjustments in the social policy area will lead to the termination of the most inefficient assistance programs or reductions in associated spending, coupled with improved targeting. As such, the government will implement a World Bank-supported plan to improve targeting of social benefits, create a monitoring program for poverty and an evaluation system for specific policy measures, such as the Unified Monthly Benefit. It will also adopt reforms in the agricultural sector which is a major contributor to economic activity. In the health field, policy objectives will center on cost control, improving efficiency, and reinforcing primary health services. Specific actions designed to achieve these goals will involve, among other things: extending wider decision-making responsibilities to hospitals and regional health care providers; reducing hospital length of stays and unused capacity; implementing a law on health insurance policy; completing the development of a system of health accounts and flow of funds in line with World Bank recommendations; and providing sufficient funding for control and prevention of various diseases and for widespread vaccinations for children. Reform in the area of education will evolve along lines agreed with the AsDB, and in particular we will introduce block funding and submit a status report on rationalization of the education sector, both on a national basis. With the assistance of the World Bank, the government is in the process of conducting a comprehensive review of expenditures in health, education and social protection areas. The results of this study will determine appropriate spending and reform policies--in the context of the government's overall poverty reduction program--over the medium term.
22. The external public debt-to-GDP ratio is expected to peak at around 113 percent next year, before starting to decrease gradually. Nonetheless, since a large portion of this debt is concessional in nature, its net present value will likely fall to 80 percent of GDP and although large, this level of debt can be serviced.
23. The non-interest current account deficit is projected to remain broadly constant at around US$152 million over the 2000-2002 period. With the targeted increase in gross reserves and the scheduled amortization of foreign debt, the estimated gross financing requirement under the program will be about US$346 million over the same time frame. International financial institutions are expected to provide the greatest share of the financing through concessional loans, while bilateral donors are projected to provide significant grants. Indeed, the ambitious reform program of the Kyrgyz government can only be implemented if the international donor community continues to provide support for it. Given the projected level of disbursements, a cumulative financing gap over the 2000-2002 period is estimated at US$114 million.
24. The World Bank and the IMF will continue to provide technical assistance to the Kyrgyz authorities. The assistance will include resident representatives of the IMF and the World Bank as well as long-term advisors in a number of areas, most recently for banking supervision and tax policy. In addition, the IMF, the World Bank, and other donors have offered a range of technical assistance (including early next year, to improve debt management), and government officials have been invited to participate in Fund and Bank training courses.
25. A significant number of challenges and tasks remain in the transformation of the Kyrgyz economy to a true market economy. The adverse external environment has increased the urgency of pursuing appropriate stabilization and microeconomic policies. The Kyrgyz government is aware of this and is fully committed to implementing the necessary measures and reforms to accelerate the transformation process that had recently slowed. The focus of policy efforts will be fiscal consolidation and improvements to budget management, public sector reform to enhance resource allocation, and increasing the contribution of the private sector in economic activity. As well, the government will prioritize projects under the PIP that will have an immediate effect on the poorest segments of the population in order to raise currently difficult living conditions.