Public Information Notice No. 03/74

Public Information Notice: IMF Concludes 2003 Article IV Consultation with the Republic of Kazakhstan

June 17, 2003

On May 28, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Kazakhstan.¹

Background

Kazakhstan is reaping the benefits from early structural reforms and prudent macroeconomic management. Led by the petroleum sector, and supported by a favorable external environment, economic growth averaged 11 percent in the period 2000-02. Strong growth has continued in 2003, at an estimated 10.6 percent in the first quarter. The petroleum sector continues to gain in importance with high foreign investment and rising production and export volumes. The non-oil economy has also grown strongly, at about 8 percent on average in 2000-02. After sharp declines during the 1990s, overall employment has grown since 2000. Unemployment declined to 9¼ percent in 2002, and real wages rose by about 10 percent. Notwithstanding the sustained strong growth of the economy, poverty remains a serious concern, especially in the rural areas and the rising oil wealth has yet to benefit significantly the majority of the population.

Inflation remained basically unchanged in 2002 at 6½ percent and was broad based, although relatively stronger in the services sector. Impediments to regional trade may have contributed to sharply higher prices of fruits and vegetables. The 12-month inflation rate began to edge-up towards the end of 2002 and reached just over 7 percent by March 2003.

Monetary Policy

The growth of the monetary and credit aggregates continued to slow in 2002. The sterilization of budget surpluses in the National Fund for the Republic of Kazakhstan (NFRK) and the partial sterilization of additional large foreign exchange purchases by the National Bank of Kazakhstan (NBK) were crucial in this regard. Increased monetization continues to facilitate monetary policy, while the level of dollarization of bank assets and liabilities is stabilizing.

In 2002, monetary policy resulted in keeping inflation stable. The nominal exchange rate weakened against the U.S. dollar because of large-scale interventions, and, with moderate inflation, the tenge continued to depreciate in real effective terms. In the first quarter of 2003, reserve money did not exhibit the usual pronounced seasonal decline and broad money growth accelerated, driven by net foreign assets growth. Also, in the first quarter of 2003, the tenge appreciated against the dollar and marginally against the Russian ruble, but was steady against the euro. The nominal exchange rate against the ruble has shown only marginal changes in recent years despite a large inflation differential with Russia.

Fiscal Policy

Fiscal policy has played a major role in containing aggregate demand and inflationary pressures. The fiscal stance, as measured by the non-oil budget balance, was severely tightened in 2002. There was considerable underspending on investment programs and the expenditure to GDP ratio declined. Budget revenues were very strong in the first two months of 2003. Together with seasonally low expenditures, this resulted in an overall surplus of about 1.6 percent of projected annual GDP.

The external current account deficit declined in 2002 to under 2 percent of GDP, as both petroleum and non-oil export growth recovered and import growth continued to slow. Net Foreign Direct Investment inflows, largely in the oil sector, have averaged over $2 billion per year (more than 9 percent of GDP) since 2000. Gross official reserves rose to over $3 billion at end 2002 and further to $4 billion at end-March 2003 (3.7 months of projected 2003 imports) and balances in the NFRK reached $2.2 billion in mid-April 2003. Public external debt dropped to around 14 percent of GDP at end 2002 and Kazakhstan's official sector became a net creditor to the rest of the world. Kazakhstan's credit rating was upgraded in September 2002 by Moody's to minimum investment grade.

Structural Reforms

After a rapid introduction of market reforms in the early years of transition, the momentum of structural reform has slowed since 2000. A weak judicial system, entrenched vested interests, "capture" of important sectors, combined with a lack of transparency have resulted in an uneven playing field and a poor investment climate outside the oil and financial sectors, particularly for small and medium-size domestic and foreign investors.

Welcome progress was achieved, however, in 2002 in the areas of treasury modernization, simplification of NFRK funding rules, as well as the introduction of a systematic reform of utility pricing. The trade regime is generally liberal with relatively low average tariffs. However, reforms to reduce tariff peaks and eliminate specific and combined tariffs have not been implemented. Also, ad hoc restrictions prevail on both imports and exports. Efforts to accede to the World Trade Organization were reenergized, but there are no near-term prospects for accession.

Significant progress in strengthening the financial sector has continued. Bank capital has increased significantly as a result of both new share issues and retained earnings. The NBK has energetically fostered domestic capital market development, notably mortgage lending and mortgage-backed securities. Legislative reforms of the bankruptcy code were also an important step forward. Legislation regarding anti-money laundering is still in preparation, and Kazakhstan has yet to join the Strasbourg Convention. A reassessment of the payment system in early 2003 found it to be functioning according to the best international practices.

Executive Board Assessment

Executive Directors commended the authorities for Kazakhstan's strong macroeconomic performance, which has been marked by fast and broad-based GDP growth, rapidly mounting international reserves and assets in the NFRK, and reductions in public sector external and internal debt. Market confidence has improved, with an attendant upgrade in Kazakhstan's credit rating. While high world energy prices have contributed to these results, Kazakhstan was reaping the benefits of early implementation of first-generation structural reforms and continued sound macroeconomic policies.

Looking ahead, Directors considered that the key challenge facing Kazakhstan's policymakers is the continued effective management of rapidly rising oil production and revenues. Directors generally agreed that, while considerations regarding intergenerational savings should guide such efforts, the widespread poverty poses an immediate demand on these resources. Directors agreed that a rebalancing of policies should be considered. Some relaxation of the fiscal stance at this stage would be appropriate to accommodate important outlays, together with a more flexible exchange rate policy and a monetary policy consistent with a further lowering of inflation. Equally, a reinvigoration of second-generation structural reforms is essential for building a sound investment climate and fostering sustained broad-based growth outside the energy sector.

Directors discussed the tension between the recent trend of the real exchange rate and the authorities' objective of lowering inflation. While taking note of the clarification of the authorities' single policy objective—securing price stability—they observed that high budget surpluses, strong productivity gains, sterilization of oil proceeds in the NFRK, and rapid financial deepening, have contributed to keeping inflation low. Directors judged that some real appreciation of the currency may become unavoidable because of Kazakhstan's strong balance of payments position. In this regard, they noted that the tenge has continued to depreciate in real effective terms because of large foreign exchange purchases by the National Bank. They called for the NBK to limit its interventions in the foreign exchange market so as to exercise firmer control over the growth of the monetary and credit aggregates. Directors considered that achieving the aimed—for reduction in inflation would be difficult without a more substantial appreciation of the tenge against the U.S. dollar.

Directors welcomed the intention to ease the stance of fiscal policy through increases in priority outlays, and judged that the proposed reductions in the rates of the value added tax, income tax, and social security tax are also steps in the right direction. To ensure the appropriate use of budgetary resources, they encouraged the authorities to strengthen their institutional capacity and the targeting of social assistance, and to proceed, with help from the international community, to develop and execute more ambitious and well-thought-out public sector investment programs. They welcomed, in this connection, the progress being made in strengthening capacity and increasing allocations in the health and education sectors, and Directors encouraged further increases in well-targeted outlays in these areas. Directors also urged the government to focus on infrastructure investments that are complementary to, rather than in competition with, private sector investment. In this connection, they considered that more transparent budgetary procedures would facilitate open and comprehensive discussion of how best to ensure efficient allocation of public resources. Directors cautioned against relying on import substitution policies and using the Development Bank and other recently created institutions to "pick winners" among firms.

Directors noted the important role the NFRK has played in easing the burden on monetary policy, moderating pressures for an appreciation of the exchange rate, and building a protective buffer against unforeseen pressures on the budget and the balance of payments. The rapidly mounting wealth in the NFRK will need to be carefully safeguarded through strict adherence to budgetary procedures, further simplification of its operating rules, and greater transparency. Directors called on the authorities to release complete and timely information about oil bonuses, tax payments, and other oil-related payments.

Directors expressed concern about the relatively slow progress in structural reforms in recent years, after a very impressive start. They called for an improvement of the investment climate so as to diversify the economy and raise productivity, particularly in the non-oil sector. Key areas needing further reform include public administration and the judiciary, and, more broadly, fighting corruption and providing a less difficult environment for small and medium enterprises. Directors emphasized that Kazakhstan's strong external position has created an important opportunity for trade liberalization and that substantial progress in this area should not be delayed but proceed in parallel with the negotiations on the World Trade Organization accession. Directors also welcomed the revision of the land code and introduction of private property rights, which should contribute to efforts to develop the non-oil sector and combat rural poverty. They supported the authorities' plans for complete capital account liberalization by 2007, but underscored the need for appropriate sequencing with financial sector reforms to safeguard macroeconomic stability.

Directors welcomed the considerable progress made in strengthening the financial sector and its supervision, and endorsed Kazakhstan's request for a focused Financial Sector Assessment Program update. They encouraged the authorities to monitor closely the still rapid growth of bank credit and emphasized that the fast growth of the economy could mask incipient problems with the quality of banks' assets. Directors commended the progress made toward creating a unified financial sector supervisory agency and endorsed the intention to separate this agency from the NBK. Directors commended the authorities for their efforts at countering money laundering and the financing of terrorism, and were encouraged by the authorities' intention to usher quick passage of the legislation aimed at fully implementing the UN Security Council Resolution and Conventions on terrorism financing.

Directors welcomed Kazakhstan's subscription to the Special Data Dissemination Standard and the completion and publication of fiscal and data Reports on the Observance of Standards and Codes. They noted that the corrections provided to the international investment position and the balance of payments have brought Kazakhstan into conformity with the requirements of Article VIII, Section 5.