## _cr11151

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---

### I. KAZAKHSTAN: RESPONDING TO INFLATION

- Background
  - Annual headline inflation increased to about 8½ percent in April, exceeding the official objective range of 6-8 percent for the fourth consecutive month.
  - Domestic food prices grew by 13½ percent year-on-year in April, up from 4¾ percent in July 2010.
  - Food accounts for 38.8 percent of the consumption basket; bread products account for nearly 9 percent.
  - Contextual risks:
    - Economy recovering faster than anticipated; base of growth beginning to broaden.
    - Monetary policy remains accommodative.
    - Short-term capital inflows have recently increased.
    - Large planned increases in public wages and pensions, and tariff harmonization with the customs union with Russia and Belarus.
    - Global commodity prices remain volatile with upside risks to food and oil prices.

- Inflation developments: a large role for food
  - Domestic food inflation more than doubled to 10½ percent in the second half of 2010.
  - Bread (wheat-related) products are a primary channel from global wheat price increases to headline inflation and expectations.
  - The cumulative increase in headline inflation during the initial nine months of the current shock is less than half of that experienced during 2007-08; the impact on food inflation is about one-third of the 2007-08 shock.
  - Non-food and services prices have risen as second-round effects begin to appear.
  - Domestic credit growth contracted through most of 2010 and remains negative in real terms; growth of monetary aggregates remains contained despite large public wage increases.

- Estimating short-run drivers of inflation (small dynamic quarterly model, sample 2002Q2-2010Q3)
  - Model variables: quarterly inflation (πt), output gap (yt*), broad money (mt), unit labor costs (ulct), change in nominal Tenge/$ exchange rate (Δet), food price shock defined as (πf,t − πt−1).
  - Key econometric findings (robust standard errors in brackets; significance notation: * 1%; ** 5%; *** 10%):
    - Model [1] (Inflation):
      - L1 Inflation: 0.47 [0.033]*
      - Output Gap: 0.02 [0.007]**
      - LD4 Unit Labor Costs: 0.03 [0.016]**
      - LD1 Exchange rate: 0.04 [0.013]**
      - Food Price Shock: 0.51 [0.023]*
      - Constant: 0.01 [0.001]*
      - Observations: 34
      - SE Regression: 0.0020
    - Model [2] (Inflation with L1 Core Inflation):
      - L1 Core Inflation: 0.55 [0.124]*
      - Output Gap: 0.03 [0.016]**
      - Food Price Shock: 0.50 [0.056]*
      - Constant: 0.01 [0.002]*
      - Observations: 34
      - SE Regression: 0.0040
    - Model [3] (Core Inflation excluding food):
      - L1 Core Inflation: 0.19 [0.088]*
      - L2 Core Inflation: 0.20 [0.086]*
      - Food Price Shock: 0.36 [0.037]*
      - Constant: 0.01 [0.002]*
      - Observations: 34
      - SE Regression: 0.0040
  - Interpretation of coefficients:
    - Food price shocks: about half of a food price shock passes through to headline inflation in the near term (coefficient 0.51 in Model [1]).
    - Exchange rate: statistically significant at the 10 percent level in the preferred specification and has a sizable magnitude.
    - Unit labor costs: significant with effects materializing with a lag (~one year).
    - Output gap: limited role in short-run inflation dynamics.
    - Money growth: not significant in the final model.
  - Contributions to inflation:
    - Food price shock makes a marked contribution to inflation volatility (σ) but much less to average inflation (θ).
    - Inflation persistence (lagged inflation) and unit labor costs are important drivers of both inflation volatility and average inflation.
    - Exchange rate contributions are limited across measures.
  - Second-round effects:
    - Model [2] indicates feedback from core inflation to headline inflation; the impact of core inflation is notably larger in Kazakhstan than in similar studies for other emerging economies.
    - Model [3] suggests domestic food prices significantly affect core inflation (about two-thirds of the pass-through to headline inflation).
  - Robustness and diagnostics:
    - Breusch-Godfrey test: no serial correlation up to fourth order.
    - White’s test: does not indicate heteroskedasticity.
    - Chow Breakpoint test: no parameter instability at the midpoint of the sample.
    - Recursive one-step-ahead forecast: residuals exceed standard error bands in the first two quarters of 2006; remainder of sample within tolerance bands.
  - Energy price term considered but found insignificant.

- Mounting inflation risks
  - Near-term risks that could broaden price pressures:
    - Rapid pace of economic recovery and broadening growth base.
    - Continued accommodative monetary policy.
    - Increases in short-term capital inflows.
    - Large planned public wage and pension increases.
    - Tariff harmonization pressures from customs union commitments.
    - Sustained volatility of global commodity prices due to low global food inventories, oil price risks, and supportive global demand.

- Ongoing policy response and recommendations
  - Near-term recommended mix:
    - NBK should continue to gradually withdraw monetary accommodation.
    - NBK should clearly communicate the causes and outlook for inflation.
    - Hard-to-reverse fiscal outlays—particularly higher wages—should be avoided.
    - Administrative measures to control inflation should be used cautiously and phased out over time in favor of existing social safety nets.
  - Longer-term priorities:
    - Strengthen the transmission of monetary policy.
    - Improve social safety nets.
    - Enhance the economy’s supply response.

- Policy considerations and conclusions
  - Empirical evidence points to a dominant role for food price shocks in recent inflation dynamics, with meaningful second-round effects transmitted into core inflation.
  - Given food weight of 38.8 percent and bread products ~9 percent of the consumption basket, controlling inflation requires a comprehensive policy response combining:
    - Gradual monetary tightening and clear communication by the NBK.
    - Fiscal restraint on permanent wage and pension increases.
    - Careful, time-limited use of administrative price measures and shift toward targeted social protection.
    - Structural measures to bolster supply responsiveness and improve monetary policy transmission.

*Prepared by Ana Lucía Coronel, Dmitriy Rozhkov, and Ali Al-Eyd (all MCD), and Narayanan Raman (SPR); Approved by the Middle East and Central Asia Department; June 2, 2011.*

---

### Trade liberalization and external integration

- Trade liberalization and WTO accession
  - Kazakhstan participates in CAREC and aims at becoming a WTO member in 2012.
  - Authorities pursue export-promotion policies and support exports through tax exemptions.
  - Accession negotiations pursued from a harmonized position with customs-union partners; authorities expect to conclude bilateral negotiations with most partners by end-2011.

- Composition and direction of trade
  - Rapidly growing importance of China, especially for imports.
  - Russia’s relative weight as a trading partner has declined.
  - Russia, the EU, and China remain key trading partners.
  - CCA share in 2010: about 3 percent for both exports and imports.
  - Product structure: exporter of fuel and energy; importer of machinery and food products.

- The Customs Union with Russia and Belarus
  - Agreement signed November 2009; came into force January 2010.
  - July 2010: common customs code adopted and duties redistribution began.
  - Shares of total customs duties in the customs union:
    - Kazakhstan’s share: 7.3 percent.
    - Russia’s share: 88 percent.
    - Belarus’s share: 4.7 percent.
  - Tariff changes and fiscal impact:
    - Kazakhstan’s average tariff rate for industrial products estimated to have increased from 4.6 to 8.5 percent (simple averages).
    - For agricultural products, estimated increase from 12.1 to 16.7 percent.
    - Authorities estimate additional customs-duty-related revenues of 0.3 percent of GDP in 2010.
  - Implementation issues: mutual recognition of import certificates, synchronization of supplier registries, and differing transport tariffs remain outstanding.
  - Effects on shuttle trade: more restrictive rules could adversely affect consumer-product imports and shuttle trade from neighboring countries.

- How to further improve trade (findings and policy recommendations)
  - Broad findings:
    - Outer-oriented trade regimes enhance growth prospects; remaining impediments are largely institutional.
    - Improving trade-related institutions can have significant positive effects, particularly for landlocked countries and for sophisticated and high-technology exports.
  - Kazakhstan’s institutional challenges:
    - Limited progress in trading across borders; large number of documents; long preparation times; multiple approving agencies; high costs of exporting and importing.
  - Measures already undertaken:
    - Simplification of customs procedures; customs modernization; customs data exchange; pilot Joint Customs Control with China and Kyrgyz Republic; CAREC trade facilitation programs.
  - Recommended further steps:
    - Reduce costs of exports and imports: simplify procedures, cut number of documents, reduce clearing agencies.
    - Reduce remaining tariff and non-tariff barriers; ensure customs-union tariff increases do not slow liberalization; eliminate export/import restrictions; simplify tariff structure.
    - Use regional integration as a stepping stone toward multilateral liberalization.
    - Continue WTO accession negotiations as a key priority.

*Source: _cr11151 - 6.      Further efforts in the direction of trade liberalization are under way. Along with*

---

### Oil wealth management and fiscal framework

- Oil and the Kazakhstani economy
  - Reserves and production:
    - Nearly 40 billion barrels in reserves.
    - Kazakhstan has the world’s ninth largest proven reserves (3 percent of global reserves) and 2 percent of global production.
  - Sector shares (2010):
    - Oil sector value added: 11½ percent of GDP.
    - Oil exports: nearly 57 percent of total exports of goods and services.
    - FDI to extractive industries: 75¼ percent of total FDI.
    - Government revenues from extraction and exports of oil: about 46½ percent.
  - Significant new discoveries (most notably Kashagan) imply persistence of oil’s key role.
  - Direct impact on non-oil growth is limited; benefits largely confined to related sectors.
  - Oil-related outflows:
    - Total repatriation of investment income in 2010 amounted to nearly 30 percent of oil exports.
    - Investment of the NFRK abroad accounted for 34 percent of gross outflows in the financial account.
    - The increase in NFRK outflows accounted for about 70 percent of the increase in gross outflows, and 84 percent of the increase in oil exports.

- Lessons from commodity exporters
  - Mineral wealth can limit industrialization via Dutch disease (real exchange rate appreciation) and capital diversion to mining.
  - Empirical evidence shows oil wealth has often not been used effectively to catalyze development.
  - Kazakhstan’s oil intensity:
    - Kazakhstan: Average 0.10 Min 0.08 Max 0.11 2009 0.11 (Table III.1 excerpted among other oil exporters).

- Fiscal institutions and the NFRK
  - The NFRK is the cornerstone for managing oil wealth; managed by the central bank.
  - Transfers to the NFRK are in both domestic and foreign currency; proceeds invested in foreign assets (primarily G3 sovereign debt securities).
  - Government budget receives a fixed transfer from the fund of $8 billion annually, with the caveat that the NFRK is not allowed to fall below 20 percent of GDP.
  - NFRK increased from US$22 billion at the end of March 2009 to over US$36 billion in April 2011.
  - Box III.1: summary of principal elements of the taxation regime for the oil sector:
    - Corporate income tax: currently set at 20 percent; expected to be lowered gradually to 15 percent by 2014.
    - Rent tax on exports: comes into effect when global oil prices exceed $40 a barrel; tax rate varies between 7-32 percent.
    - Mineral extraction taxes: volume-based royalty tax; rate escalates as volumes rise.
    - Excess profit tax: “super tax” applicable on income after corporate income tax; rates depend on levels above allowable expenses.
    - Crude oil export duty: $20 per ton beginning 2010, raised to $40 in 2011; compared to Russia’s US$453.70 per metric ton in May 2011.
    - Stability of the tax regime: some production sharing agreements signed before January 1, 2009 may be stabilized; excess profit tax cannot be stabilized.

- NFRK objectives and implications
  - Facilitating capital formation:
    - Public sector investment supported by oil wealth but absorptive capacity limits further use.
    - Current limit on transfers indirectly results in ceilings on public investment in health, education, and infrastructure.
    - Kazakhstan’s investment in health and education lags behind many emerging markets.
  - Ensuring macroeconomic stability:
    - NFRK insulates the economy from swings in capital inflows due to oil-price fluctuations.
    - Savings in the NFRK help contain real exchange rate appreciation.
    - Investment of the fund in foreign assets reflects lack of domestic absorptive capacity and limits domestic spillovers.
  - Safeguarding future generations:
    - Kazakhstan expected to generate substantial oil revenues for approximately the next 40 years.
    - Continued saving of oil fund revenues is crucial for inter-generational equity.

- Implications and recommendations
  - NFRK rules provide clear basis but impose a relatively rigid framework; mechanism provides little flexibility over transfer size when oil revenues vary.
  - Basis for setting annual transfers at $8 billion does not appear linked to optimal saving calculations or intermediate targets for reducing the non-oil deficit.
  - Authorities continued to borrow to fund fiscal expenditures despite fiscal balance returning to surplus in 2010.
  - Flexibility in transfer size would support domestic capital formation and macro stability within a medium-term fiscal framework.
  - Authorities’ long-term aim: reduce the non-oil deficit to 3 percent of GDP by 2020; no intermediate targets have been determined.
  - Except for the US$8 billion transfer, authorities exclude oil revenues in fiscal revenue calculations and thus record fiscal deficits that require borrowing.
  - Policy recommendations:
    - Adopt a rule based on intermediate targets for the non-oil deficit over the medium term.
    - Assess changes in transfer rules carefully given long-horizon uncertainties.
    - Pursue measures to catalyze private investment: preserve macro stability; improve access to financing; upgrade investment and business climate.
    - Ensure clarity and predictability in the extractive sector: predictable, well-communicated reforms; avoid repeated ad hoc revisions that raise investor uncertainty.
    - Enhance investment climate and economic diversification: continue structural reforms to improve trading across borders, access to credit, health and education spending, and public administration efficiency.
  - Key statistics and rankings:
    - Authorities’ target: non-oil deficit reduced to 3 percent of GDP by 2020.
    - Transfer exception: US$8 billion transferred to the budget from the NFRK.
    - KMG estimate: up to $136 billion needed to fully develop the first phase of the Kashagan oil field.
    - Doing Business 2011 improvements:
      - Ease of starting a business: from 85th in 2010 to 47th in 2011.
      - Registering property: 28th.

*Prepared by N. Raman (SPR).*

_Italic: Source — IMF staff report excerpt (chapter on inflation, policy response, and trade), as provided in the supplied content unit._

### 2011. The views expressed in this document are those of the staff team and do not necessarily reflect

### I. KAZAKHSTAN: RESPONDING TO INFLATION

### Background
- Annual headline inflation increased to about 8½ percent in April, exceeding the official objective range of 6-8 percent for the fourth consecutive month.
- Domestic food prices grew by 13½ percent year-on-year in April, up from 4¾ percent in July 2010.
- Food accounts for 38.8 percent of the consumption basket; bread products account for nearly 9 percent.
- Key contextual risks noted:
  - Economy recovering faster than anticipated; base of growth beginning to broaden.
  - Monetary policy remains accommodative.
  - Short-term capital inflows have recently increased.
  - Large planned increases in public wages and pensions, and tariff harmonization with the customs union with Russia and Belarus.
  - Global commodity prices remain volatile with upside risks to food and oil prices.

### Inflation developments: a large role for food
- Food price shocks have driven much of the recent rise in headline inflation:
  - Domestic food inflation more than doubled to 10½ percent in the second half of 2010.
  - Bread (wheat-related) products are a primary channel from global wheat price increases to headline inflation and expectations.
- Comparison with 2007–08 shock:
  - The cumulative increase in headline inflation during the initial nine months of the current shock is less than half of that experienced during 2007-08.
  - The impact on food inflation is about one-third of the 2007-08 shock.
- Non-food and services prices have risen as second-round effects begin to appear, though their response is more contained.
- Domestic credit growth contracted through most of 2010 and remains negative in real terms; growth of monetary aggregates remains contained despite large public wage increases.

### Estimating short-run drivers of inflation
- A small dynamic quarterly model (sample 2002Q2-2010Q3) was estimated, augmenting a Phillips-curve framework with supply-side variables:
  - Quarterly inflation (πt), output gap (yt*), broad money (mt), unit labor costs (ulct), change in nominal Tenge/$ exchange rate (Δet), and a food price shock defined as (πf,t − πt−1).
- Key econometric findings (Table I.1; robust standard errors in brackets; significance levels preserved):
  - Model [1] (Inflation):
    - L1 Inflation: 0.47 [0.033]*  
    - Output Gap: 0.02 [0.007]**  
    - LD4 Unit Labor Costs: 0.03 [0.016]**  
    - LD1 Exchange rate: 0.04 [0.013]**  
    - Food Price Shock: 0.51 [0.023]*  
    - Constant: 0.01 [0.001]*  
    - Observations: 34  
    - SE Regression: 0.0020
  - Model [2] (Inflation with L1 Core Inflation):
    - L1 Core Inflation: 0.55 [0.124]*  
    - Output Gap: 0.03 [0.016]**  
    - Food Price Shock: 0.50 [0.056]*  
    - Constant: 0.01 [0.002]*  
    - Observations: 34  
    - SE Regression: 0.0040
  - Model [3] (Core Inflation excluding food):
    - L1 Core Inflation: 0.19 [0.088]*  
    - L2 Core Inflation: 0.20 [0.086]*  
    - Food Price Shock: 0.36 [0.037]*  
    - Constant: 0.01 [0.002]*  
    - Observations: 34  
    - SE Regression: 0.0040
  - Significance notation: * significant at 1%; ** 5%; *** 10%.
- Interpretation of coefficients:
  - Food price shocks: about half of a food price shock passes through to headline inflation in the near term (coefficient 0.51 in Model [1]).
  - Exchange rate: statistically significant at the 10 percent level in the preferred specification and has a sizable magnitude.
  - Unit labor costs: significant with effects materializing with a lag (~one year).
  - Output gap (demand factor): limited role in short-run inflation dynamics; measured coefficients and significance weaker relative to supply variables.
  - Money growth was not significant in the final model, possibly reflecting dollarization and unstable money demand in the short run.
- Contributions to inflation:
  - Using Model [1], the food price shock makes a marked contribution to inflation volatility (σ) but much less to average inflation (θ).
  - Inflation persistence (lagged inflation) and unit labor costs are important drivers of both inflation volatility and average inflation.
  - Exchange rate contributions are limited across measures.
- Second-round effects:
  - Model [2] indicates feedback from core inflation to headline inflation; the impact of core inflation is notably larger in Kazakhstan than in similar studies for other emerging economies, implying second-round effects could be challenging to reverse.
  - Model [3] suggests domestic food prices significantly affect core inflation (about two-thirds of the pass-through to headline inflation), reinforcing risks to inflation persistence.
- Robustness and diagnostic tests:
  - Breusch-Godfrey test: no serial correlation up to fourth order.
  - White’s test: does not indicate heteroskedasticity.
  - Chow Breakpoint test: no parameter instability at the midpoint of the sample.
  - Recursive one-step-ahead forecast test: residuals exceed standard error bands in the first two quarters of 2006, remainder of sample within tolerance bands.
- Note: A term for energy price shocks was considered but found insignificant, likely reflecting Kazakhstan’s status as an energy producer and price regulations on energy products.

### Mounting inflation risks
- Near-term risks that could broaden price pressures:
  - Rapid pace of economic recovery and broadening growth base.
  - Continued accommodative monetary policy.
  - Increases in short-term capital inflows.
  - Large planned public wage and pension increases.
  - Tariff harmonization pressures from customs union commitments.
  - Sustained volatility of global commodity prices due to low global food inventories, oil price risks, and supportive global demand.

### Ongoing policy response
- Recommended near-term policy mix emphasized in text:
  - The NBK should continue to gradually withdraw monetary accommodation.
  - The NBK should clearly communicate the causes and outlook for inflation.
  - Hard-to-reverse fiscal outlays—particularly higher wages—should be avoided.
  - Administrative measures to control inflation should be used cautiously and phased out over time in favor of existing social safety nets.
- Longer-term policy priorities identified:
  - Strengthen the transmission of monetary policy.
  - Improve social safety nets.
  - Enhance the economy’s supply response.

### Policy considerations and conclusions
- Empirical evidence points to a dominant role for food price shocks in recent inflation dynamics, with meaningful second-round effects transmitted into core inflation.
- Given significant food-weight in the consumption basket (38.8 percent) and large direct channel via bread products (~9 percent), controlling inflation requires a comprehensive policy response combining:
  - Gradual monetary tightening and clear communication by the NBK.
  - Fiscal restraint on permanent wage and pension increases.
  - Careful, time-limited use of administrative price measures and a shift toward targeted social protection.
  - Structural measures to bolster supply responsiveness and improve monetary policy transmission.

*Prepared by Ana Lucía Coronel, Dmitriy Rozhkov, and Ali Al-Eyd (all MCD), and Narayanan Raman (SPR); Approved by the Middle East and Central Asia Department; June 2, 2011.*

### 14.      On balance, the results underscore the importance of supply factors in

### 14.      On balance, the results underscore the importance of supply factors in

### Key findings on inflation dynamics and supply factors
- Food price shocks (driven by external factors) tend to dominate inflation dynamics and can cause a large short-run divergence between headline and core inflation.
- Monetary conditions could become distorted if policy were to focus solely on core inflation, leaving room for inflation expectations to become decoupled from policy objectives, and ultimately requiring a tightening of monetary policy that could negatively affect output growth.
- There is scope for monetary policy to respond to rising headline inflation when there is a large externally-driven divergence between core and headline inflation.
- Greater exchange rate flexibility, coupled with efforts to enhance the economy's supply response, would help facilitate adjustment to external shocks.
- Wages have a significant role, particularly regarding contributions to average inflation, underscoring the need to promote productivity and labor market flexibility and to avoid further excessive wage increases.

### Model robustness and transmission of food price shocks
- Model [3] was found to comply with the standard robustness tests discussed in the text.
- Additional exercises:
  - Using Model [1] with core inflation as the dependent variable confirmed strong food price effects on core inflation, with a magnitude of around two-thirds of that observed for headline inflation.
  - Using Model [3], replacing the food price shock term with headline inflation produced results similar to Model [3], showing a large, significant impact of headline inflation on core inflation.
- These exercises suggest transmission of food price shocks to core inflation both directly and via headline inflation, and indicate additional research on this transmission is warranted.

### D. Mounting inflation risks (economic context and indicators)
- Economic rebound and output gap:
  - Kazakhstan’s economy grew by 7 percent in 2010 from 1¼ in 2009, suggesting that the output gap is quickly closing.
  - Growth is largely driven by extractive industries but the base of growth is becoming more broad based.
  - Unemployment at an historic low of 5½ percent (compared to about 7½ percent prior the crisis).
- Short-term capital inflows and sterilized intervention:
  - Rebound in global oil prices and appreciation of the Russian ruble contributed to increased foreign exchange inflows and speculative appreciation pressures on the tenge.
  - The NBK engaged in heavy sterilized intervention in early 2011, resulting in a large build-up of FX reserves.
  - The amount of outstanding NBK short-term notes increased by nearly $4 billion to almost $10 billion (or 113 percent of currency in circulation) in the year through April.
  - The growth of monetary aggregates has remained somewhat contained, but maintaining the current pace of intervention could be challenging despite declining yield on these notes.

### E. Ongoing policy response (current stance and measures)
- Monetary stance and financial conditions:
  - Policy rate was hiked by 50 bp to 7.50 percent, but monetary stance remains accommodative.
  - Real interest rates are negative and have declined since the start of the crisis.
  - Reserve requirements on both domestic and foreign currency deposits are at historic lows.
  - Domestic market rates: three-month interbank rate around 1.7 percent; (average weighted) deposit and lending rates at 3.6 and 12.4 percent, respectively.
  - Banks hold approximately $11-12 billion in correspondent accounts at the NBK.
- Fiscal and wage developments:
  - Authorities plan a gradual fiscal consolidation from 2011.
  - Public wages and pensions will be increased by 25-30 percent (for the third consecutive year).
  - Increased expenditure on the development program is under way.
- Use of administrative measures:
  - Authorities relied mainly on administrative measures—export bans, moral suasion, signed memoranda with producers, activation of the state grain reserve—to mitigate pass-through to headline inflation as food prices increased in mid-2010.
  - Such measures are unsustainable, undermine market forces, present undue fiscal costs, and have had limited effect as headline inflation has become elevated and food prices have continued to rise.
- Factors conditioning policy response:
  - Little observed pass-through from rising global food prices to core inflation so far.
  - Heavy reliance on administrative measures reflects limited traction of monetary policy (caused by high dollarization and low financial market development) and a legacy of heavy government intervention.
  - Lack of domestic competition and productive capacity across industries, notably in agriculture and food production.
  - Institutional shortcomings limit efficient administration of targeted social assistance.

### F. Policy considerations and recommendations
- Near-term measures to control inflation and mitigate second-round effects:
  - Gradually remove the accommodative bias in monetary policy that was necessary during the crisis; position policy to respond to more broad-based price pressures and establish a neutral, if not slightly restrictive, monetary stance.
  - The NBK’s readiness to manage a possible increase in short-term capital inflows would benefit from enhanced liquidity management (in coordination with the Ministry of Finance) and implementation of announced macro-prudential enhancements, including graduated provisioning requirements against lending in foreign currency to unhedged borrowers.
  - Improve the communication of monetary policy: monitor inflation closely, clearly communicate current and expected causes of inflation, and reinforce commitment to maintaining the current objective range to anchor expectations.
  - Establish a prudent fiscal stance: support price stability and guard against procyclicality while balancing the need to maintain essential support to vulnerable sectors; employ existing social safety nets.
  - Use administrative measures cautiously: remain selective and time bound given near-term impediments to administering well-targeted social assistance.
- Medium- and longer-term structural reforms to enhance resilience:
  - Improve monetary policy efficiency by strengthening the monetary toolkit, promoting development of domestic financial markets and competition in the banking sector, and allowing greater exchange rate flexibility to enhance policy traction and adjustment to external shocks.
  - Develop adequate social safety nets with proper identification and timely provision of well-targeted assistance to the most vulnerable.
  - Enhance the economy’s supply response through structural measures aimed at improving competitiveness, promoting agricultural productivity, and labor market flexibility—some measures are embedded in the Development Plan.

### Model and data specifications (Annex I.1 — relevant technical details)
- Model setup:
  - Equation combines standard wage and price markup equations augmented for emerging-economy features (following Mohanty and Klau, 2001).
  - Productivity growth was excluded due to data limitations; output gap used as proxy for labor market conditions; money growth introduced to better account for demand developments.
- Data characteristics:
  - Apart from the output gap, data used in equation (I.1) are quarterly changes to ensure stationarity.
  - Data are seasonally adjusted; period covers 2002Q1—2010Q3.
  - Inflation, ߨ௧, is defined as the (log) quarterly change in the CPI; core inflation defined similarly using CPI-excluding food.
  - Output gap, ܱ෠௧, defined as deviation of actual output from potential output; potential output estimated using the common Hodrick-Prescott filter.
  - Unit labor costs, ݑ௧, derived using average nominal wages, employment, and output.
- Definition of food price shock:
  - The food price shock (݂ߨ௧െ࣊ି૚࢚) is defined as the difference between domestic food price inflation and headline inflation from the previous period to avoid potential endogeneity problems.
  - A similar energy price term was defined but not found significant in the final model specification.

_Italic: Source — IMF staff report excerpt (chapter on inflation, policy response, and trade), as provided in the supplied content unit._

### 6.      Further efforts in the direction of trade liberalization are under way. Along with

### 6.      Further efforts in the direction of trade liberalization are under way. Along with

### Trade liberalization and WTO accession
- Kazakhstan participates in the Central Asian Regional Economic Cooperation Program (CAREC), committing to further reduce and simplify trade tariffs and significantly reduce or eliminate non-tariff barriers as steps toward eventual WTO membership.
- Kazakhstan aims at becoming a WTO member in 2012.
- Authorities pursue export-promotion policies and support exports through tax exemptions.
- Accession negotiations are being pursued from a harmonized position with customs-union partners; the authorities expect to conclude bilateral negotiations with most partners by end-2011.

### Composition and direction of trade
- Major directional shifts over the last decade:
  - Rapidly growing importance of China, especially for imports; China has become the major destination for exports of energy producers in the region (primarily oil and gas).
  - Relative weight of Russia as a trading partner has continued to decline, especially as a destination for exports.
  - Russia, the EU, and China remain key trading partners for Kazakhstan.
- Very low share of CCA countries among Kazakhstan’s trading partners:
  - In 2010, the CCA share was about 3 percent for both exports and imports.
- Product structure has remained broadly unchanged since the early 2000s:
  - Kazakhstan: exporter of fuel and energy; importer of machinery and food products (despite substantial domestic agriculture and important wheat exports).
  - New Development Plan to 2020 envisages: increase in share of manufacturing in GDP; measures to increase productivity in agriculture; improving business environment; modernizing enterprises; creating new high value added export-oriented sectors; selective support to key industries (including telecommunications and transport). The impact on trade structure remains to be seen.

### Trade with CCA and informal channels
- Trade between CCA countries has picked up over the last decade but remains below levels expected given proximity and size; Kazakhstan is an outlier with especially low intra-CCA trade.
- Statistics on intra-CCA trade are not fully reliable due to informal channels and re-exports (primarily from China) that can obscure official data.

### The Customs Union with Russia and Belarus
- November 2009: Belarus, Kazakhstan, and Russia signed an agreement to create a customs union, seen as the first step toward a single economic space planned for creation by 2012.
- The agreement came into force in January 2010: most duties on mutual trade eliminated and customs rules harmonized.
- July 2010: member countries adopted a common customs code, finalized customs rules, and began to redistribute collected duties.
- Shares of total customs duties in the customs union:
  - Kazakhstan’s share: 7.3 percent.
  - Russia’s share: 88 percent.
  - Belarus’s share: 4.7 percent.
- Expected benefits and risks for Kazakhstan:
  - Benefits: greater access to the large Russian market; eventual free movement of labor and capital; agricultural and commodity exports may benefit from removal of customs duties.
  - Risks: potential exposure of Kazakhstan’s manufacturing sector to competition from Russian companies; trade diversion from higher external import tariffs.
- Tariff changes and fiscal impact:
  - Kazakhstan’s average tariff rate for industrial products estimated to have increased from 4.6 to 8.5 percent (simple, not trade-weighted averages).
  - For agricultural products, estimated increase from 12.1 to 16.7 percent.
  - Authorities estimate additional customs-duty-related revenues of 0.3 percent of GDP in 2010.
- Implementation and outstanding issues:
  - Mutual recognition of import certificates and synchronization of supplier registries need full practical implementation.
  - Transport tariffs differ significantly between members and remain under intense negotiation.
  - Since the customs union has been in operation for less than a year (as of the source), it is too early to fully evaluate impacts on trade direction, though some long-term trade diversion could be expected.
- Effects on small neighboring countries and shuttle trade:
  - A relatively liberal regime for shuttle or “suitcase” trade was replaced by more restrictive rules (prior regime: single customs fee including VAT of €0.6 per 1 kg for light industry goods and 13 percent of value for fruits and vegetables; replaced by ad valorem tariff rates of 10 to 20 percent, but not less than €1-4 per kg depending on product).
  - Restrictive changes could adversely affect consumer-product imports from China, Turkey, India, Iran, and South Korea, and locally produced agricultural and industrial goods from Kyrgyz Republic and Tajikistan.
  - Kyrgyz Republic and Tajikistan announced interest in joining the customs union, possibly in response to adverse impacts on their shuttle trade.

### How to further improve trade (findings and policy recommendations)
- Broad findings:
  - Outer-oriented trade regimes enhance growth prospects for developing countries; exporting orientation is a key component of development policy.
  - With traditional tariff and non-tariff barriers substantially reduced, remaining impediments to trade are largely institutional.
  - Improving the quality of trade-related institutions can have significant positive effects on trade, particularly for landlocked countries and for exports of sophisticated, differentiated, and high-technology products—important for Kazakhstan’s diversification objectives.
- Kazakhstan’s institutional challenges in trade:
  - Progress in improving the general business environment has been made (simplifying procedures, reducing costs of starting a business), but progress in trading across borders has been limited.
  - Compared to other transition economies, Kazakhstan ranks poorly on indicators of ease of trading across borders due to:
    - Large number of documents required for exporting or importing.
    - Long time required to prepare documents.
    - Multiple agencies required to approve documents.
  - High costs of exporting and importing remain a binding constraint on trade expansion.
- Measures already undertaken:
  - Simplification of customs procedures; customs modernization; customs data exchange with neighboring countries.
  - Ongoing pilot programs on Joint Customs Control with China and Kyrgyz Republic.
  - Many measures undertaken under CAREC trade facilitation programs; reducing institutional impediments is a main CAREC trade-policy priority.
- Recommended further steps:
  - Emphasize reductions in the costs of exports and imports by:
    - Further simplifying procedures.
    - Cutting the number of documents required to export or import.
    - Reducing the number of clearing agencies involved.
  - Continue steps to reduce remaining traditional tariff and non-tariff barriers:
    - Ensure that tariff increases resulting from the customs union do not slow progress in liberalization.
    - Eliminate remaining export and import restrictions.
    - Simplify the tariff structure.
    - Gradually reduce non-tariff barriers (including all export and import restrictions and all forms of government subsidies), possibly in coordination with other customs-union members.
  - Design regional integration as a stepping stone toward multilateral trade liberalization with:
    - Continued reduction in external tariffs.
    - Simple and transparent rules with comprehensive product coverage.
    - Effective implementation of regional agreements.
  - Continue WTO accession negotiations as a key economic priority.

*Source: _cr11151 - 6.      Further efforts in the direction of trade liberalization are under way. Along with*

### 1.      Efficient management of the oil wealth is crucial in supporting medium-term

### 1.      Efficient management of the oil wealth is crucial in supporting medium-term

### B. Oil and the Kazakhstani Economy
- Kazakhstan has a large and significant extractive industries sector, with oil playing a major role.
- With nearly 40 billion barrels in reserves and 2 percent of global production, Kazakhstan has the world’s ninth largest proven reserves (3 percent of global reserves), and is among the 20 largest oil producers.
- Oil sector value added accounted for 11½ percent of GDP in 2010.
- Oil exports represented nearly 57 percent of total exports of goods and services in 2010.
- The bulk of foreign direct investment (FDI) in recent years has flowed to the extractive industries sector (75¼ percent in 2010), with oil taking the largest share.
- In 2010, about 46½ percent of government revenues came from extraction and exports of oil.
- Significant new discoveries (most notably Kashagan) imply the key role of oil is likely to persist over the medium and long term.
- Oil and oil-related investment flows support domestic development by:
  - Attracting high levels of FDI (Kazakhstan has attracted the highest levels of FDI in the CIS in per capita terms).
  - Generating substantial export and fiscal proceeds that can be deployed to support non-oil activities and catalyze oil-related services such as transportation.
  - Providing employment and income opportunities, though limited relative to the sector’s size.
  - Involving national oil and gas company KazMunaiGaz (KMG) in exploration and extraction through profit sharing and equity partnerships with foreign investors.
- Direct impact of oil sector activity on non-oil growth is limited:
  - Benefits largely confined to a few related sectors (e.g., transportation and communications).
  - Other domestic drivers (manufacturing, construction, real-estate, various services) do not appear to benefit directly.
  - Companies generally bring their own funds for investment, limiting the role of the domestic financial system.
- Oil-related outflows through the balance of payments are significant:
  - Indications that total repatriation of investment income in 2010 amounted to nearly 30 percent of oil exports.
  - Investment of the NFRK abroad accounted for 34 percent of gross outflows in the financial account of the balance of payments.
  - The marginal outflow is significant: the increase in NFRK outflows accounted for about 70 percent of the increase in gross outflows, and 84 percent of the increase in oil exports.
- Dependence on oil poses macroeconomic and structural challenges:
  - Oil sector is capital-intensive and not a main source of employment; expansion unlikely to generate comparable job growth.
  - Volatility of oil prices causes macroeconomic challenges and exchange rate volatility.
  - Counter-cyclical fiscal action may be constrained by lack of other revenue sources, although saving oil proceeds mitigates this risk.
  - Policies to limit exchange rate volatility could result in a pro-cyclical monetary stance.
  - Effectiveness of macroeconomic policy is hampered by the limited ability of the small non-oil sector to counteract swings in oil prices.
- Unique features of Kazakhstan’s oil industry amplify risks:
  - Offshore reserves in the Caspian Sea face seasonal weather variation and desert environment impacts.
  - Geological conditions (sediment layers, highly pressurized wells, potential for salt and impurities) affect accessibility and production quality.
  - Planned activity in the Kashagan oilfield could be particularly affected by price variations.

### C. Lessons from Commodity Exporters
- The presence (or absence) of natural endowments influences likely development paths:
  - Leamer (1987): with capital and labor, countries specialize in labor-intensive industries, then accumulate capital, then produce capital goods.
  - Adding a third factor (natural resource endowments) changes predictions: countries need not follow the standard development path.
  - Álvarez and Fuentes (2006): different natural endowments (agriculture, forestry, extractive industries) influence development paths differently; mineral resources seem to limit industrialization.
- Two factors explaining why mineral wealth limits industrialization (Álvarez and Fuentes):
  - Real exchange rate appreciation (Dutch disease) prevents reducing net imports and moving up the industrial ladder.
  - Mineral extraction is capital-intensive, diverting scarce physical capital to mining and limiting deepening of capital in industry.
- Klein (2010) suggests countries with lower “oil intensity” (share of oil in GDP) have incentives to build better fiscal institutions and thus enjoy governance spillovers.
- Mineral exporters can develop comparative advantage in other fields (e.g., chemicals), but this channel is weaker for oil exporters than for other mineral producers.
- Surpluses from the mineral sector can inhibit industrialization if not distributed to other sectors:
  - If mineral surpluses support capital formation and productivity (public investment and financial intermediation) and real exchange rate volatility is managed, they could support industrialization.
  - If used to raise consumption or if exchange rate volatility is excessive, industrialization efforts may be limited.
  - Empirical evidence in many emerging markets and developing countries shows oil wealth has often not been used effectively to catalyze development.

- Table III.1: Selected Oil Exporters -- Oil Intensity (1985–2009) (oil intensity defined as real oil GDP/real GDP; countries sorted by average oil intensity; median about 0.31)
  - Libya: Average 0.62 Min 0.52 Max 0.71 2009 0.52
  - Qatar: Average 0.50 Min 0.40 Max 0.58 2009 0.50
  - Kuwait: Average 0.48 Min 0.28 Max 0.64 2009 0.36
  - Equatorial Guinea: Average 0.46 Min 0.00 Max 0.84 2009 0.58
  - Oman: Average 0.45 Min 0.33 Max 0.52 2009 0.34
  - Nigeria: Average 0.45 Min 0.34 Max 0.57 2009 0.34
  - Angola: Average 0.44 Min 0.15 Max 0.57 2009 0.40
  - Congo, Rep. of: Average 0.34 Min 0.28 Max 0.47 2009 0.31
  - Azerbaijan: Average 0.33 Min 0.20 Max 0.49 2009 0.49
  - Saudi Arabia: Average 0.33 Min 0.23 Max 0.39 2009 0.28
  - Algeria: Average 0.32 Min 0.27 Max 0.36 2009 0.27
  - United Arab Emirates: Average 0.31 Min 0.18 Max 0.52 2009 0.18
  - Gabon: Average 0.30 Min 0.22 Max 0.37 2009 0.22
  - Syria: Average 0.26 Min 0.12 Max 0.36 2009 0.12
  - Venezuela: Average 0.23 Min 0.17 Max 0.33 2009 0.22
  - Turkmenistan: Average 0.22 Min 0.11 Max 0.30 2009 0.11
  - Bahrain: Average 0.20 Min 0.12 Max 0.25 2009 0.12
  - Iran: Average 0.13 Min 0.09 Max 0.17 2009 0.09
  - Yemen: Average 0.13 Min 0.08 Max 0.16 2009 0.08
  - Cameroon: Average 0.11 Min 0.05 Max 0.17 2009 0.05
  - Indonesia: Average 0.11 Min 0.07 Max 0.14 2009 0.07
  - Kazakhstan: Average 0.10 Min 0.08 Max 0.11 2009 0.11
  - Chad: Average 0.07 Min 0.00 Max 0.32 2009 0.21

### D. Fiscal Institutions and Oil Wealth in Kazakhstan
- The NFRK is the cornerstone for managing oil wealth:
  - Oil revenue (taxes and royalties) is managed within institutional structures dedicated to preserving oil wealth.
  - The NFRK is the repository of the bulk of fiscal revenues arising from oil and is managed by the central bank.
  - Transfers to the NFRK are in both domestic and foreign currency; proceeds are invested in foreign assets, primarily liquid instruments such as G3 sovereign debt securities.
  - The government budget is allocated a fixed transfer from the fund of $8 billion annually, with the caveat that the NFRK is not allowed to fall below 20 percent of GDP.
  - Authorities have adhered to set targets for transfers from the NFRK.
  - NFRK increased from US$22 billion at the end of March 2009 to over US$36 billion in April 2011.
- Box III.1. Taxation Regime for the Oil Sector in Kazakhstan (summary of principal elements)
  - Corporate income tax: Applicable to all companies operating in Kazakhstan, currently set at 20 percent of eligible income; expected to be lowered gradually to 15 percent by 2014.
  - Rent tax on exports: Comes into effect when global oil prices exceed $40 a barrel; tax rate varies between 7-32 percent depending on export proceeds.
  - Mineral extraction taxes: Volume-based royalty tax applicable to extraction of oil, condensates, and natural gas; rate escalates as volumes rise and varies depending on product and export/domestic sale.
  - Excess profit tax: A “super tax” applicable on income after paying corporate income tax and based on excess profits over allowed deductible expenses; rates depend on levels above allowable expenses.
  - Crude oil export duty: Since the beginning of 2010, a crude oil export duty of $20 per ton was levied, raised to $40 in 2011; this rate remains well below that in neighboring Russia (US$453.70 per metric ton in May 2011).
  - Stability of the tax regime: Production sharing agreements signed before January 1, 2009 may be exempt from changes if “stabilized” and having undergone “tax expert evaluation”; excess profit tax cannot be stabilized; stabilized contracts can be changed by mutual agreement.
- The NFRK framework aims to balance capital formation, macroeconomic stability, and saving for future generations:
  - Facilitating Capital Formation:
    - Public sector investment is supported by oil wealth, but absorptive capacity limits further use of oil resources for development investment.
    - Current limit on transfers from the NFRK to the federal budget indirectly results in ceilings on public investment in health, education, and infrastructure.
    - Kazakhstan’s investment in health and education lags behind many emerging markets.
  - Ensuring Macroeconomic Stability:
    - The NFRK insulates the economy from swings in capital inflows generated by global oil price fluctuations.
    - Savings in the NFRK help contain real exchange rate appreciation arising from oil-related inflows.
    - Investment of the fund in foreign assets reflects lack of domestic absorptive capacity and limits spillovers to the domestic economy and financial system.
    - Lack of inward investment by the NFRK may explain prominent role of public and quasi-public enterprises in providing credit to the non-oil sector.
  - Safeguarding Future Generations:
    - Kazakhstan is expected to generate substantial oil revenues for approximately the next 40 years.
    - Continued saving of oil fund revenues is crucial to ensuring oil wealth is equitably shared inter-generationally.

### E. Implications for Kazakhstan — Enhancing the Role of Oil and the Oil Fund
- The NFRK rules provide a clear basis for managing oil wealth but impose a relatively rigid framework:
  - The mechanism provides little flexibility over the size of transfers to the budget when oil revenues are much larger or lower than anticipated.
  - The basis for setting annual transfers at $8 billion does not seem to reflect calculation of optimal savings or be linked to intermediate targets for reducing the non-oil deficit.
  - Authorities continued to borrow to fund fiscal expenditures despite the fiscal balance returning to surplus in 2010.

*Prepared by N. Raman (SPR).*

### 15.      Flexibility in the size of the transfers would be important to support domestic

### 15.      Flexibility in the size of the transfers would be important to support domestic

### Flexibility in transfers and fiscal framework
- Flexibility in the size of the transfers would be important to support domestic capital formation and maintain macroeconomic stability within the context of a medium-term fiscal framework.
- Previous analytical work by staff suggests that a rule based on intermediate targets for the non-oil deficit over the medium term may provide greater fiscal flexibility.12
- The authorities’ long-term aim is to reduce the non-oil deficit to 3 percent of GDP by 2020, but no intermediate targets have been determined.10
- Except for the US$8 billion that is transferred to the budget from the NFRK, the authorities exclude revenues from oil in their calculation of fiscal revenues; by that definition they continue to record fiscal deficits that need to be financed by borrowing.11
- Given long-horizon uncertainties, any changes in transfer rules should be assessed carefully; alongside efforts to attract long-term FDI, there appears to be scope for an increase in well-targeted public expenditure in high priority areas—including health, education, and infrastructure—beyond that detailed in the Development Plan 2020.

### Attracting foreign investment
- Measures to catalyze private investment, both in the oil and non-oil economy, should be pursued to encourage a sustainable investment outlook.
- The public sector alone cannot completely fund the economy’s full capital formation needs.13
- Kazakhstan needs to continue to ensure sustained private investment through multi-faceted reforms:
  - preserving macroeconomic stability;
  - improving access to financing;
  - upgrading the investment and business climate.
- Recent work suggests addressing trade and other distortions has an especially significant effect on sustaining high rates of growth (Duttagupta and Mlachila, 2008).

### Ensuring clarity and predictability in the extractive sector
- Clear rules and stability, rather than the political framework, are crucial to ensuring continued investments.
- The authorities have recently tried to rebalance the benefits accruing from the oil wealth, including renegotiations of profit sharing contracts, higher taxes, changes to laws that privilege the public and quasi-public entities,15 and stronger enforcement of local content regulations in all spheres.
- Repeated revisions of the rules have raised concerns because large-scale, long-horizon investments lead investors to place a premium on certainty.
- Reforms to the investment regime should be predictable and well communicated, allowing companies time to comply with new requirements.
- To date, changes in the rules do not appear to have had a meaningful adverse impact on the willingness of foreign investors to continue to invest in Kazakhstan, but there is a need for more predictability and transparency in the operating environment to improve investors’ capacity to plan.

### Enhancing the investment climate and economic diversification
- Kazakhstan has made significant progress in improving the investment environment:
  - In the 2011 Doing Business rankings compiled by the World Bank, its position improved by 15 places (the fastest improvement in the region).
  - Kazakhstan scores well in registering property (28th) and improved on ease of starting a business (from 85th in 2010 to 47th in 2011).
  - Other surveys point to strengths in public finance, infrastructure and labor market flexibility.
- Areas for improvement identified:
  - Trading across borders: Kazakhstan fares poorly and “falls well into the bottom half of the countries in the sample,” with the Doing Business index ranking it close to the bottom 1 percent.
  - Access to credit: Kazakhstan slipped by 3 places in the latest World Bank survey, reflecting ongoing financial sector problems.
  - Health and education: Despite relatively high per capita income, Kazakhstan lags on health and education indicators, reflecting relatively low spending in these areas.
  - Public administration: Efficiency of the bureaucracy and aspects of public administration hinder business capacity to invest and expand.
- Improvements in the business environment are key to support the authorities’ diversification strategy:
  - Investments in non-oil activities need productivity levels that allow them to compete successfully.
  - The chemical industry could be an area of comparative advantage for Kazakhstan.
  - International experience suggests that, in addition to macroeconomic stability, mechanisms to support capital formation—including a healthy business environment—are needed to promote industrialization.

### Key statistics and rankings (as presented)
- Authorities’ target: non-oil deficit reduced to 3 percent of GDP by 2020.
- Transfer exception: US$8 billion transferred to the budget from the NFRK.
- KMG estimate: up to $136 billion needed to fully develop the first phase of the Kashagan oil field.13
- Doing Business 2011 improvements:
  - Ease of starting a business: from 85th in 2010 to 47th in 2011.
  - Registering property: 28th.
- Table III.3 key indicator excerpts:
  - World Competitiveness Yearbook (2011): Finance 51 (13.6), Health and environment 55 (6.8), Education 41 (30.5), International trade 39 (33.9), Bureaucracy 39 (33.9).
  - Doing Business Survey 2011: Finance: availability of credit 72 (60.7), Trade: Trading across borders 181 (1.1), Dealing with construction permits 147 (19.7).
  - Global Competitiveness Index 2010-11: Finance: Financial market development 117 (15.8), Finance: Soundness of banks 131 (5.8), Health 100 (28.1), Education: Primary 77 (44.6), Education: Higher education and training 65 (53.2), Trade: Prevalence of trade barriers 116 (16.5), Public institutions 91 (34.5).
- Note: A higher rank score (and percentile score) is better.

### Conclusion
- Kazakhstan’s oil sector will continue to play a significant role in the economy; ensuring that oil wealth benefits are widely shared is important.
- Oil wealth has been prudently managed and has brought significant improvements in economic development and wellbeing.
- There is a need to ensure the oil sector contributes to medium-term development objectives by:
  - improving the investment climate to facilitate private sector activity, especially in areas of comparative advantage such as the chemicals sector;
  - enhancing absorptive capacity for further public investment;
  - pursuing structural reform efforts to reduce trade distortions and ensure a predictable operating and tax setting in the extractive sector;
  - finding the optimal balance between the use of commodity revenues and their accumulation in the NFRK within a consistent medium-term fiscal framework.

*Source: _cr11151 - 15.      Flexibility in the size of the transfers would be important to support domestic*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11151.pdf_