Public Information Notice No. 05/4

Public Information Notice: IMF Executive Board Concludes 2004 Article IV Consultation with the Kyrgyz Republic

January 14, 2005

On November 19, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Kyrgyz Republic.¹

Background

The Kyrgyz Republic has enjoyed strong economic performance since the last Article IV consultation in February 2003. Real GDP growth was 6.7 percent in 2003 and 7 percent in January-September 2004. Economic activity is becoming more broad-based, and annual real GDP growth outside the Kumtor gold mine and the energy sector has been steadily at or above 4 percent since 2000. Productivity improvements, including greater capacity utilization, have made an important contribution to growth, although investment has been an important factor this year. Per capita U.S. dollar GDP rose by 1/3 from 2000 to 2003, during which time the official poverty rate fell from 52 to 41 percent. At about 3 to 4 percent, annual inflation rates remain low. External current account deficits in 2002 and 2003 were equivalent to about 2½ percent of GDP, with both imports and exports growing rapidly. Private transfers received from Kyrgyz working abroad have become an important source of income, reaching about 5 percent of GDP. External debt has stabilized, while the ratio of debt to GDP (and other debt ratios) have begun to fall. With the receipt of about $80 million in privatization proceeds resulting from the sale of government shares in Centerra, the Canadian company that operates the Kumtor gold mine, official reserves of the central bank have reached nearly $500 million, equivalent to about 5 months of imports.

The Kyrgyz Republic's good economic performance owes much to its macroeconomic policies. The general government fiscal deficit has been gradually reduced from 5½ percent of GDP in 2002 and is on target toward 4 percent of GDP this year. Fiscal consolidation has helped to stabilize external debt, particularly by containing the externally-financed public investment program. Tax performance has improved gradually, and the ratio of general government tax revenues to GDP will reach about 18 percent this year, compared to 16 percent in 2001. The 2001-04 Paris Club debt rescheduling has been an important factor allowing more spending on social and anti-poverty priorities. Social spending (including education, health, social security and welfare, and the pension fund) rose from 12 percent of GDP in 2000-01 to 14 percent presently.

The exchange rate of the som has been broadly stable. Low inflation has allowed for a modest nominal appreciation while maintaining external competitiveness. Ratios of money and credit to GDP remain low, even by Commonwealth of Independent States standards. Nevertheless, remonetization is progressing and growth rates of private sector credit are high. The banking sector is being reshaped by foreign investment, with seven foreign banks now operating in the country and accounting for one half of bank loans and deposits. Most bank lending and deposit taking continues to take place in U.S. dollars or other foreign currencies. Financial soundness indicators suggest a gradually strengthening banking system.

In June 2004 the IMF Executive Board completed the fifth review under the three-year economic program supported by the Poverty Reduction and Growth Facility (PRGF).

Executive Board Assessment

Directors commended the Kyrgyz authorities for the economy's strong performance in recent years, reflecting prudent fiscal and monetary policies and a favorable external environment. Economic growth has begun to broaden, inflation has remained low, the balance of payments has strengthened, external debt has been reduced, and poverty has declined albeit from high levels. Nevertheless, Directors noted that important challenges remain. The still heavy external debt burden calls for continued fiscal discipline while ensuring adequate spending to support poverty reduction efforts. The anticipated decline in gold exports calls for actions to diversify exports and preserve cost competitiveness through low inflation and structural reforms to boost productivity growth. Further efforts will also be needed to improve the investment climate by advancing tax reform, improving public administration, addressing corruption and governance problems that contribute to the growing shadow economy, and strengthening the financial sector.

Directors recognized the authorities' good record of responding to Fund policy advice, both under surveillance and the most recent PRGF-supported program. While the strengthening of policy implementation has been particularly evident in the fiscal area, Directors underscored that further fiscal consolidation is essential. The gradual reduction of fiscal deficits needs to be continued for the success of the external debt strategy, and spending controls need to be further strengthened to keep expenditures on the budgeted track. Directors welcomed the partial sale of state-held shares in the Centerra gold company which provides more flexibility to increase poverty-related investments, without compromising the prospects for debt sustainability. Going forward, they supported the gradual reorientation of spending toward poverty-reducing areas, in line with the country's poverty reduction strategy, but underscored the importance of ensuring the quality of social sector and poverty reduction projects. Over the medium term, the authorities were also encouraged to embark on a reform of the civil service.

Directors welcomed the gradual increases in the ratio of tax revenues to GDP in recent years even though some tax rates have been reduced. This performance mainly reflects improved administrative efficiency, and Directors looked forward to more concrete steps toward broadening the tax base and further efforts to improve tax administration. They supported the recent efforts to overhaul the tax code and to simplify and strengthen small business taxation, and welcomed plans to gradually reduce the payroll tax rate, beginning in 2005, which will be a key step in the effort to contain the shadow economy.

Directors commended the National Bank of the Kyrgyz Republic's (NBKR) skillful monetary and exchange rate management. They observed that the rapid growth of private sector credit calls for strong bank supervision and close monitoring of the quality of banks' loan portfolios. They welcomed the increasing foreign participation in the banking system, but saw this development as calling for enhanced cooperation with foreign supervisory counterparts. Directors also stressed the need for strengthening central bank independence, and deepening financial markets. They welcomed the progress in implementing most of the Financial Sector Assessment Program recommendations, and looked forward to steps to addressing the remaining issues, including in the area of combating money laundering and the financing of terrorism. Directors agreed that the managed float exchange rate regime remains appropriate under the country's circumstances, while encouraging the authorities to allow more flexibility in the exchange rate, including by allowing it to appreciate when warranted by market forces.

Directors took note of updated staff projections of the Kyrgyz Republic's external debt suggesting that further Paris Club debt relief appears necessary. Directors underscored, however, that reaching and maintaining debt sustainability will also require continued implementation of sound macroeconomic policies and structural reforms as well as a prudent debt strategy. Many Directors highlighted the importance, in this context, of containing both concessional and non-concessional borrowing in the future, with several of them encouraging a continued shift to grant financing.

Directors urged the authorities to approach structural reforms with renewed vigor. While financial sector reform is advancing, energy sector reform needs to be accelerated, in particular by taking further measures to improve cost recovery, including through tariff increases. On governance, Directors welcomed the adoption of the Extractive Industries Transparency Initiative, but stressed that concrete and wide-ranging steps will be needed to improve the business climate. It will be important that all public policy decisions carefully consider the implications for corruption and governance to minimize opportunities for public officials to exercise undue discretion. Directors commended the Kyrgyz Republic's liberal trade policies. They encouraged the authorities to work with other Eurasian Economic Community members to ensure that tariffs and other trade policies remain as liberal as they are today and to foster close regional cooperation.

Directors agreed with the general conclusions of the ex post assessment (EPA) on the lessons from past Fund engagement and the guidelines for future Fund support. They noted that policy implementation had been uneven in early programs reflecting a variety of factors, including the difficult, unchartered, and rapidly changing conditions of the transition to a market-based economy as well as weaknesses in Fund program design and sequencing. Directors were, however, encouraged that policy implementation has improved considerably under the current PRGF arrangement. Directors also highlighted the lessons of the EPA on the importance of avoiding the build-up of unsustainable debt. Looking ahead, they stressed the need to reduce the gap between legislative initiatives and policy implementation as a signal of strong ownership of reform policies, as well as to pay particular attention to weaknesses in public administration and governance issues that contributed to serious setbacks under earlier programs.