Public Information Notice No. 99/27

Public Information Notice: IMF Concludes Article IV Consultation with Kyrgyz Republic

March 29, 1999

On March 3, 1999 the Executive Board concluded the 1998 Article IV consultation¹ with the Kyrgyz Republic.

Background

The Kyrgyz Republic embarked upon a successor three-year ESAF arrangement in mid-1998 to consolidate the gains in macroeconomic stabilization and the establishment of a market-based economy that had been achieved under the first three-year ESAF arrangement. However, the financial turmoil in Russia severely affected macroeconomic performance in 1998 and slowed down the reform momentum in some areas. These developments confronted the Kyrgyz authorities with the challenge of designing an appropriate policy package to address the adverse external environment and bring the ESAF program back on track.

After two years of robust growth at about 7 percent in 1996 and 10 percent in 1997, real GDP growth slowed down to only 2 percent in 1998, as gold and agricultural production leveled off and the financial turmoil in Russia hit the Kyrgyz economy in August 1998. At the same time, the twelve-month inflation was reduced to single-digit levels by mid-1998 before accelerating to 18 percent by year-end, mirroring the 35 percent depreciation of the national currency, the som, that was triggered by the events in Russia. The external shock severely affected traditional Kyrgyz export markets in the CIS, and coupled with buoyant import demand for consumption goods, contributed to a doubling of the external current account deficit to about 17 percent of GDP in 1998. The large depreciation of the som and the shortfall in exports also led to a noticeable worsening of the external debt indicators; the external debt/GDP ratio rose from 54 percent in 1997 to 66 percent in 1998, and the NPV of debt/exports ratio from 115 percent to 137 percent.

Despite these setbacks, considerable progress was made in fiscal consolidation and retrenchment. The primary deficit (excluding the foreign-financed public investment program, PIP) was reduced from 13 percent of GDP in 1995 to less than 2 percent in 1998 and the general government balance (including the PIP) from 17 percent of GDP to 9 percent, respectively, as non-priority spending was reduced and efforts to modernize the tax system and administration strengthened tax collections. However, in view of weaknesses in expenditure management and the drying up of domestic financing due to sharply rising interest rates for Treasury bills in the wake of the Russia crisis, sizable budgetary expenditure and pension arrears emerged toward the end of 1998.

In 1998, reserve and broad money growth slowed down to 7 percent and 17 percent, respectively, as the National Bank of the Kyrgyz Republic (NBKR) increased key central bank rates, mopped up banks’ excess liquidity, and stiffened penalty rates for the nonobservance of reserve requirements. Nevertheless, the significant tightening of monetary policy and large-scale interventions in the foreign exchange market by the NBKR could not prevent a sharp depreciation of the som and a resurgence in inflation. By year-end, the exchange rate had stabilized at about 30 som per U.S. dollar. While the banking system remains sound in general, some commercial banks have been experiencing increasing difficulties in meeting prudential ratios and in securing loan repayment by some borrowers, which prompted the NBKR to enhance its supervision of the banking system.

Structural reforms continued at a steady, if uneven, pace, but implementation weaknesses remain in some important areas. Improvements were made in the area of civil service reform, external debt management, statistics, legal and regulatory reform, and the adoption of sectoral strategies especially for the agricultural and energy sectors; a major milestone in promoting the country’s economic development was the recent approval of a referendum allowing the full private ownership of land under the constitution. A comprehensive reform of the public pension system was launched under a World Bank-supported adjustment operation, which, however, was challenged recently before the Constitutional Court. The legal and regulatory framework was strengthened through the adoption of a variety of laws conducive to economic activity in a market environment, including a new bankruptcy law, a civil code, a law on collateral, a banking law, as well as changes in a number of laws to comply with WTO rules, given the Kyrgyz Republic’s accession to the WTO in October 1998 as the first country in the CIS. But progress related to other legislation, such as the mortgage law, has been slow, and implementation difficulties have undermined the effectiveness of the modernized legal framework. Under the relaunched privatization program, only a few enterprises were sold in 1998; the privatization of large state-owned monopolies has proven particularly slow, and some public enterprises, such as Kyrgyz Airlines, continue to be a burden on the budget. Efforts to transform state and privatized enterprises into viable businesses under the AsDB-financed corporate governance program have encountered some delays, although progress has been made in introducingmodern management techniques, entrepreneurial know-how, and international accounting and disclosure standards.

Executive Board Assessment

Executive Directors noted that the external shock caused by the onset of the Russian crisis in August 1998 had slowed down the macroeconomic stabilization and structural adjustment that had successfully begun under the first three-year ESAF arrangement. While noting that there had been some policy shortcomings in the immediate response to the crisis, Directors commended the authorities for the strong policy actions subsequently adopted to bring the program back on track. In their view, those actions, together with the authorities’ commitment to pursue tight financial policies and enhance structural reforms, should help stabilize the situation and foster an environment conducive to sustained economic growth.

Directors agreed that the policy mix should be shifted to give fiscal policy a larger role in further containing domestic demand, while setting the stage for a recovery of the private sector. In this context, they agreed that the fiscal adjustment envisaged for 1999, while ambitious, was required in the current environment. They therefore welcomed the revenue-enhancing measures adopted by the authorities, and urged them to resist proposals to grant tax holidays or exemptions, which could erode the tax base. Directors expressed concern about the magnitude of budgetary expenditure and pension arrears accumulated during 1998, and urged the authorities to adopt a supplementary budget for 1999 so as to facilitate the clearance of arrears. In the same vein, they welcomed the authorities’ intention to strengthen expenditure management and overhaul the treasury system. Several Directors emphasized that social spending should be protected from the cuts in the 1999 supplementary budget, so as to help alleviate the impact of the current economic crisis on the poorest and most vulnerable segments of the population. They stressed, in particular, the importance of focusing on the efficiency of spending on health and education.

Directors concurred with the view that monetary policy was appropriately tightened in the aftermath of the Russian crisis, but felt that the National Bank of the Kyrgyz Republic could have better protected its foreign reserves during the first few weeks of the crisis by allowing a faster depreciation of the currency. They encouraged the national bank to continue the present exchange rate policy stance, which limits intervention in the foreign exchange market to the smoothing of temporary fluctuations in the exchange rate. They shared the authorities’ concern about the financial impact of the Russian crisis on the Kyrgyz banking system, and commended the national bank for its decisions to raise prudential requirements and strengthen banking supervision.

Directors expressed concern about the deterioration in the Kyrgyz Republic’s balance of payments and the worsening of key external debt indicators. They recognized that these developments were related to a large extent to the impact of the financial turmoil in Russia, and they approved the authorities’ request for an up-front augmentation of access under the ESAF to meet a larger balance of payments need. Nevertheless, Directors stressed the need for enterprises to adjust along the lines of the country’s comparative advantage so as to producemarketable exports and help the country achieve external viability over the medium term. They also urged the authorities to follow a cautious external borrowing strategy.

Directors commended the authorities for their decision to close three nonviable free economic zones and to control more strictly the activities of the remaining zones. Additionally, they commended the Kyrgyz Republic’s recent accession to the WTO and the authorities’ commitment to maintaining an open and liberal trade and exchange regime.

Directors expressed concern about the slowdown of the reform momentum in some structural areas, especially privatization and the modernization of the legal and regulatory framework. They underscored the importance of rapidly implementing structural reforms as an important factor to improve the efficiency of the economy and its resilience to external shocks. Emphasis on structural issues would also contribute to a more sustainable fiscal situation. In particular, they urged the authorities to speed up the privatization of the large state monopolies, including Kyrgyz Airlines, and to adopt the necessary legal framework for the private ownership of land.