Public Information Notice No. 01/126

Public Information Notice: IMF Concludes 2001 Article IV Consultation with the Kyrgyz Republic

December 19, 2001

On November 30, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Kyrgyz Republic.¹

Background

Over the past two years, macroeconomic performance in the Kyrgyz Republic has improved significantly. Real GDP growth accelerated to 5 percent in 2000 from 3.7 percent in 1999, and to 6.7 percent in the first nine months of 2001 compared with the same period a year earlier. Growth was mainly driven by agriculture, mining, trade, and construction.

The proposed program has three pillars: further macroeconomic stabilization, a credible external debt strategy, and more focused structural conditionality. The key policy parameters of the first-year program are an increase in the primary fiscal surplus excluding the Public Investment Program (PIP), to 2½ percent of GDP in 2002 from 0.3 percent of GDP in 2000, and containing the growth of broad money to 13½ percent during the program period. The first-year program aims at maintaining economic growth at 5 percent in 2001 and 4.5 percent in 2002 with a further reduction of inflation to 7 percent during 2001 and to 6 percent during 2002. Over the next 3 years, average real GDP growth is projected at around 4½ percent.

The major contribution to growth is expected to come from improvements in total factor productivity as a result of the expected impact of the structural reforms to be implemented under the program. The economy's gross investment ratio is projected to remain unchanged at 16 percent of GDP despite the planned streamlining of the PIP. The government's share of investment is expected to fall from 8.5 percent of GDP in 2000 by about 4 percentage points of GDP by 2004, mainly as a result of the PIP streamlining and reorientation towards export-enhancing projects. The streamlining of the PIP is a component of the debt reduction strategy. The authorities expect that the decline in government investment will be compensated by higher private investment.

The authorities agree that a continuation of a strong fiscal adjustment is needed to address the external debt problem but also to restore policy credibility. To this end, they have already approved the 2002 budget, which includes new tax measures to both compensate for the income tax reductions approved by parliament in July 2001 and increase the tax-to-GDP ratio. On the expenditure side, the authorities expect to lower PIP spending to 5.5 percent of GDP from 6 percent of GDP in 2001. The overall cash deficit would be reduced to 4.9 percent of GDP in 2002 from 6.0 percent of GDP in 2001 and 9.6 percent in 2000.

The authorities plan to maintain a tight monetary policy for lower inflation, a stable exchange rate, and the required balance of payments adjustment. The National Bank intends to continue with the flexible exchange rate regime and to intervene in the foreign exchange rate market only to accumulate reserves and smooth temporary market fluctuations.

The external current account deficit and the capital account surplus are both projected to narrow in 2001 as a percent of GDP and to stabilize in 2002. On trade, the authorities intend, in line with their commitment to the WTO, to reduce the top import tariff from 20 percent to 17.5 percent in the 2002 budget, while reducing the number of tariff bands from six to four.

The proposed first-year program is financed. The $91 million external financing needed during the first-year program is expected to be met through a combination of debt reschedulings in the context of the Paris Club and balance of payments support from multilateral institutions. The average financing gap for 2003-04, estimated at US$31 million after Paris Club debt reschedulings and support from Fund resources, is expected to be covered by customary balance of payments support from other international financial institutions and bilateral donors. The government will continue to be prudent in its external borrowing and is implementing the comprehensive debt strategy approved in 2001.

The program focuses structural conditionality on areas that are macro relevant and critical for the success of the program. Priority is given to four areas: banking sector reform, privatization of the four strategic enterprises, reduction of the energy sector's quasi-fiscal deficit, and improving governance. The authorities have elaborated their plans to combat poverty in their Interim National Strategy for Poverty Reduction (I-NSPR). About half the population of the Kyrgyz Republic live in poverty. The strategy paper outlines a set of macroeconomic policies and structural reforms aimed at supporting economic growth and poverty reduction. A full-fledged NSPR will be prepared by September 2002.

Executive Board Assessment

Directors commended the authorities' recent macroeconomic policy performance, which has resulted in strong growth, low inflation, and stability in the foreign exchange market. The government's commitment to a deepening of structural reform has already resulted in an improved implementation record in 2001, but resolute implementation of the new economic program will be needed to enhance prospects for sustained growth and poverty reduction, and a resolution of the country's debt problem.

While acknowledging the improved fiscal performance, Directors underscored the need to stay firmly on course in implementing the 2002 budget in order to avoid repeating the fiscal slippages of past years. They stressed that achieving the budget's revenue targets will require greater efficiency in tax administration and prompt implementation of the tax policy measures approved as part of the 2002 budget. Over the medium term, broader reforms, aimed at improving tax revenue performance to generate sufficient resources for additional social spending and reducing the external debt burden, should be placed high on the agenda.

On the expenditure side, Directors urged the authorities to move forward with the Treasury reform and welcomed their intention to enhance the control of the Ministry of Finance over the implementation of the budget. They highlighted, in particular, the importance of ensuring, through close cooperation with line ministries and international donors, that the PIP is adequately streamlined, kept in check, and prioritized with a view to raising the efficiency of public investment.

Directors commended the National Bank of the Kyrgyz Republic on its monetary and exchange rate policy. They agreed that an appropriately tight monetary policy should be continued to consolidate the recent gains in reducing inflation and building confidence in the currency, and that the flexible exchange rate regime should continue to serve the country well. Interventions in the foreign exchange market should take place only to accumulate reserves and smooth temporary market fluctuations.

Directors welcomed the recent actions to strengthen the banking system, including the liquidation of four insolvent banks, but stressed that banking sector reforms will need to be sustained to re-establish public trust in banks and mobilize savings to support investment. They urged the authorities to be ready to implement the new Regulatory Response Policy whenever necessary. Directors also looked forward to further steps to strengthen the powers of the debt recovery agency and the regulatory authority of the central bank.

Directors commended the authorities for their ambitious external debt strategy. They stressed the critical importance of a strong medium-term fiscal adjustment through increased revenue collection and a streamlined PIP at a level compatible with the country's debt service capacity. The commitment to devote the proceeds from privatization to external debt reduction is welcome, and Directors recommended the authorities to work closely with the World Bank and other International Financial Institutions to accelerate the divestiture of the large strategic enterprises. They also urged the authorities to improve their debt management capacity and maintain strict discipline in external borrowing. Directors welcomed the willingness of Paris Club creditors to reschedule debt service payments falling due in the period ahead, while noting that, over the medium term, debt reschedulings on highly concessional terms will be needed to improve the prospects for growth and for achieving debt sustainability.

Directors looked forward to a sustained implementation of the authorities' streamlined structural reform agenda. In addition to banking sector reforms, they stressed the importance of reducing the quasi-fiscal deficit of the energy sector. Directors welcomed the authorities' efforts to improve governance, including the recent establishment of the Economic Policy Council, which should improve the efficiency and coordination of economic policy making. Strong efforts will be required over an extended period of time, however, to improve the business environment. They urged the authorities to reduce the impediments to private sector growth, enhance transparency in the management of public finances, and simplify tax and customs administration.

Directors commended the work done in developing the National Strategy for Poverty Reduction, in particular, the comprehensive poverty diagnosis and the participatory process that have underpinned the development of the strategy. They noted, however, that much remains to be done in assessing the costs of the proposed policies, setting spending priorities in the context of a medium-term fiscal framework, and defining in detail key policies in the areas of social safety net and public administration reform.

Directors welcomed the Report on Standards and Codes on fiscal transparency. They encouraged the authorities to implement its recommendations, including the proposals for further improving the integrity and quality of fiscal data.