Public Information Notice No. 99/73

Public Information Notice: IMF Concludes Article IV Consultation with Kazakhstan

August 9, 1999

On July 26, 1999, the Executive Board concluded the Article IV consultation with Kazakhstan.¹

Background

By early 1998, Kazakhstan was showing the effects of the progress made in transforming its economy into a market-based system. Output was growing, following upon the trend started in mid-1996. Annual inflation had fallen to less than 10 percent. The external account deficit, though large, was primarily financed by large foreign direct investment inflows, mainly in the oil, gas, and metallurgy sectors.

In mid-1998, Kazakhstan was hit by a series of large shocks: a decline of commodity prices, resulting in a fall of Kazakhstan's terms of trade of 14 percent during 1998; a sharp nominal depreciation of the Russian ruble and other CIS currencies, leading to a real effective appreciation of the Kazakh tenge of more than 10 percent between early August and late September; turmoil in emerging markets, which temporarily cut off Kazakh borrowers from international financial markets; and a severe drought.

These shocks had a profound impact on domestic economic developments. Real GDP fell by 2.5 percent in 1998. Influenced by the decline in import prices, consumer prices fell in March 1999 to a level 1.2 percent below that of March 1998. The current account deficit widened from 3.6 percent of GDP in 1997 to 5.4 percent of GDP in 1998, as the impact on exports of the fall of commodity prices exceeded the influence on imports of the decline in activity. Inflation rebounded in the immediate wake of the April 4, 1999 shift to a freely floating exchange rate regime (see below) but price pressures started to abate again a few weeks later.

In reaction to external developments, the National Bank of Kazakhstan (NBK) accelerated the rate of crawl of the Tenge vis-à-vis the U.S. dollar, starting in June 1998. It also twice rose its refinance rate, first to 20½ percent in August and then to 25 percent in November. Interest rates on treasury bills and NBK notes rose in parallel, reaching 26 percent at the end of the year. Nevertheless, due to repeated pressures in the foreign exchange market, the NBK conducted sizable interventions in 1998 and the first quarter of 1999, resulting in a measurable fall in international reserves. Faced with this situation and the degradation in the country's external competitiveness, the government of Kazakhstan and the NBK jointly announced a shift to a floating exchange rate regime on April 4, 1999.

Fiscal developments in 1998 were heavily influenced by the declining level of economic activity, which resulted in weaknesses in tax collection. Despite efforts to reduce expenditure, the budget deficit of the general ggovernment widened to 8 percent of GDP in 1998 from 7 percent of GDP in 1997. Expenditure arrears slightly decreased during 1998. The deficit was primarily financed with large privatization receipts, amounting to more than 4 percent of GDP, and borrowing from multilateral financial institutions.

Substantial progress was made in 1998 and early 1999 in the area of structural reforms. Noticeably, the deterioration in the external environment did not influence the direction or pace of reforms, except the privatization of very large enterprises that was adversely affected by conditions in international financial markets. Numerous initiatives were taken to strengthen the budgetary process. The 1999 Budget Law introduced important changes to the fiscal system, including the elimination of the major extra-budgetary funds, which contributed to increasing its transparency. The adoption of the Budget System Law created a systemic foundation for financial relations between different levels of government. A Ministry of Revenue was created in October 1998 to strengthen tax administration. In addition, important steps were taken to reform the public sector, the civil service, public provision of health and education services, and the banking sector. In the latter area, the number of banks was further reduced to 71 during 1998, and progress was made toward the implementation of strict prudential norms, with 13 banks in full compliance with the enhanced prudential requirements at end-1998. Development of the new pension system, launched on January 1, 1998, was marked by a steady increase in the market share of private pension funds, which reached 31 percent at end-June 1999.

Executive Board Assessment

Executive Directors observed that a series of large external shocks had affected Kazakhstan's economy in 1998 and halted the resumption in economic growth seen since mid-1996. Directors welcomed the steps already taken to restore conditions for sustainable growth, including the switch to a freely floating exchange rate regime, and commended the authorities for the progress made on many important aspects of structural reforms. However, they felt that the authorities' response to the changes in the external environment had not been sufficient to address the main challenges posed by these developments. In this regard, Directors stressed the need to consolidate the fiscal position, maintain a prudent monetary policy, and pursue the transition process, in order to return the economy to a sustainable growth path.

Directors agreed that the change in the exchange rate regime was appropriate in light of the large price fluctuations in Kazakhstan's main exports and the uncertainties affecting its external environment. They stressed that, for the exchange rate policy to help strengthen competitiveness and restore confidence in the domestic currency, monetary policy supported by appropriate fiscal and structural policies should remain tight to prevent any entrenchment of inflation. Directors cautioned that while monetary aggregates remained unstable, the inflation targeting approach may not be the most appropriate option at this time. They added that any move to lower interest rates should await further evidence of declining inflation.

Directors commended the National Bank of Kazakhstan (NBK) for its efforts to strengthen the regulatory regime and enhance banking supervision. Concerning the possible impact of exchange rate movements on the banking system's profitability, they urged the NBK to enforce strictly first-group banks' compliance with international prudential standards, bring all banks into compliance with these standards by the year 2000 as envisaged, and press ahead with plans to privatize the largest state-owned bank.

Directors observed that, despite repeated efforts by the authorities to amend the 1999 budget, the current policy stance still envisaged a large general government deficit. While aware of the constraints presented by the difficult economic environment under which the fiscal consolidation will take place in 1999, most Directors called for a substantial strengthening of fiscal policy. They encouraged the authorities to pursue their efforts to improve tax administration. Moreover, for the period starting with the 2000 budget, they also urged the authorities to include meaningful steps toward increasing revenue, primarily by broadening the tax base, including to the self-employed. Some Directors, however, considered that the authorities' fiscal target for 1999 could be seen as appropriate, especially in light of the cyclical conjuncture, but called on the authorities to take the necessary actions to reduce the fiscal deficit and ensure a sustainable fiscal position over the medium term. They stressed the importance of avoiding unsustainable cuts, and saw scope for greater prioritization of expenditure to prevent deterioration of social services.

Directors pointed out that a realistic budget would allow the government to ensure that no new arrears were incurred. They stressed the importance of eliminating promptly any arrears on pensions and wages, and of establishing a schedule for the elimination of all other arrears, starting with the 2000 budget.

Directors commended the authorities for their determined pursuit of structural reforms. They particularly noted the progress made in the implementation of the pension system reform, budgetary transparency, civil service reform, and public provision of health and education services.

Directors called for additional steps to improve the climate for private sector development. In this connection, they welcomed the improved rules-based system for investment incentives, the authorities' plans to reform the judicial system, as well as their renewed commitment to privatizing the large enterprises. Directors encouraged the authorities to be more specific and transparent with their privatization program in general.

Directors expressed serious concern about the recent reversals of trade liberalization. They regretted the imposition of trade restrictions on imports from neighboring countries in the period prior to the change in exchange rate regime and called for the prompt rescission of any of the restrictions that are still in place. Directors also called for a reversal of recent trends in external tariff setting, marked by an upward drift in average tariffs and the proliferation of specific and mixed tariffs. Despite the recent improvements in export prices, Directors stressed that Kazakhstan's external environment will remain difficult. They emphasized the positive influence that a comprehensive adjustment program could have on investors' confidence and on the availability of external financing on appropriate terms. In the meantime, Directors cautioned against the high degree of risk involved in unchecked foreign currency borrowing.

Directors regretted that the Kazakh authorities and the staff were not able to reach an agreement on policies that would bring the Extended Fund Facility program back on track. In the present difficult external environment, they encouraged the authorities to formulate without delays an economic program that could be supported by the IMF.