Press Release No. 08/44

Press Release: Statement of an IMF Staff Mission at the Conclusion of a Visit to the Kyrgyz Republic

March 6, 2008

An International Monetary Fund (IMF) mission visited Bishkek during February 25-March 5, 2008 to conduct discussions for the sixth and final review of the Kyrgyz Republic's arrangement under the Poverty Reduction and Growth Facility (PRGF). The mission, which also discussed with the authorities the outlook for 2008 and the macroeconomic policy mix for the period ahead, issued the following statement today in Bishkek:

"The mission expresses its gratitude for the open and frank discussions and the warm hospitality offered during the mission's stay. Based on the Kyrgyz authorities' policy performance in the last half of 2007, the mission will recommend completion of the sixth review under the PRGF arrangement. The IMF's Executive Board is expected to consider the completion of the review in May.

"Economic growth rebounded strongly in 2007, but inflation also rose sharply. Real GDP grew by 8.2 percent, with nongold output rising by 8.7 percent, led by strong activity in the transport, trade, and manufacturing sectors. A surge in international food and energy prices during the second half of the year contributed to an increase in inflation, to 20 percent by end-2007, compared to 5 percent at end-2006. Non-food, non-energy inflation also increased and reached 8½ percent by end-2007, up from 3 percent at end-2006.

"Based on preliminary data, the current account deficit is estimated to have remained broadly unchanged in 2007, at 6½ percent of GDP. The trade deficit remained high. Strong import growth was offset by an almost equally strong export performance and a further increase in remittances. The current account deficit was more than financed by official and private capital inflows, including foreign direct investment, allowing the National Bank of the Kyrgyz Republic (NBKR) to increase its international reserves by about $375 million to almost $1.2 billion, covering over 3½ months of imports.

"The fiscal outturn for 2007 benefited from the strong overall economic performance and the increase in trade. The consolidated general government budget deficit is estimated to have remained limited to 0.4 percent of GDP, well below the deficit of 3.1 percent of GDP envisaged in the budget, as a result of a significant overperformance in revenue collection. Tax revenues, mainly value added taxes and import duties, exceeded projections, reflecting the strength of the economic recovery, but also improvements in revenue administration. Sizable increases in expenditures, particularly toward the end of the year, including on goods and services and an increase in pensions, did not keep pace with the growth in revenues.

"Faced with rapidly rising inflation, the NBKR started to tighten monetary policy in the fall of 2007. Monetary policy had been expansionary in the middle of the year, with the NBKR resisting pressures on the nominal exchange rate to appreciate through large unsterilized foreign exchange purchases. Starting in September, the NBKR drastically scaled down its intervention in the foreign exchange market and started to actively mop up som liquidity through repurchase operations and issuing NBKR bills. As a result, the som appreciated by almost 10 percent vis-à-vis the U.S. dollar through early December. Interest rates rose considerably, but still became negative in real terms. For the year as a whole reserve money grew by 38 percent, while broad money and credit grew by 33 and 88 percent, respectively, although the level of monetization is still low. Credit growth to the private sector came to a virtual standstill in the last quarter, however, as a decline in loans provided by Kazakh-owned banks (which account for about half of private sector credit) was only just offset by lending by domestic banks.

"More recently, some downward pressures on the exchange rate have emerged. The som depreciated by about 5 percent against the U.S. dollar since mid-December. This partly reflected seasonal factors, including an exceptionally cold winter, as well as a large injection of liquidity stemming from a year-end government spending surge that the NBKR was unable to fully absorb. The more uncertain economic and financial environment in neighboring Kazakhstan may also have played a role. In January and February, the NBKR intervened repeatedly—selling over $60 million—to support the som.

Strong policies are needed to address inflation, balancing this with the need to protect growth in a more difficult global and regional economic environment.

"The Kyrgyz Republic faces a difficult year. International food and energy prices have continued to rise, contributing to further increases in domestic prices. These price shocks come at a time of an expected slowdown in the global economy and a more uncertain regional outlook, including due to the impact of the global financial turmoil on financial and economic developments in Kazakhstan. Any regional economic slowdown would have a strong impact on the Kyrgyz economy. In light of this, the pace of economic expansion, excluding gold production, is expected to slow, to about 5 percent in 2008. With an expected further improvement in gold production, overall economic growth would reach about 7 percent. The current account deficit is expected to widen to about 8 percent of GDP in 2008, including due to a significantly higher import bill for food and energy products.

"The most immediate challenge is to avoid that high inflation becomes entrenched, putting at risk the gains from the authorities' earlier policies. While the increase in inflation has been largely due to external factors, the underlying rate of inflation, excluding food and energy prices, has been rising as well. Additional price pressures will emerge from the further rise in international wheat and energy prices in recent weeks, the already granted increase in government wages, and from the planned increase in utility tariffs by mid-2008. The authorities are committed to bring down inflation to between 12 and 15 percent by year-end.

"To bring down inflation, a swift tightening of monetary policy is needed to reduce second round effects and avoid that price expectations are adjusted upward. Policies should aim to reduce non-food, non-energy inflation to close to 5 percent. The NBKR should mop up liquidity more forcefully through its open market operations and allowing interest rates to rise. Excess reserves of the banks are relatively high, although this may also reflect that banks generally have become more cautious. Still, the NBKR should step up the issuance of NBKR notes, while a gradual conversion of non-marketable government debt in its portfolio into marketable instruments by the Ministry of Finance would allow the NBKR to make greater use of repurchase operations. Consideration could also be given to increasing the interest rate of the NBKR's deposit facility. More generally, in its conduct of monetary policy, the central bank should not be constrained by considerations about its profitability.

"Given the large import content of the consumer basket, in the near term, the NBKR is right to resist downward pressures on the nominal exchange rate. In light of the low level of monetization, the power of the conventional monetary transmission mechanism working from interest rates is still relatively weak. This leaves the exchange rate as a more effective monetary tool to influence inflation. However, the NBKR should avoid large losses in reserves if the downward pressures on the exchange rate of the som were to persist or intensify. If the sentiment in the foreign exchange market reverses again, the NBKR should allow the som to appreciate.

"Fiscal policy needs to be supportive of monetary policy in order to avoid placing the entire burden of reducing inflation on the central bank. However, fiscal policy will need to strike a balance between reducing inflation on the one hand, and protecting economic growth in the face of the increased downside risks and mitigating the effects of the higher price levels on the poor on the other hand. Some widening of the deficit relative to 2007 is therefore appropriate, but not to 2.7 percent of GDP as envisaged in the consolidated general government budget for 2008. Instead, the authorities should strive to limit the consolidated budget deficit to about 1½ percent of GDP. This can be achieved by significantly reducing non-priority spending, while safeguarding social and capital spending, as well as by further strengthening revenue performance. In addition, the reduction in the retirement age introduced last year will need to be reversed to limit the Social Fund deficit, as well as to help ensure its long-term sustainability. To help cushion the effects of the higher wheat prices on the poor, social benefits would need to be raised, while continuing to improve their targeting. Given prevailing social safety net weaknesses, however, consideration could also be given to temporarily further reducing the VAT on bread and bread products.

"Strong supervisory vigilance over the banking sector continues to be needed. With a strong capital base and high levels of liquidity, the Kyrgyz banking system seems well placed to weather a more challenging economic and financial environment. Lending to the private sector expanded very rapidly in 2007, albeit from a low base. A potential decline in the quality of loan portfolios resulting from an economic slowdown, or from last year's overly rapid lending, would likely not affect loan quality indicators immediately. Strong supervision efforts, including enhanced analysis and inspections, are therefore needed to detect and address the emergence of any potential liquidity or solvency issues early on."