Bishkek, Kyrgyz Republic
August 30, 2000

Mr. Horst Köhler
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. Köhler:

1. This letter supplements our letter and attached Memorandum of Economic and Financial Policies (MEFP) of the Government and the National Bank of the Kyrgyz Republic (NBKR) for 2000, transmitted to Mr. Camdessus on January 22, 2000, requesting a second annual arrangement under the successor three-year arrangement under the Poverty Reduction and Growth Facility (PRGF).

2. Developments in the first quarter of 2000 under the program were less favorable than we had expected when the program was approved and as a result, several of the program’s performance criteria for end-March were not observed. Since then, however, we have made a determined effort to bring the program back on track and most of the quantitative performance criteria and all indicative targets for end-June were observed (Table 1). At the same time, the performance criteria on the cumulative fiscal deficit, and on external and pension arrears were not observed, as explained below. The structural performance criterion for end-March and one of the two criteria for end-June were fully observed, as were most of the structural benchmarks (albeit some with a slight delay). The second structural performance criterion for end-June on licensing was partly observed, as some improvements to procedures can only be implemented after approval of amendments to the law on licensing. We expect this law to be discussed and approved in September.

3. The economic situation has improved considerably in recent months. Real GDP growth at 7.4 percent and inflation at 7.1 percent for the first six months of the year were more favorable than we had earlier expected. Monetary policy has been kept tight and the exchange rate has remained stable. After a very weak first quarter, fiscal revenues recovered significantly in May and June and current expenditures were contained, although this was not sufficient to offset unexpectedly higher capital expenditures, for the reasons outlined below. At the same time, we incurred debt service arrears to some of our creditors while we were engaged in discussions to achieve a reduction in our heavy debt service burden.

4. We believe that we have made substantial gains on the stabilization front and have brought the program back on track. The government and the NBKR remain committed to achieving the program objectives for the rest of the year, although we recognize that in some areas our program commitments will need to be modified somewhat. Below we describe these modifications, for which we request the Fund’s approval, and the steps we are taking to ensure that the program’s general objectives are achieved. Table 1 attached to this letter specifies quantitative performance criteria and indicative targets for the second half of the program year. Table 2 lists structural performance criteria and benchmarks for that period.

5. In light of the developments in the first half of the year we have revised our 2000 growth projection upward to around 5 percent and inflation downward to around 15 percent, despite significant upward adjustments in prices of imported oil and gasoline, and an increase in government wages (see below). Monetary policy will continue to be tight in order to achieve the inflation projection, in line with the targets shown in Table 1. The savings on debt service related to restructuring of our external debt will be added to international reserves; we now expect to achieve a gross international reserves level at end-2000 on the order of $200 million (3.5 months of imports), about $30 million more than originally envisaged. National Bank bills were introduced in June, which should provide us with an additional monetary instrument.

6. Since the beginning of the year we have also made progress in addressing the problems in the banking sector. Specifically, a comprehensive strategy for restructuring of the financial and banking system was adopted, Bishkek Bank was closed, Kurulush Bank was partially recapitalized, another small bank was put under temporary supervision, and capital requirements were increased as of August 1. On site inspections have been accelerated and by end-July 11 institutions were examined. By end-September we intend to complete inspections of 13 institutions, and the remaining banks by the end of the year. By end-November, in close cooperation with Fund staff, we will adopt a restructuring plan for Kairat Bank. By end-2000 a tender will be issued for the privatization of the Savings and Settlement Corporation. To reestablish confidence in the banking sector and to bring the bank restructuring program to a successful conclusion, a strong independent National Bank will be important. The government will not initiate any proposals that would undermine this independence.

7. As noted above, revenue performance improved significantly in recent months, and despite the fact that parliament did not approve the increases in the retail and land tax envisaged under the program, the performance criterion on cash tax revenues for end-June was observed. Parliament also did not approve an extension of the VAT base to include excises and customs and other duties. Nevertheless, with the better growth performance, some increase in revenues on account of amendments to the taxation of products produced in free economic zones and sold domestically, and continued efforts to improve tax and customs administration (in line with our understandings with IMF staff), we expect to achieve our original revenue targets. In addition, we have already increased the patent tax for certain highly profitable activities and as of September will increase the license fee for the right to sell alcohol. The new tax regime for vehicles, approved on July 19, will be strictly enforced. We realize the importance of increasing tax revenues to deal with our heavy debt service burden and in September will also resubmit to parliament draft legislation to increase the retail tax rate and to expand the VAT base, together with proposed amendments to legislation to improve the use of cash registers and reduce incentives for tax avoidance.

8. As noted above, current expenditures have been kept in line with program commitments, however, higher-then-expected capital expenditures, associated with the foreign financed investment program (PIP) led to the non-observance of the performance criterion on the fiscal deficit for end-June. The outcome was about som 120 million (0.2 percent of annual GDP) higher than allowed under the program. The expenditures were to a large extent related to the implementation of a few large projects (including the Osh-Bishkek road, the restructuring of KyrgyzEnergo, and the Manas airport) which accounted for almost 75 percent of all capital expenditures. Since the beginning of the year we have made significant efforts to improve both control and projections of PIP-related expenditures, although this has proven insufficient, partly in view of the lumpiness of several of the project disbursements. Specifically, we have established a dedicated PIP unit in the Ministry of Finance and established criteria for the selection and prioritization of expenditures. Despite a delay in technical assistance to the unit, we have completed an inventory of existing investment projects and delayed or suspended a number of projects. Unfortunately there still are delays in reporting financial flows for the projects and thus it is difficult to react to deviations from the program in a timely fashion.

9. Despite these problems we aim contain the PIP to the level established in the program. To improve control, as of August 1, project implementation units will present on a monthly basis progress reports to the PIP Department of the Ministry of Finance for efficient monitoring of the usage of PIP funds. Furthermore, with the assistance of the technical assistance adviser, we aim to strengthen the technical skills of the PIP Department of the Ministry of Finance as well as the State Committee on Foreign Investments and Economic Development, with special emphasis on enhancing the economic and financial analysis of investment projects and, using the developed evaluation system of scores, on prioritizing projects, taking into account the economic and social impact. Because of the large size of the PIP and the heavy involvement of multilateral and bilateral creditors, we intend to approach creditors later in the year with a view to discuss a further rationalization and reduction of the investment program.

10. One expenditure area where we are deviating from the original program is budgetary wage policy as we decided to increase wages by 20 percent on average as of August 1. This increase, in our view is warranted on several grounds: (i) wages for civil servants have not been raised since 1997 and have been cut in half in real terms between the beginning of 1997 and June 2000; (ii) such increase will help improve the poverty situation, since current wage income for public sector employees is below the poverty line, and; (iii) improving income levels for public sector employees should help to reduce corruption. The increase in the wage bill will be offset by savings on interest payments to Russia (som 300 million), resulting from our agreement to restructure the debt owed. We have also reached agreement on a rescheduling with Pakistan and are expecting to conclude discussions with Turkey in the near future. Other debt service arrears have been paid. Furthermore, in late June and early July, we initiated steps to reinvigorate civil service reform, including, amongst others, a merger of government audit agencies, elimination of some ministerial departments, and a downsizing of the Ministry of the Interior, which should result in a reduction of the number of government employees. However, savings from these changes are not expected to be significant this year because of required separation payments. The programmed budget deficit will be maintained at som 4.1 billion for the year, which in terms of GDP (at 6.8 percent) signifies a moderate tightening compared with the original program target.

11. In tandem with the increase in wages, we have also increased pensions by 20 percent. Pension arrears were reduced to som 45.5 million at end-June. While this was higher than originally programmed, it was lower than the level of som 75 million agreed with Fund staff, in consultation with Bank staff, earlier this year. Eliminating all arrears by the end of last year had proven impossible. The last remaining pension arrears were eliminated before the pension increase was announced, and we are confident that we can finance the additional cost from our improved receipts, which will be partly generated by higher than earlier expected wages (including in the private sector).

12. Besides the steps in civil service and banking reform mentioned above, we have made progress in most other areas of structural reform included in the program, including: amending taxation of free economic zones; reducing licensing requirements (although some steps still remain to be taken); simplifying and clarifying inspection requirements; and, removing conflict of interest situations. We are confident that the procedures to simplify licensing procedures will be in place by the end of September. We will also take strong steps to remove regulatory authority from all market participants. Due to lack of consultants or funds, some measures may be delayed somewhat from the original target dates (e.g. conclusion of audit of Kyrgyzgas) but nevertheless these measures are being implemented. We would like to stress that we have made significant progress with reforms in the energy sector, including a 40 percent increase in electricity tariffs and unification of gas tariffs. These reforms will continue with financial support from the World Bank, which is expected to be approved shortly. We also assure you that we will continue our reforms in the agriculture sector, which we see as key to the future development of this country. In the context we will seek the elimination of the moratorium on land sales by the end of this year.

13. We are in the process of further working out a comprehensive poverty reduction strategy, in consultation with civil society and donors. Significant preparatory work has been done and procedures have been put in place to involve all layers of the population. During the next few months we expect to consolidate the inputs that have been provided and to complete the remaining analytical work, which will allow us to complete the design of our strategy later this year or early 2001.

14. In view of the steps we have already taken to bring the program back on track and the measures we intend to implement during the rest of the year, as well as the elimination of the external and pension arrears, we request waivers for the non-observance of the performance criteria on pension arrears and the cumulative fiscal deficit at end-June, 2000, and on the non observance of the performance criteria or external debt service arrears. We also request a waiver for the non-observance of the structural performance criterion on licensing for end-June. On that basis we request the completion of the first and mid-term reviews under the PRGF program, with the concurrent approval of the disbursements of SDR 4.77 million each, relating to these reviews.

15. We assure you that we stand ready to take any additional measures, in consultation with Fund staff, that may become necessary to achieve the program’s objectives.

Yours sincerely,

Performance Criteria

September 30, 2000

1. Complete on-site inspections of 5 financial institutions, in addition to the 8 institutions inspected as of June 30.

December 31, 2000

1. Eliminate moratorium on land sales.

Benchmarks

September 30, 2000

1. Submit to parliament a system of presumptive taxation for small businesses (in line with FAD recommendation), for implementation in 2001.

2. Reduce early retirement privileges and special pensions.

December 31, 2000

1. Introduce a property tax system in coordination with the establishment of a land registry system.

2. Reduce all in-kind tax payments and netting out of arrears to no more than 10 percent of tax revenues in 2000.

3. Reduce the top tariff rate to 15 percent.

4. Complete privatization and restructuring plan for Kyrgyz Airlines (including issuing an international tender).

5. Offer for sale majority shares in at least 50 enterprises under the case-by-case privatization program.

6. Complete audits of KyrgyzGasMunaizat, Kyrgyzgas, and Munai.

7. Offer for sale one power distribution company, and finalize and approve a concept paper forsubmission to parliament for the denationalization and privatization of KyrgyzGas.