: / Strategies / Kyrgyz Republic Country Assistance Strategy (2003)

Kyrgyzstan Review, 10 years ago

Economic Performance, Prospects and Debt Management

The Kyrgyz Republic has made considerable progress in attaining macroeconomic stability. Strong fiscal, quasi-fiscal and external adjustment efforts, together with structural measures in areas such as energy and banking, have facilitated a significant improvement in overall economic performance in the aftermath of 1988 regional financial crisis (see Table 2). Real GDP grew, on average, at about 5 percent during 1999-2001. Although the impact of a landslide at the Kumtor gold mine and the reduced external demand for power in 2002 interrupted this progresswith the growth rate turning slightly negative in 2002growth is expected to return to its positive trend from 2003 onwards, barring any unexpected shocks. The combination of tight fiscal and monetary policies over the same period has resulted in a significant decline in inflation to single digit rates since 2001, with average inflation of just over 2 percent in 2002. The exchange rate has been relatively stable, and during the first year of the governments program supported by the current IMF PRGF, program benchmarks have generally been met.
The economys production base continues to be narrowly defined, but spending patterns have entered into a more viable path. On the supply side, growth has been led by agriculture and services, and two major, non-labor intensive industrial sectors, i.e. gold mining and power, with first signs of recovery in manufacturing over the last decade appearing only in 2002. On the demand side, the recent adjustments in the fiscal deficit (from 11.6 to 5.2 percent of GDP over 1999-02) and the external account deficit (from 14.7 to 3.2 percent of GDP over 1999-02) have resulted in a more sustainable policy stance with an increase in domestic savings (see Table 2). Improved discipline over externally financed public investment expenditures have resulted in a reduced reliance on external sources of savings. Equally important has been the progress in reducing large quasi-fiscal operations (from about 17 to 10 percent of GDP over 1999-2002), primarily through a series of price adjustments and structural reforms in the power sector.
However, notwithstanding the fiscal adjustment, the Kyrgyz Republic is saddled with a heavy burden of external debt. Debt sustainability remains an outstanding issue over the medium term with the net present value of public debt remaining over 180 percent of exports and over 370 percent of budget revenueswell above the HIPC threshold of 150 percent and 250 percent, respectively. The March 2002 Paris Club Agreement, although providing favorable debt service relief over the short-term, did not change the stock of external debt. The Agreement, however, includes a goodwill clause that allows for a potential stock reduction operation in the future, subject to good progress in consolidating macroeconomic stability through further adjustment and reform. In the period ahead, along with reducing the reliance on external financing, increased access to grants and concessional financing are critical for the sustainability of the required external and fiscal adjustment.
And further reforms and fiscal adjustment are necessary to consolidate macroeconomic stability and maintain growth momentum. Adjustment in recent years has been achieved largely on the basis of across-the-board expenditure cuts that are unsustainable and have often failed to reflect strategic priorities. Civil servants are poorly paid and often seek alternative sources of income, which reduces the quality of public services and promotes rent-seeking behavior. Reduced maintenance of infrastructure has affected such critical areas as irrigation networks, transportation and education and health facilities. Public expenditures on health and social protection, other than pensions, have been severely constrained. Furthermore, the present level of quasi-fiscal operations, which have continued to be incurred through pricing public utility services below their economic costs, are far from being sustainable.
In view of the Kyrgyz Republics low income and high poverty levels, achieving sustainable growth is the most fundamental requirement for poverty reduction. Sustaining growth is expected to be more challenging over the medium-term than in the mid-1990s given Kyrgyz Republics high external indebtedness. Public investment and consumption-led growth of 1996-01, financed primarily by external resources, is no longer affordable over the medium term. While growth performance since 2000 was comparatively more balanced, private investment and export performance are still far from providing tangible growth stimulus. A greater effort to reduce the external imbalance and shift its origins from public to private sector activities should, therefore, be a policy priority in the period ahead. In turn, this shift will need to be reinforced by an effort to gradually increase domestic savings, as their current level at about 14 percent of GDP, although significantly improved since 1999, remains below the levels required to sustain significant long-run growth.
A more vibrant and innovative private sector and strengthened financial sector will be critical to maintaining the momentum of growth and broadening its basehence, increasing its resilience to external shocks. It is equally critical to increasing the economys access to diversified inflows of external capital, including foreign direct investment. In the period ahead, diminishing gold reserves in the Kumtor gold mine are already expected to make it more difficult to sustain exports and growth. The reforms in the agricultural sector, if broadened and deepened to create an enabling environment for private sector initiatives and to induce productivity gains, are likely to play a major role in maintaining a positive trend in export and overall economic growth. Nevertheless, the agricultural sector alone is not likely to generate growth rates that are needed for any significant reduction of povertyi.e., at about 5 percent and above, as suggested by the most recent poverty analysis. Similar efforts are needed for improving the investment climate for SMEs, which account for over 36 percent of GDP and are key to employment generation and diversification of sources of growth. In addition, the authorities should focus on attracting private investments in large-scale industries, such as hydro-generation as well as miningsectors where the economic potential of the Kyrgyz Republic is significant.
These efforts will need to be complemented by a coherent trade sector promotion strategy, with an emphasis on trade facilitation and diversification. Despite a liberal trade regime and WTO membership, international trade has so far failed to boost growth and productivity. This, in turn, reflects external regional barriers on flows of goods as well as well-documented internal barriers to investment, including excessive regulation, through permits, certification, licensing and inspections, which impedes both domestic and foreign direct investments and the growth of exports. These difficulties of the business environment are compounded by the limited financial intermediation capacity of the banking sector, with high real interest rates and a marginal capacity to provide long-term financing. Building confidence through improved banking supervision and payments infrastructure, and a strengthening of creditor rights are also challenges to be addressed.
Continued public finance reforms will also be needed to underpin these efforts. Notwithstanding the efforts during the last three years to improve the tax system, much remains to be done to simplify tax structures, to further rationalize tax rates, and to improve tax collection and compliance. Similarly, despite major efforts to curtail public expenditures, much remains to be done to increase both allocation-efficiency and cost-effectiveness of expenditures and to eliminate implicit subsidies to utilities. High poverty levels in the Kyrgyz Republic pose additional challenges to public expenditure policies in order for the authorities to fulfill basic poverty alleviation objectives, and adequately fund social services and highest priority public infrastructure spending.
These expenditure management challenges call for a broader and deeper reform strategy. The IDAs recent Public Expenditure Review suggests that achieving above outlined expenditure policy objectives in the medium-term require: (i) completing critical social sector reform initiatives and investments that have already commenced; (ii) further delineating and reducing the role of the government to avoid the recurrence of broad but incomplete agendas and the initiation of large projects with public resources (to be reflected in a gradual decrease in externally financed PIP to below 4 percent of GDP by 2005); (iii) focusing sector policies mainly on the poor (with a strong regional dimension and strong focus on children), particularly in the human development areas; (iv) strengthening local governance with a view to ensure more equitable and efficient delivery of public services in parallel with empowering communities to take control of their own future; and (v) complementing policy reforms by institutional measures that will ensure the efficient management of tight public resources and transparency and accountability in public sector operations. These measures would not only release economic resources for providing key basic social programs and maintaining basic infrastructurehence, preventing the erosion of key national assets such as education or access to electricitybut would also create room for private sector growth.
Confronting medium-term pressures requires a strong reform effort and a well-designed debt sustainability strategy. Under a base case economic scenario of continued strong reforms along the lines outlined above, maintaining a per capita growth rate of over 3 percent and reducing the fiscal deficit below 4 percent of GDP over the medium term would be consistent with a steady improvement of the debt burden in the period ahead barring external shocks and adverse regional environment (see Table 2 above). However, reduction of the external debt burden to sustainable levels through this decade would be possible only if the ongoing efforts to maintain access to concessional external financing and to secure a concessional debt stock reduction are successful. It should be emphasized that improving the depth and pace of structural reforms and fiscal management capacity over the medium-term is critical for maintaining access to strong donor assistance and the realization of the full benefits of reforms. Falling short of this target may result in a forced domestic and external adjustment, without addressing the fundamental weaknesses of the economy. As such, it would have a negative impact on growth prospects, would re-generate fiscal pressures and could undermine the hard-won gains toward poverty alleviation.
Weak reform effort will unaffordably delay the achievement of fiscal and debt sustainability. In a low case scenario of weak reform effort, which is developed on the basis of the risk that forthcoming 2005 parliamentary and presidential elections may create for the depth and the pace of the reform performance, structural reform pace is slowed; key governance, banking system, public finance, and energy reforms are delayed; and improvements to the business enabling environment are far from advancing, leading to stagnant domestic investments and marginal foreign investment inflows. As a result, economic activity would slow, as the private sector would not sustain the economys growth momentum, when the growth impulse arising from public investment declines and when the diminishing Kumtor gold production remains largely uncompensated. Under these assumptions, the GDP growth would average barely over two percent per annum in the period ahead. As fiscal reforms are deferred, increasing fiscal fragility and lower donor financial support would severely constrain social and development expenditures. Furthermore, the strategic reallocation of expenditures and efficiency gains would be limited, which would further delay prospects for fiscal sustainability and growth. Altogether these policy slippages could trigger higher inflation, depreciating exchange rates, and a current account deficit that would maintain the external debt dynamics at an unsustainable path over the long-run. The ability to comfortably service debt, as well as to address poverty reduction challenges, would be significantly reduced. This sort of low case scenario might be short lived since both domestic and social pressure as well as pressure from diminishing external financing would be likely to bring about a correction of domestic policies. However, if a cycle of weak reforms followed by corrections is repeated over time, the low-case macroeconomic outlook could be triggered.
Nevertheless, it should also be emphasized that even with good policies, adverse environmental and economic shocks could lead to a severe deterioration of the macroeconomic environment, including a depreciation of the exchange rate and sluggish investment activity. Agriculture, hydropower and mining sectors are vulnerable to weather related developments and natural disasters. These vulnerabilities make the strengthening of medium-term reforms aimed at diversifying the economy and strengthening the private sector all the more critical to reducing growth volatility and improving debt sustainability.
The limits of national strategies also need to be recognized. Increased harmonization of Central Asia trade regimes would have a significant impact on the Kyrgyz Republic. Increased cooperation on the efficient use of water between upstream and downstream countries, and agreement on the related potential electricity generated from water for domestic use and exports, would also have a critical impact on the economy of the Kyrgyz Republic. Similarly, cooperation in control of communicable diseases, increased knowledge sharing, and environmental protection could all have positive externalities for the Kyrgyz Republic.