Public Information Notice No. 03/28

Public Information Notice: IMF Concludes 2002 Article IV Consultation with the Kyrgyz Republic

March 7, 2003

On February 19, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Kyrgyz Republic.¹

Background

Program summary

After two years of real GDP growth above 5 percent, output stagnated in 2002. It was adversely affected by a large landslide at the Kumtor gold mine—the country's major exporter—and weather-related contraction in hydro-electric energy production. On the other hand, real GDP excluding gold and energy recorded a 3.5 percent growth rate. Price stabilization has continued: the 12-month inflation fell to a lowest level during independence to 2.3 percent.

The proposed program is consistent with the country's National Poverty Reduction Strategy (NPRS) presented to the IMF and the World Bank on December 9, 2002. It projects a real GDP growth of 5 percent a year in 2003-2006 supported by productivity gains through structural reforms and more efficient use of capital and labor. The key policies include a continuous fiscal adjustment and a modest growth of som broad money of 15 percent in 2003 after rapid remonetization of the economy observed recently. The National Bank will continue its exchange rate policy of a managed float, which has served the country well. It will intervene in the foreign exchange market to smooth temporary market fluctuations and to accumulate reserves as appropriate. The program aims at a 4 percent inflation in 2003 and the medium term.

Total factor productivity is expected to be the main source of growth resulting from structural reforms, including in the areas of governance and the banking sector. As gold production is expected to start declining in the medium term, other industries will need to offset its negative growth impact which calls for strong cost competitiveness of exports. Export volumes are projected to grow 4.5 percent per year.

The continuation of fiscal adjustment is necessary for the success of the foreign debt reduction strategy launched in 2001. To strengthen the tax base, the government has introduced the 2003 budget with several new tax measures including an extension of VAT to cover large agricultural producers' sales in the domestic market. Overall, the general government tax-to-GDP ratio is expected to increase to 18 percent in 2003 from 17 percent in 2002. The authorities intend to streamline the Public Investment Program to 4.5 percent of GDP in 2003 so that the overall cash deficit will decline to 4.6 percent of GDP down from 5.6 percent of GDP in 2002. In the medium term, the fiscal deficit is targeted to fall to 3 percent of GDP. The proposed second-year program is fully financed through a combination of debt reschedulings from the Paris Club and balance of payment support from multilateral institutions.

The need to reduce trade restrictions in Central Asia is crucial to reap the benefits of foreign trade. The Kyrgyz authorities already maintain a liberal and low tariff trade regime. Recently, in line with World Trade Organization recommendations, the top import tariff has been further reduced and the number of tariff bands cut from six to four. The authorities also agreed to refrain from introducing new tariffs or nontariff barriers on agricultural or other imports.

Progress in improving governance to reduce corruption and state capture and reforms in the banking sector are critical for the success of the program. The new governance initiative aims at increasing the efficiency of public administration, the effectiveness of corporate governance, and the transparency of the judiciary. The banking reform, drawing on the recommendations of the recent Financial Sector Assessment Program (FSAP), aims at strengthening bank supervision, divesting state-owned banks, and computerize the payments system.

The Kyrgyz Republic joined the IMF on August 5, 1992. Its quota² is SDR 88.8 million (about US$120 million). The Kyrgyz Republic's outstanding use of IMF credits at end-November 2002 totaled SDR 137.9 (about US$186.4 million).

Executive Board Assessment

Directors commended the Kyrgyz authorities for their prudent monetary and fiscal policies. While real GDP contracted somewhat in 2002, partly owing to one-time factors, it was set to grow again in 2003 at about the strong pace of the preceding five years. Inflation has fallen significantly over the same period and remains well contained, and international reserves are growing, supported by broad exchange rate stability for the som. Importantly, economic growth has reduced poverty, especially in the rural areas, and income distribution has improved.

Directors emphasized that, despite the encouraging progress seen in those areas, many challenges remain. The level of external debt remains high, more needs to be done to reduce poverty and improve social conditions, and in light of the decline in gold resources, greater diversification of the economy is needed, built on stronger small- and medium-scale enterprises. More progress in reducing corruption and state capture and improving governance is also essential to encourage private sector investment and economic diversification, and to instill greater public faith in state institutions. Directors welcomed the authorities' determination not to repeat the uneven policy implementation of previous Fund-supported programs, and to move ahead with a realistic and pragmatic policy and reform agenda.

Directors commended the authorities for meeting the current Poverty Reduction Growth Facility-supported program's fiscal targets despite the shortfall of revenue from the Kumtor gold mine. At the same time, they stressed that achieving a sustainable fiscal position over the medium term will depend crucially on further reforms in tax administration and broadening the tax base. In this context, Directors welcomed the submission to parliament of legislation to extend the VAT to large agricultural producers, while also having included in the budget measures to protect the poor from potentially higher food prices. On the expenditure side, Directors supported the authorities' intention to use the scope created by a further streamlining of the Public Investment Program and cuts in spending on less essential items to increase spending on social and poverty reduction programs.

Directors noted that the central bank's monetary policy has contained inflation while allowing for a remonetization of the economy. In view of the strong growth of the monetary aggregates, they urged the authorities to react quickly to any sign of rekindling inflation by tightening monetary conditions through open market operations. The recent issuance of marketable government securities by the Ministry of Finance to the central bank provides room for maneuver in this respect.

Directors considered that the exchange rate policy of managed floating has been successful in preventing excessive appreciation of the nominal exchange rate and thereby supporting competitiveness. They commended the authorities for their liberal trade and foreign exchange regimes.

Directors emphasized that, in light of steadily declining gold resources, diversifying the export base will be essential if the authorities' medium-term growth and poverty reduction objectives are to be attained. Improved cost competitiveness in the non-gold sector through increases in productivity, along with continued low inflation, would be important in that regard. At the same time, Directors noted that the trade restrictions and other non-tariff barriers constrain Kyrgyz export prospects in the region, and hamper the realization of the country's comparative advantage and export potential. They emphasized the importance of addressing these restrictions in the context of intensified regional cooperation.

Directors agreed that the implementation of the external debt strategy was on track, and they encouraged the government to adhere strictly to its objectives, in particular by further fiscal consolidation and by avoiding fiscal slippages in the run-up to the 2005 parliamentary and presidential elections. Directors welcomed the completion of all bilateral debt reschedulings with Paris Club creditors, and encouraged the authorities to pursue agreements with all remaining non-Paris Club creditors on comparable terms. Strong implementation of the PRGF-supported program would be the best way to encourage Paris Club creditors to exercise their goodwill clause for a debt stock relief in 2004.

Directors believed that more should be done to push forward the structural reform agenda. They stressed that strengthening governance, the legal system, and the banking sector is crucial to improving the business climate, attracting foreign direct investment, and boosting productivity. The authorities should take a firm stance against corruption and state capture, which undermine private investment and the opportunities of small and medium-size enterprises. Directors underscored the need to continue developing the still small banking sector, and address bank vulnerabilities. They urged the authorities to apply strictly the prudential regulations in order to improve public trust in banks. They welcomed the submission to parliament of a draft law on anti-money laundering and combating the financing of terrorism, in line with the recommendations of the Financial Sector Assessment Program. Directors stressed the importance of restructuring and privatizing public enterprises.

Directors commended the authorities for the broad participatory process employed in preparing the National Poverty Reduction Strategy (NPRS), which provides a comprehensive approach to poverty reduction and medium-term macroeconomic strategy. However, Directors underscored the need to strengthen costing, prioritization, and sequencing of policy measures in the NPRS, and to finalize implementation plans and monitoring and evaluation mechanisms in the NPRS Secretariat.