Public Information Notice No. 05/87

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with the Republic of Kazakhstan

July 13, 2005

On July 1, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Kazakhstan.¹

Background

Kazakhstan's economy continued to grow rapidly and real GDP growth remained robust at an estimated 9.4 percent in 2004. Increased hydrocarbon production continued to underpin growth, although the output of nonhydrocarbon sectors also expanded at a rapid pace. Consumer price inflation picked up to 6.9 percent, near the upper end of the National Bank of Kazakhstan's (NBK) band of 5-7 percent. Labor market conditions tightened, with real wages increasing by 14 percent, the unemployment rate declining to 8.4 percent, and a marked pickup in immigration. Activity remained strong in early 2005 with an estimated 9.3 percent real GDP growth in the first quarter, and inflation picked up to an average of 7.1 percent during January-April. Sustained rapid growth has led to a significant reduction in poverty, but some other social indicators remain weak.

Fiscal policy imparted stimulus to the economy as the non-oil deficit widened by about 1½ percentage points to 4.7 percent of GDP in 2004, while the overall budget surplus remained broadly unchanged at 2.7 percent of GDP. The impact of tax cuts was partly offset by higher nontax revenue and one-off receipts. As a result, non-oil revenues increased broadly in line with estimated non-oil GDP, but declined in relation to overall GDP. On the expenditure side, public spending increased by 0.8 percent of GDP, reflecting a rise in social expenditures by 0.4 percentage point as well as sizable increases in the housing, agriculture, and energy areas. Assets of the National Fund of the Republic of Kazakhstan (NFRK) rose by US$1.4 billion (3.4 percent of GDP) to over US$5 billion.

The external position strengthened further in 2004, supported by high oil prices and large-scale external borrowing by banks. The current account swung into surplus, with the rise in hydrocarbon export receipts more than offsetting a very rapid expansion of imports and higher profit remittances abroad. Non-oil exports also expanded rapidly, aided by buoyant nonfuel commodity prices. The capital account surplus widened, reflecting continued large foreign direct investment inflows and an increase in private sector external borrowing, as banks took advantage of low international interest rates and favorable investor perception of Kazakhstan to mobilize funds abroad through syndicated loans and eurobond issuance. As a result, official reserves (excluding NFRK assets) rose to US$9.3 billion at end-2004, equivalent to six months of imports, with a marked pickup in the pace of accumulation during the last quarter of the year.

The conduct of monetary policy has been complicated by the large inflows of private capital, surging oil earnings, and buoyant demand conditions. In an effort to stem upward pressure on the tenge while containing money growth, the NBK supplemented its exchange market intervention with continued large-scale sterilization operations. In the event, with sterilization costs mounting, the increase in the NBK's reserves was not fully sterilized. Reserve and broad money growth accelerated, the tenge appreciated by 9 percent against the U.S. dollar and 4 percent against the ruble, and the NBK incurred a net loss for 2004.

With the deposit base expanding and external funding readily available at attractive terms, bank lending has boomed. Credit surged by over 50 percent in 2004, while deposits increased by about 70 percent, with the share of tenge deposits rising markedly to almost two thirds. Property-related lending expanded especially rapidly and, by end-2004, accounted for 18 percent of bank credit. Banks have also become increasingly active internationally on the assets side, through branch operations, acquisitions of financial entities in neighboring countries, and a pickup in cross border lending operations. The banking system's ratios of classified loans and loan losses have edged up.

Although considerable progress in the structural area has been achieved since the early 1990s, the pace of reform implementation has slowed in recent years. Privatization of small- and medium-sized enterprises is basically complete, prices have been liberalized, and a framework for prudential regulation and supervision of the financial sector is in place, including with the establishment of the Financial Supervision Agency in 2004. In addition, steps have been taken to bring foreign trade policy legislation and enforcement practices into compliance with the World Trade Organization. However, transition indicators compiled and reported by the European Bank for Reconstruction and Development show little improvement since the late 1990s in the areas of competition policy and enterprise restructuring.

Executive Board Assessment

Executive Directors commended the Kazakhstani authorities' prudent macroeconomic policies in the past several years, which have been critical in achieving rapid economic growth, declining unemployment, and sustained reduction in poverty. Looking forward, Kazakhstan's economic outlook remains highly favorable, providing a good opportunity to continue addressing the country's pressing social needs and regional disparities, and improving living standards on a lasting basis. Kazakhstan's sizable petroleum wealth offers tremendous opportunities but also presents significant challenges. Directors agreed that meeting these needs and challenges will require continued efficient and sustainable management of petroleum wealth, keeping inflationary pressures in check, and implementing structural reforms to promote economic diversification.

Directors noted that the fiscal stance remains consistent with fiscal sustainability, given the outlook for oil prices and production. While welcoming the increase in social spending, Directors cautioned that the large across-the-board increases in civil service salaries could exacerbate inflationary pressures and have longer-term fiscal implications. Accordingly, they encouraged the authorities to consider reforms aimed at restructuring the civil service and improving its pay structure. Directors also emphasized the importance of intensifying scrutiny over spending efficiency.

Directors welcomed the authorities' commitment to maintaining low inflation. Given the choice of a looser fiscal stance, they considered that sufficient upward exchange rate flexibility should be allowed to dampen inflationary pressures and bring inflation down within the NBK's band. Achievement of the inflation objective would clearly demonstrate the commitment of the authorities to price stability as the primary goal of monetary policy. Directors also discussed the impact that appreciation of the tenge could have on competitiveness. They recognized that the overall policy mix, particularly the quality of fiscal and structural policies, would be crucial for generating the productivity gains needed to preserve the competitiveness of the non-oil sector over the longer term.

Directors noted that the conduct of monetary policy in the present context characterized by large capital inflows, and given the authorities' plan to remove the remaining capital account restrictions by 2007, would benefit from increased exchange rate flexibility. Looking ahead, Directors welcomed the authorities' intention to move to a full-fledged inflation-targeting regime over the medium term. While the related supporting infrastructure is being developed, some exchange market intervention and accompanying sterilization may still be warranted in the near term to avoid excessively rapid appreciation. Directors welcomed plans to broaden reserve requirements, and agreed that coverage of all foreign and domestic liabilities would aid the conduct of monetary policy. They also looked forward to the planned recapitalization of the NBK.

Directors saw the ongoing process of remonetization and dedollarization as a welcome sign of increased confidence in the banking system. While the banking system remains well capitalized, the recent surge in bank lending warrants close monitoring of the quality of loan portfolios. Directors urged the authorities to implement promptly the measures under consideration to stem risks related to banks' foreign borrowing and property-related lending. They welcomed efforts to close gaps in prudential regulations over related-party lending as well as the plans to mitigate risks associated with cross-border lending.

Directors urged the authorities to ensure that banking supervision, including supervisory resources, keeps pace with the growth and development of the financial system, particularly in light of the ongoing efforts to promote Almaty as a regional financial center. To facilitate effective consolidated supervision of financial institutions, Directors encouraged the authorities to enhance procedures for the exchange of information with central banks and supervisory agencies in neighboring countries. They also called for approval and implementation of enhanced legislation to meet international standards in combating money laundering and the financing of terrorism.

Directors welcomed the authorities' initiative to redesign the longer-term oil wealth management strategy and the rules governing the NFRK. Directors welcomed the authorities' interest in a fiscal ROSC reassessment, which would help in the design of the new NFRK rules. They noted that full integration of the NFRK with the budget will improve the transparency of oil revenue and better inform fiscal policy decisions. To safeguard oil wealth and protect the economy from fluctuations in world oil prices, Directors recommended that the release of funds from the NFRK to the budget be guided by a medium-term fiscal sustainability framework that targets the non-oil deficit-grounded by prudent assumptions regarding longer-term oil prices and production. Directors welcomed the authorities' plan to join the Extractive Industries Transparency Initiative, which would further enhance transparency.

Directors stressed that decisions on further sizable tax cuts should be aligned with the new oil wealth management strategy, and be based on the availability of sufficient budgetary resources, once priority spending needs have been met. They urged the authorities to resist proposals to differentiate tax rates across sectors, particularly VAT rates, given their highly distortive nature.

Directors called for reinvigorating structural reforms to enhance economic governance and improve the investment climate. Institutional development should be stepped up, especially in relation to procurement systems and public investment monitoring. Reforms in the areas of competition policy and enterprise restructuring should improve the provision of basic services and lower the cost of doing business in Kazakhstan. Directors observed that early WTO accession and further trade liberalization, particularly through a reduction in tariff dispersion and steps to facilitate regional trade, would help boost the non-oil sector's growth prospects.

Regarding development institutions and industrial promotion, Directors stressed the need to ensure that the clusters initiative remains focused on labor training and infrastructure provision, and that development institutions' lending is well-targeted and restricted to addressing genuine market failures in the availability of long-term financing. They urged the authorities to refrain from offering tax incentives and providing credit on subsidized terms or to projects of uncertain commercial viability.

Directors commended the improvements in the quality and provision of economic statistics. They encouraged the authorities to work toward a more rigorous separation of national accounts data (including imports) into the oil and non-oil sectors of the economy, and to seek technical assistance to this end.