Bishkek, Kyrgyz Republic
February 10, 1999

Mr. Michel Camdessus
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. Camdessus:

1.  Our letter to you of May 27, 1998 and the accompanying Memorandum on Economic and Financial Policies described the objectives, policies and measures included in our economic program for the period April 1, 1998 to March 31, 1999. This program has been supported by the first annual arrangement under the successor three-year ESAF arrangement. In the attached supplement to the Memorandum on Economic and Financial Policies, we report on developments during the first nine months of the program and describe our policy objectives and intentions for the remainder of the program period until end-March 1999. We also include a broad outline of our policies for 1999.

2.  As shown in Table 1 attached to the supplement to the Memorandum on Economic and Financial Policies, we missed several quantitative performance criteria for end-September, mainly due to the impact of the Russian crisis and unprogrammed expenditure needs. Many of these breaches were minor, however, and in view of the corrective actions we are implementing, we request waivers for the non-observance of the floor on net international reserves; the ceilings on domestic expenditure arrears on wages and pensions; the limit on short-term external borrowing; the zero ceiling on external arrears; and the spending levels on health and education. Table 1 also provides the status of the quantitative and indicative benchmarks for end-December 1998 and end-March 1999 that take account of recent developments and newly agreed measures.

3.  Our performance has been satisfactory as regards the observance of the structural benchmarks envisaged in the program. As shown in Table 2 attached to the supplement to the Memorandum on Economic and Financial Policies, all structural performance criteria and all but three benchmarks for end-June, end-September, and end-December were met.

4.  We believe that the policies described in the attached supplement to the Memorandum on Economic and Financial Policies are sufficient to achieve the objectives of the program, and we stand ready to take any additional measures that may be necessary for this purpose in consultation with the IMF staff. We will also consult with you on the adoption of any additional measures that may be appropriate, in accordance with the policies of the Fund on such consultation. In support of our continuing adjustment effort, we request the completion of the midterm review under the first annual ESAF arrangement under the successor ESAF. In addition, to counter the impact of the Russia crisis on the Kyrgyz economy and help meet a larger balance of payments need, we also request an up-front augmentation of the access under the ESAF by SDR 8.88 million (10 percent of quota under the Eleventh Review).

1.  After the successful completion of the first three-year adjustment program supported under the ESAF, we have entered a successor ESAF arrangement, which covers the period 1998–2000. Our new program is designed to consolidate the stabilization gains achieved so far and to implement a government and legal structure that is consistent with a market economy. The economic and financial objectives for the three-year ESAF period, as well as the objectives, policies, and measures for the first-year program covering April 1, 1998-March 31, 1999, are described in the Memorandum attached to the letter to the Managing Director of the Fund dated May 27, 1998 and the accompanying Policy Framework Paper (PFP).

2.  Macroeconomic and financial developments until end-1998 were less favorable than envisaged under the program, reflecting to a large extent the difficult economic environment resulting from the financial crisis in Russia. Real GDP in 1998 is now estimated to have grown by about 2 percent only, compared to a program objective of 6 percent. Our foreign reserves and the external current account have deteriorated sharply. End-of-period inflation reached 18.4 percent in 1998, compared to a target of 12 percent. In spite of buoyant tax receipts, fiscal developments have been less favorable due to unforeseen expenditures related to two natural disasters, our decision to make the downpayment for an airplane lease on behalf of Kyrgyz Airlines, and, more recently, the drying up of the domestic treasury bill market. As a result, we were unable to clear all domestic expenditure arrears under the program definition, which at end-December 1998 amounted to som 217 million; moreover, expenditure on education fell short by som 44 million compared to the program target.

3.  Against this background, in our efforts to rein in liquidity, and to avoid a precipitous depreciation of the exchange rate that would undermine hard-won gains in stabilization, we had to intervene in the foreign exchange market and missed the programmed floor on net international reserves at end-September by a large margin. In addition, tax collections of the Social Fund lagged behind schedule, leading to a nonobservance of the related performance criterion on pension arrears. Reflecting the difficult fiscal situation in the wake of the Russia crisis, the performance criteria on Republican budget wage arrears, external arrears, the stock on short-term external borrowing, as well as on health and education spending, were also missed, albeit only marginally (Table 1).

4.  All structural performance criteria and benchmarks under the program for end-June, end-September, and end-December were observed, except for (i) the overhaul of land legislation due to the referendum on private land ownership that took place in mid-October; (ii) the replacement of energy subsidies provided by KyrgyzEnergo with direct budgetary subsidies; and (iii) the use of a joint taxpayer identification number by the State Customs Committee (SCC) and the State Tax Inspectorate (STI) (Table 2). However, we have already observed the benchmark on the adoption of a joint taxpayer identification number by the STI and the Social Fund, which was initially scheduled for end-March 1999.

5.  In response to the Russia shock and to reverse the slippages in program implementation before the Executive Board meeting, we have already taken strong corrective actions. To this end, and with a view to showing our continued commitment to the objectives of the ESAF-supported program, the following measures were taken towards the completion of the mid-term review under the first annual arrangement under the successor three-year ESAF arrangement:

• The National Bank of the Kyrgyz Republic (NBKR) achieved a stock of net international reserves (NIR) of US$20.1 million, compared to a revised target of US$10.5 million; the level of net domestic assets (NDA) of the NBKR (excluding the Turkish loan and the EBRD credit line) at som 3,018 million was kept within the revised program limit of som 3,038 million.

• Parliament approved a significant increase in excise rates on most petroleum and alcohol products.

• Parliament approved the 1999 budget, as agreed with the staff of the IMF.

• The government collected som 1,397 million in tax revenues during the fourth quarter of 1998, thereby exceeding the revised program target of som 1,371 million.

• Our expenditure on health reached som 247 million during the fourth quarter of 1998, compared to the revised target of som 220 million.

• All external arrears were cleared, including on those loans for which government guarantees were called.

• As part of a broader package to limit the abuse of free economic zones (FEZs), three economically nonviable zones (Alai, Chong-Alai, and Kara-Kulja) were closed. In addition, draft legislation was submitted to Parliament to prohibit all retail trade activities with the domestic market and reduce significantly the size of one of the remaining FEZs.

• Kyrgyz Airlines doubled its domestic airfares as a first step toward reaching cost recovery levels, thus curbing the airline's repeated recourse to the budget.

• An action plan on civil service reform, as outlined in paragraph 13 of the PFP, was adopted by the state authorities.

• Finally, the government adopted a resolution to establish a moratorium on the imposition of new user fees by line ministries, unless approved by the Minister of Finance, based on the results of the recent stock-taking exercise and to transfer 50 percent of such fees to the budget.

6.  With these measures, we believe that the program has been brought back on track and further strengthened to respond to the adverse external environment. Nevertheless, the key macroeconomic objectives for 1999 need to be adjusted, with the exception of the inflation target of 8 percent, which we will revisit at the time of the discussions of the second annual arrangement. Real GDP growth will be 2–3 percent, while the external current account deficit is targeted to improve to about 12 percent of GDP in 1999, after a temporary deterioration to 16.7 percent of GDP in 1998. In terms of months of imports, official gross reserves are targeted to improve from 2.6 months in 1998 to 3.2 months in 1999.

7.  Fiscal consolidation remains a centerpiece of the program. The 1999 budget approved by parliament aims at a primary surplus (excluding the foreign-financed public investment program) of about 1½ percent of GDP. The deficit will be exclusively financed through external concessional resources, privatization receipts, and sales of treasury bills, to the extent that the treasury bill market recovers. The budget for 1999 is based on prudent revenue assumptions in light of the impact of the Russian crisis on economic activity and trade. Tax revenue is projected to increase by 1.5 percentage points of GDP, benefitting from the increase in excises on most petroleum and alcohol products (0.7 percent of GDP), the depreciation of the exchange rate, and improved tax administration. To this end, we will step up our revenue collections to counter the possible emergence of tax arrears and bankruptcies as a result of the Russia crisis. We will continue to implement on time the structural measures to strengthen the tax and customs administration, as stipulated in paragraph 8 of the Memorandum attached to the Letter of Intent dated May 27, 1998 and in points 15 to 24 in the matrix attached to the PFP. In particular, as stipulated by the new provisions of the constitution, any changes in the tax code need the consent of the government. We will ensure that any such amendments will be at least revenue neutral. We will refrain from further reducing land tax rates. In order to increase fiscal transparency, we will also gradually increase the inclusion of special resources (user fees) in the budget, based on the stocktaking exercise recently conducted. We will adhere to the moratorium on the imposition of new fees of this type, unless approved by the Minister of Finance, and enforce the government resolution adopted in December 1998 to transfer 50 percent of such fees to the budget.

8.  On the expenditure side, we will clear all wage and pension arrears by end-December 1999. Total budget arrears will be reduced by som 15 million during the first quarter, som 266 million in the second, som 140 in the third, and som 140 million in the fourth quarter. Moreover, we will reduce arrears under the program definition by about half during the first quarter of 1999. Given the size of arrears, we will submit to Parliament a supplementary budget with compensatory expenditure cuts amounting to som 280 million before the beginning of the second annual arrangement. We will also step up our efforts at improved expenditure management and ensure that spending on health and education be kept at least constant in real terms throughout 1999. To accomodate the payment of the 1998 wage arrears, the wage bill in 1999 will remain constant in nominal terms. We will design the timing and the specifics of government pay increases, as well as targets for reducing overstaffing, in close cooperation with the IMF staff. If lease payments under the leasing agreement between Kyrgyz Airlines and a European finance consortium need to be made by the government, we will identify compensating expenditure cuts to ensure that the revised fiscal targets for the first quarter of 1999 will be met. In addition to the increase in domestic airfares, we will accelerate the privatization program for Kyrgyz Airlines so that the restructuring of the company can be completed by end-1999. This will include the spin-off of landing and navigation systems, the transfer of the local airports to local authorities, and the separation of domestic from international flights. In addition, we have introduced a new airport user fee to alleviate potential budgetary costs of our airline and airport operations. In view of the tight domestic and external financing available during the first quarter of 1999, we will postpone commitment of all nonessential spending to the remainder of the year. Beginning in the second quarter, we will also build up a cash cushion in the counterpart fund account at the NBKR, which will exceed som 200 million by end-1999.

9.  We have adopted an action plan for a comprehensive reform of the public pension system under the World Bank SOSAC and will proceed with its timely implementation. We will refrain from increasing the budgetary subsidy to the Social Fund for 1999 beyond the som 300 million envisaged under the program.

10.  Monetary and credit policies will continue to aim, for the time being, at an end-of-period inflation target of 8 percent in 1999. Following the significant loss of foreign exchange reserves and the temporary slump in money demand and financial intermediation in the wake of the Russia crisis, we expect that the growth rates for reserve and broad money will recover in 1999 to 9 percent and 11 percent, respectively. The revised NIR target for end-March 1999 is based on the same accumulation of reserves in flow terms, as agreed in November 1998, adjusted for external disbursements and debt service. For 1999 as a whole, NIR is targeted to grow by US$12 million to partially recover the reserve shortfall to date and ensure an import cover of 3.2 months of imports.

11.  In the conduct of monetary policy, we will build on the modernization of our set of monetary policy instruments. Based on the latest MAE technical assistance report, we will work to reduce the NBKR's exposure to commercial bank default. To this end, we will establish procedures to unwind the results of a clearing, to reject or queue unfunded payments, and to impose a debit cap on intraday balances in the clearing system (a new structural benchmark for end-March). We will also draft a regulation to accept treasury bills to collateralize Lombard loans irrespective of their maturity. We will strictly enforce banks' compliance with reserve requirements, and strictly apply the penalty rates for noncompliance. Moreover, those banks that miss the reserve requirement three times in a row will be placed under direct supervision of the NBKR while those banks not observing such requirements six times in a row will be placed under NBKR temporary administration. In addition, the NBKR will tighten the regulations on loan loss provisioning. Moreover, we will further enhance our monitoring of the banking system to protect Kyrgyz banks from any spillover of the Russian financial crisis. To this end, we will develop a special program of frequent on-site inspections targeted especially at the major banks, including through an increase in staffing, in order to detect loan repayment difficulties as soon as they occur and ensure that the NBKR's asset classification regulations are properly applied. Finally, the NBKR and the Ministry of Finance will strive to improve their coordination so as to facilitate short-term liquidity forecasting.

12.  The exchange rate policy agreed upon under the program will be maintained. We will not resist a depreciation of the som and only intervene to offset minor and temporary fluctuations in the exchange rate. We intend to build up our reserve position beyond the revised program targets in the event of unexpected capital inflows if there are signs that money demand has strengthened. If the inflows are not deemed to be associated with an increase in the demand for money, we will allow the som to appreciate in order to preserve the inflation target.

13.  Reflecting the impact of the Russian crisis on import demand and our exports to CIS markets, and in light of the pledges made at the CG meeting in Washington on December 11, 1998, a financing gap of US$12.4 million remains under the 1998/99 program. We request that this gap be closed through an up-front augmentation of the access under the ESAF. We expect that for 1999 as a whole a financing gap of US$23.8 million could materialize. We will strive to tap additional external resources at concessional terms to cover this gap, but will stand ready to adopt any demand management policies deemed necessary to close it. Following our accession to the WTO, we will also maintain our liberal trade regime and refrain from introducing any new trade barriers and taxes or raising import tariffs.

14.  We will continue to follow a cautious external borrowing strategy and continue with the modernization of our external debt management. We will refrain from borrowing on nonconcessional terms beyond the limits agreed under the program and avoid taking recourse to the Turkish commercial credit line. We will ensure that no external payments arrears emerge during the remainder of the program period.

15.  We will persevere in the implementation of our structural reform agenda, as outlined in detail in the policy framework paper. In line with the outcome of the recent national referendum that allowed the private ownership of land, we will expeditiously revise the land code and the land registration law, with a view to submitting them to parliament by end-March 1999. By that date, we will also complete the harmonization of the tax payer identification number of the STI, SCC and the Social Fund. To improve transparency of fiscal operations, we will begin to introduce direct budgetary subsidies in the 1999 supplementary budget to replace the current energy subsidies provided by KyrgyzEnergo. In the area of privatization, we will proceed to initiate tenders for the divestiture of Kyrgyz Telecom and KyrgyzEnergo and appoint an international advisor for the privatization of Kyrgyz Airlines by end-March 1999 (a new structural benchmark).

16.  We realize the importance of compiling and reporting statistical data of high quality. To this end, we will continue our efforts to improve the statistical data base and the methodologies applied. In particular, we will improve our reporting of fiscal data to the Fund for publication.

Use the free Adobe Acrobat Reader to view Table 1.