Mission Concluding Statement 

Kyrgyz Republic: Staff Concluding Statement of the 2021 Article IV Mission

March 31, 2021

Washington, DC: An International Monetary Fund (IMF) staff team led by Mr. Nikoloz Gigineishvili conducted a remote mission from March 12 to March 30, 2021 in the context of the 2021 Article IV consultation with the Kyrgyz Republic. At the conclusion of the mission, Mr. Gigineishvili issued the following statement:

Recent Developments, Outlook, and Risks

1. The Kyrgyz economy was hit hard by the COVID-19 pandemic. The sharp decline in tourism, non-gold exports, and the slowdown in domestic activity have led to a significant contraction of GDP by 8.6 percent in 2020. The authorities took a range of measures to save lives and cushion the impact on the economy. These included emergency health spending, stepping up the food security program for the vulnerable, and temporary tax deferrals and subsidized loans to support small and medium enterprises (SMEs). Due to the COVID-19 shock, the overall budget deficit widened to 3.3 percent of GDP, public debt increased to 68 percent of GDP, the overall balance of payments weakened, the exchange rate depreciated, and inflation accelerated. The National Bank of the Kyrgyz Republic (NBKR) raised its policy rate twice from 4.25 in early 2020 to 5.5 percent in February 2021, while supporting banks through liquidity injections, deferrals of loan payments and the temporary relaxation of capital and loan provisioning norms. The Kyrgyz Republic was the first country to receive the Fund’s COVID-related emergency financial assistance of about $242 million (100 percent of quota) under the Rapid Financing Instrument (RFI) and the Rapid Credit Facility (RCF).

2. Growth is expected to rebound in 2021, but uncertainty remains high. Barring a resurgence of the pandemic, the economy is projected to grow by 3.8 percent in 2021 and by 6.4 percent in 2022, underpinned by a more favorable global outlook, recovery of domestic activity, higher gold production, an increase in remittances from oil exporting neighbors, and a rebound in tourism, transportation and related services. Growth should gradually converge to its potential of 4 percent in the medium term. Annual inflation will remain elevated in the coming months due to base effects but decline to about 7.4 percent by end-2021 and return to the central bank’s target range of 5-7 percent thereafter.

3. However, global economic conditions remain uncertain and warrant contingency planning. A slower than expected rollout of vaccines or emergence of new COVID-19 variants may delay the recovery to 2022 or beyond and, therefore, securing vaccines as soon as possible is essential to save lives and livelihoods. Lower gold prices or weaker remittances could weaken the balance of payments. If these risks materialize, accommodative macroeconomic policies will need to be maintained longer, and health and social spending increased. Political stability, policy predictability, and decisive reforms to improve the business climate would strengthen business confidence.

Fiscal Policy

4. In 2021 the general government budget deficit is projected to widen to 4.2 percent of GDP subject to availability of financing. This reflects a cyclical recovery in tax revenue and the observed improvement in tax compliance due to digitalization of tax filings, a moderate decline in the public sector wage bill after accounting for the planned increase in wages of certain categories of public sector workers, and the budgeted increase in spending on goods and services and investment. This fiscal stance maintains the needed fiscal stimulus while preserving some fiscal space in view of the uncertain outlook. However, if sufficient financing cannot be mobilized, the authorities should identify contingency expenditure cuts while preserving health and social spending, and investment projects with the highest expected social and economic returns. Engaging with international partners to demonstrate their credible commitment to reforms would help to mobilize more concessional resources given that higher domestic financing may increase borrowing costs.

5. In the medium term, the main challenge is to steadily reduce public debt while creating fiscal space for development needs. At 68 percent of GDP, public debt leaves little room for fiscal policy to respond to future downturns. The mission recommends anchoring fiscal policy to the goal of reducing public debt to below 60 percent of GDP by 2025. This is still considerably higher than the pre-crisis 51.6 percent of GDP but would provide additional fiscal buffers. To achieve this target, consolidation measures of about 1 percent of GDP would be needed if taken in 2022 to reduce the overall fiscal deficit to about 3 percent.

6. More fiscal efforts will be needed to create room for spending on health, education, social assistance, and infrastructure . Options to achieve these objectives may include (a) optimizing the public sector wage bill, which at 13 percent of GDP is one of the highest in the region and among low income countries and is about 30 percent of government expenditure; (b) limiting goods and services spending; (c) reducing energy subsidies; (d) improving excise taxation and the VAT refund system, and reducing tax exemptions; and, (e) strengthening tax and customs administration, including through digitalization . Consideration could also be given to improving the sales tax and the VAT. The planned modernization of the tax code is a good opportunity to implement some of these tax policy and administrative reforms to incentivize self-compliance and reduce the administrative burden on taxpayers.

7. Social assistance needs to be strengthened. According to the World Bank estimates, poverty increased by 11 percentage points to 31 percent in 2020 as incomes declined and unemployment rose and may increase further this year. Compared to other low-income countries, social spending in the Kyrgyz Republic is relatively high, but does not translate into better social and poverty outcomes due to weak targeting, low coverage, and limited adequacy. These shortcomings can be addressed by broadening the coverage of social assistance, shifting from categorical to income-based targeting, and consolidating social assistance programs to eliminate duplication.

Monetary, Exchange Rate, and Financial Policies

8. Price stability remains the main objective of monetary policy. Headline inflation increased to 10.6 percent in February 2021, primarily due to exchange rate pass-through and imported food prices, which rose globally. The NBKR’s decision to raise the policy rate by 50 basis points in February 2021 signals its commitment to contain inflation, while avoiding a premature withdrawal of stimulus considering the uncertain recovery. The NBKR is recommended to continue monitoring food and non-food prices, wages, remittance flows, credit and import growths, and other indicators of demand pressures, and should be prepared to tighten the stance of monetary policy further if inflation continues to increase and signs of second-round inflation pressures emerge . Preserving institutional and operational independence of the central bank will be critical for the efficient conduct of monetary policy. Clearly communicating the policy direction would help anchor inflation expectations. At the same time, liquidity support should be provided selectively to banks if they experience temporary liquidity pressures.

9. Exchange rate flexibility is an important buffer against external shocks. After a prolonged period of stability, the som depreciated by 19 percent against the US dollar since March 2020. The NBKR balanced the use of macroprudential tools and FX interventions to maintain financial stability and avoid excessive swings in the exchange rate. Going forward, the exchange rate should remain market-driven while FX interventions are used to smooth excessive volatility. However, the exchange rate alone cannot address the underlying structural weaknesses of the balance of payments, which require deep structural reforms to improve competitiveness of the economy.

10. The NBKR intends to move to inflation targeting in the medium term . For a smooth transition, it would be important to strengthen autonomy, the governance structure, and recapitalization rules of the NBKR, further build its analytical capacity, support development of money markets including by gradually phasing out the transitional arrangement of interest rate caps, strengthen the bank resolution framework, and improve communication. Once recovery takes hold, the NBKR intends to gradually reduce its non-core operations, which will strengthen monetary transmission. The NBKR is also developing a medium-term plan to unwind its ownership in Keremet Bank and the Guarantee Fund.

11. The banking sector is in good financial health, but risks remain. Since non-performing loans (NPL) tend to respond with a lag to an underlying weakening of the economy, elevated credit risk may materialize with a delay. Asset quality may weaken with the lapse of the temporary tax deferrals to SMEs while the deferrals of loan payments allowed during the pandemic could delay realization of NPLs. Continued supervisory vigilance and comprehensive stress-testing will be essential to monitor systemic vulnerabilities. The mission recommends maintaining sound accounting, reporting, and provisioning standards to properly appraise risks, while allowing banks sufficient time to restore capital, if impaired. Preparing a comprehensive NPL resolution strategy would also be essential.

Medium-Term Structural Reforms for Growth and Job Creation

12. The Kyrgyz Republic needs higher and more inclusive growth to absorb the rapidly growing labor force . Otherwise, unemployment will rise especially for youth, outmigration accelerate, and the income gap with emerging markets widen. This will require policymakers to guide the transformation of the economy from remittance and aid dependency to private sector-led growth underpinned by investment and exports. The government should seek to provide a market-friendly business climate, a stable legal framework, a competitive environment, and opportunities for human capital development. Structural reforms are needed in the following areas to address the main bottlenecks to growth:

• Governance. The authorities’ new Anti-Corruption Strategy aims to address systemic corruption by enhancing the role of the civil society, strengthening transparency and accountability of public institutions, and improving trust in courts and law enforcement. These objectives can be supported by (i) improving governance and transparency of state owned enterprises (SOEs); (ii) further strengthening the AML/CFT framework; (iii) publishing comprehensive asset and income declarations by senior public officials and investigating illicit enrichment; and (iv) strengthening public finance management through automation and digitalization. The revised procurement law envisages disclosure of beneficial owners in all public contracts, which is a welcome institutional reform. Full contracts with identities of beneficial owners, including for all emergency spending contracts, and audit reports should be published as committed under the RFI/RCF. Improving efficiency and transparency of complaints handling would further strengthen the public procurement system.

• Access to electricity . The electricity sector is in a difficult financial condition, is poorly managed, and is in urgent need of investment to improve service quality. To strengthen its financial and operational viability, the mission recommends developing a medium-term reform plan to optimize costs, strengthen governance and accountability, and improve revenue generation. While commercial tariffs are above cost-recovery, residential tariffs are well below this level, implying inefficient cross-subsidization. Any adjustment in residential tariffs, as recently announced by the authorities, would need to be paired with targeted social assistance to protect the most vulnerable households.

• Access to finance. Addressing information asymmetries and fostering competition would help reduce high interest rate spreads and high collateral requirements by banks. There is scope for expanding the coverage of credit registries and improving lender access to borrower information; encouraging entry of new banks and strengthening the bank resolution framework to facilitate speedy exit of the failed ones; developing a competition law; automating information exchanges between financial institutions and with the tax authority; and developing capital markets and fintech. The NBKR’s efforts to improve financial literacy are welcome.

• Access to export markets. Underdeveloped infrastructure, inadequate quality and phytosanitary controls, and lengthy customs clearance procedures for goods are significant non-tariff barriers. To address some of these issues, the authorities are planning to speed up implementation of WTO agreements to simplify trade procedures, including through digitalization, simplify customs procedures, improve quality controls, eliminate duplication of phytosanitary inspections, and introduce e-commerce legislation and supportive infrastructure. Speedy progress in these areas would support Kyrgyz exports.

• Education and skills upgrading. The Kyrgyz Republic spends more per capita on education than its peers but continues to rank poorly on school enrollment and test scores. Most education spending is on wages, while the outlays to improve the quality of education are small. It will be critical to reprioritize the education budget and develop an education reform strategy. Better integrating women in the labor market and supporting youth employment would also raise potential growth.

13. Steadfast implementation of reforms will be essential for the continued support of the international community. Many of these reforms require limited budgetary resources but could generate significant gains. The IMF stands ready to assist the Kyrgyz Republic in its reform efforts.

The mission would like to thank the authorities for the close collaboration and the candid discussions.