Public Information Notice No. 98/47

Press Information Notice: IMF Concludes Article IV Consultation with Kazakhstan

July 1, 1998

On June 24, 1998, the Executive Board concluded the Article IV consultation with Kazakhstan¹.

Background

Kazakhstan has made substantial progress in transforming its economy into a market-based system. Macroeconomic stabilization has been broadly achieved, the domestic market is fairly liberalized and open to foreign competition, and the role of the state in the economy has been considerably reduced.

Following a decline of real GDP by 31 percent during 1992–95, growth resumed in 1996, and annual growth rates of 2 percent were recorded in 1997 and the first quarter of 1998. At the same time, annual inflation has fallen continuously to less than 10 percent by May 1998, from a peak of more than 3,000 percent in mid-1994. Though the external current account deficit has widened in recent years, due in particular to imports of capital goods needed to develop Kazakhstan’s vast natural resources, the financing of the deficit has not posed major problems since Kazakhstan has benefitted from large foreign direct investment inflows, mainly into the oil and gas sectors. At end-1997, external debt amounted to about 20 percent of GDP, and gross international reserves were equivalent to about 3 months of imports of goods and nonfactor services.

Fiscal developments in recent years have been dominated by a decline in revenues due to weaknesses in tax collection and the accumulation of substantial arrears, especially on wages, utilities, and pensions. The authorities have responded to these problems with a wide-ranging effort to reform fiscal institutions, strengthen tax and expenditure policy and management, and to repay arrears. The repayment of arrears, equivalent to 3 percent of GDP, was the main factor responsible for the widening of the budget deficit in 1997, to 7 percent of GDP from 5.3 percent in 1996. (In the government’s presentation, which treats privatization receipts as revenues, the deficit widened to 3.8 percent of GDP in 1997, from 3.1 percent in 1996).

Although the fiscal deficit has been fairly high over the past two years, the government has managed to obtain noninflationary financing through significant privatization receipts and foreign borrowing. Thus, in December 1996, Kazakhstan accessed successfully the Eurobond market for the first time, and floated a second Eurobond in September 1997. Financing from the domestic banking system was less than 1 percent of GDP in 1997.

In these circumstances, the National Bank of Kazakhstan (NBK) was able to follow anti-inflationary monetary and exchange rate policies during 1997. Money demand recovered significantly during the year, and banking sector credit to the economy expanded substantially in real terms. With stable conditions in the foreign exchange market and rapidly declining inflation, interest rates fell sharply during the first nine months of 1997. However, during the last quarter of 1997 and the first quarter of 1998, the turmoil in financial markets in Asia and Russia adversely affected the foreign exchange and treasury bill markets in Kazakhstan. In response, the NBK sold substantial amounts of foreign exchange in the market while also letting the exchange rate for the Tenge depreciate somewhat from the beginning of 1998. The resulting tightening of liquidity led to a substantial increase in treasury bill yields during this period, but yields fell again in April and May as foreign exchange market pressures eased.

Substantial progress continued to be made in 1997 toward reducing the government’s role in the economy, while better defining its regulatory oversight and policy formulating functions. Privatization of small- and medium-sized enterprises has been virtually completed, and progress has been made in large scale-privatization. However, the temporary suspension of the sale of enterprises in the oil and gas sector, in the context of a review of privatization policies vis-à-vis strategic enterprises, led to a slowdown in the privatization of such enterprises in the second half of 1997 and a delay in the launching of the "Blue Chip" program, which is only now getting under way.

In addition to pursuing reform through privatization, numerous initiatives were taken to reform the transportation and communication sectors, health and education, and agriculture. Enterprise reform continued through restructuring and liquidation and the divestiture of their social assets. Legal reforms included the preparation of laws governing competition and natural monopolies and defining the government’s regulatory role in this regard. Several steps have also been taken to address the systemic weaknesses of the banking sector, including improvements in the payments system, strengthening of prudential regulations and supervision, and the merger or liquidation of insolvent banks.

A major reform of the pension system was introduced, effective January 1, 1998, through the replacement of the pay-as-you-go system with a privately managed fully-funded system, akin tothat introduced in Chile in the early 1980s. Strengthening the administration of the new system, including addressing the problem of collecting contributions in a timely manner, is a main challenge facing the government.

Executive Board Assessment

Executive Directors commended the authorities for their overall good policy implementation record, which had resulted in the resumption of economic growth and a decline in annual inflation to single digits, as well as an improvement in investor confidence. Directors also noted that significant progress continued to be made in the area of structural reform, although they regretted the recent slippages in the areas of trade liberalization and privatization.

Directors generally welcomed the authorities’ planned reform agenda, which attested to their commitment to a market-based system and to the strengthening of the role of the private sector in economic activity. Directors underscored, however, that the achievement of the government’s objectives for 1998 and the realization of Kazakhstan’s vast potential in the medium term would require continued skillful and determined policy implementation, in particular in view of the many uncertainties faced by the authorities, such as the possible contagion from the crises in Asian and Russian financial markets.

Directors noted that the uncertain external environment and the already weakened external current account position faced by Kazakhstan would require flexible monetary and exchange rate policies. In this context, Directors welcomed the greater emphasis placed by the National Bank of Kazakhstan on the use of indirect monetary policy instruments, which had given it greater flexibility in policy implementation. They also welcomed the authorities’ decision to retain the current managed floating exchange rate system, which would enable them to react appropriately if fiscal and credit policy proves insufficient to address domestic and external shocks.

Directors observed that the budget deficit expected for 1998 was large by international comparison, albeit partly as an inevitable result of the introduction of a fully funded pension system. Therefore, in order to help reduce inflation and strengthen national saving, they emphasized the importance of keeping the deficit within the programmed ceiling and of reducing it significantly over the medium term. Specifically, as regards 1998, Directors urged the authorities to implement the contingency package of expenditure reduction measures, if needed to meet the deficit target. They noted, however, that, although there was some room for further expenditure cuts in the short run, the main contribution to fiscal consolidation would have to come from additional significant improvements in revenue collection. In this regard, Directors noted that the authorities had moved quickly to adopt a new tax code, which could be a model for transition countries, and they called for its full implementation and for steps to further strengthen tax administration. Such improvements in revenue performance would be particularly important given the low revenue ratio and the expected shrinking of privatization revenues over the next several years. Several Directors also expressed concern about the continued tax arrears as well as interenterprise arrears, which risked underminingmacroeconomic stability, and urged the authorities to strengthen their efforts to address these problems.

Directors commended the authorities for the bold steps taken to reform the pension system. In view of the radical changes to the system, Directors showed understanding for the problems that the authorities had encountered in connection with the implementation of the reform, of which the shortfall in collection of contributions was of particular concern. They commended the authorities for their decision not to allow the emergence of new pension arrears, and they were encouraged by the measures taken to improve collections, which were expected soon to eliminate the need for unscheduled budgetary transfers for pension payments. Directors also noted that it would be very important for the credibility of the new system that pension contributions be allocated accurately to the individual accounts of participants, and they urged the authorities to promptly assign unique personal identification numbers to all contributors.

Directors expressed concern about the delays in the area of privatization, especially in the launching of the "Blue Chip" program. They pointed out the importance of implementing this program promptly so as to provide suitable investment instruments for the newly created pension funds and generate the envisaged financing for the budget. More generally, Directors were concerned about the uncertainties that had emerged regarding the government’s policies toward privatization in the energy sector. Directors pointed out that the government would have neither the financial resources nor the technical expertise to fully develop the oil and gas sector on its own, and urged the authorities to adopt a liberal stance toward private participation in this sector, including by foreign investors.

Directors commended the authorities for the measures taken to improve the soundness and competitiveness of the banking sector, in particular their decisions to allow greater foreign participation in this sector, as well as to change the resolution concerning the requirement on lending to small and medium-sized enterprises into a nonbinding recommendation. They also encouraged the authorities to press ahead with their plans to reduce the state’s participation in the banking sector.

Directors emphasized the need for additional measures to improve the investment climate in Kazakhstan, including through the establishment of better governance and transparency in government and business transactions. In this regard, Directors welcomed the intention of the authorities to implement some of the changes proposed by the World Bank to improve the procedures for providing tax and nontax incentives under the law on state support of direct investment. Such changes would be important to enhance transparency and diminish reliance on tax concessions and to encourage private investment activity, Directors noted.

In the area of trade liberalization, Directors found worrisome the slippages in adhering to the commitments under the program to reduce maximum import tariffs. While recognizing that the adoption of a common external tariff among CIS Customs Union partners would eventually require Kazakhstan to coordinate its policies with these partners, Directors urged the authorities, first, to implement tariff liberalization at least as ambitious as that to which they were committed under the program, and second, advocate the adoption of low and uniform rateswhen negotiating the Customs Union’s common external tariff. Directors also urged the authorities to take the necessary steps to strengthen customs administration.