A.  Background

1. In the aftermath of the breakup of the U.S.S.R., the Kyrgyz government rapidly adopted a strategy to transform the economy to a market system. During the initial stage of reforms the government liberalized most prices, created a national currency, introduced a liberal trade regime, eliminated most capital controls, and initiated the first structural reform steps in the areas of privatization, banking, and the legal and regulatory framework. However, output fell sharply, unemployment rose, and poverty increased, partly owing to the loss of extensive financial support from the U.S.S.R. and the disruption of trade and payments links.

2. Following these steps, during the last three years the Kyrgyz government has successfully implemented a comprehensive program of macroeconomic adjustment and structural reforms. The reform program has been supported by the use of resources under the Enhanced Structural Adjustment Facility (ESAF), structural adjustment credits from the World Bank, credits from other multilateral agencies, especially the Asian Development Bank (ADB), and contributions from bilateral donors.

3. The main objective of the macroeconomic and structural adjustment program during 1994–97 was to create economic conditions supportive of sustained growth based on an expanding and dynamic private sector. After a cumulative output decline of about 50 percent during 1991–95, real growth resumed at 7.1 percent in 1996 and may have reached 10.4 percent in 1997, based on preliminary calculations by the National Statistical Committee (NSC).¹ In 1996, the recovery emanated from strong growth in agricultural output, while in 1997 growth was mainly based on the start of production of the Kumtor gold mine, the only sizable foreign direct investment in the Kyrgyz Republic so far, and continued growth of agricultural output.

4. Under the program, fiscal and monetary policies were tightened considerably, pushing inflation below 15 percent by end-1997. Interest rates were reduced and the exchange rate stabilized. The overall budget deficit was contained to 9.4 percent of GDP in 1997 from 17 percent of GDP in 1995 on account of expenditure restraint, a modernization of the tax system, and a reform of budgetary procedures and intergovernmental relations. During the same period, domestic financing of the budget was curtailed from 8.2 percent of GDP to 1.2 percent of GDP, with an increasing share of nonbank financing. This adjustment facilitated the conduct of monetary policy, which also benefitted from a strengthening of the policy framework and instruments at the disposal of the NBKR, such as the introduction of open market type operations. Improvements in monetary instruments coincided with a successful reform of the financial sector, which was instrumental in increasing the public’s confidence in the banking sector. Under the reform, two remaining state banks were liquidated, and two other former state banks were recapitalized, while a number of new private banks have started operations. At the same time, prudential regulations in line with international standards were introduced, and supervision of the banks by the NBKR was strengthened.

5. Considerable progress was achieved on the structural front. A comprehensive privatization program was undertaken, and the main remaining task will be to privatize about 100 large enterprises, including utilities. In agriculture, land use rights were distributed for about 50 percent of arable land, while plans regarding the remaining land are still under consideration. Structural reforms have also covered the legal system, and a large number of laws conducive to the development of a free market have been adopted.

6. Despite the continued commitment of the Kyrgyz government to establish a market-based economy, many reforms are still ongoing and the private sector has not yet fully responded to the new market environment. The outlook for growth remains positive but restrained, as domestic savings are low and investment prospects appear limited over the medium term. Privatized enterprises have been slow to restructure, and capacity utilization has not yet picked up. The share of the shadow economy has increased over the last few years, possibly due to existing levels of taxation. Government spending priorities do not yet fully support the needed strengthening of health and education services or infrastructure investment. The pension system continues to be a major and unsustainable burden on the budget, while general governance issues affect various aspects of decision making. While social assistance is now better targeted than before, structural poverty (especially in rural areas) and unemployment continue to be a major concern.

7. Inflation appears less of a problem now than it was three years ago. However, the authorities understand that the rapid accumulation of foreign debt during the last few years has developed into a serious constraint on macroeconomic management. In addition, the economy remains vulnerable to a number of external factors, including rising costs for energy imports and possible further declines in the price of gold.

8. In short, despite the achievements of the past, the authorities are aware that the reform agenda is still unfinished, and they intend to continue their efforts both on the stabilization front and in the structural area under the programs to be supported under the successor ESAF arrangements.

9. The main aim of the government’s program for 1998–2000 is to consolidate the progress already achieved and create a sustainable environment for continued growth based on a dynamic private sector. The key macroeconomic objectives for 1998–2000 will be to (a) achieve a real GDP growth of at least 4½ percent a year; (b) reduce inflation to 5–6 percent by 2000; and (c) lower the external current account deficit to about 5 percent of GDP by 2000 from about 8 percent in 1997 (Table 2). To this end, the program will rely on appropriately tight fiscal and monetary policies and a wide array of structural reform measures. The government will also take the necessary steps to improve transparency and good governance in all aspects of economic and political decision-making. The following sections describe the general directions of macroeconomic policy and structural reforms. Table 1 lists specific measures and corresponding timetables.

10. Fiscal policy aims at further strengthening budgetary procedures and reducing the overall fiscal deficit to about 5½ percent of GDP by the year 2000. With respect to revenues, the government will take the necessary steps to broaden the tax base in order to eventually allow lower tax rates while preserving the objective of raising tax revenues to above 14 percent of GDP. To this end, the government will ensure that existing discretionary tax exemptions be removed, and no new tax exemptions, exceptions, or tax holidays be granted in the tax code or on a discretionary basis. In addition, the government will ensure that the net effects of any new amendments to the tax code proposed by the government be revenue neutral. All dividends and other payments related to the Kumtor gold mine will be transferred directly to the budget. In order to avoid an uneven demand for urban land versus rural land, the land tax will be extended to urban areas, and the criteria for the land tax rates will be reassessed. Amendments to the tax code will be submitted to parliament to include excise and customs payments into the base for the calculation of the VAT, to be implemented in 1999. With a view to preventing fraudulent refunds, the tax authorities will conduct annual audits of enterprises that receive VAT refunds.

11. To improve tax administration further, the State Tax Inspectorate (STI) will be strengthened to make it independent from local political authorities. To enhance the collection of custom duties, the State Customs Committee (SCC) will be placed under the authority of the Ministry of Finance by end-2000, and the monitoring of border posts will be improved. An independent Large Taxpayer division will be established in Bishkek and special service desks will be set up at local STI offices, with a view to improving taxpayer service and moving to a system of self-assessment.

12. The government recognizes the need to further curtail budgetary expenditures and improve their management and efficiency. Expenditures will be kept at a level that can be financed by revenues, grants, external concessional borrowing, privatization receipts and sales of treasury bills. Within this framework, non-interest current expenditures of the state government will be reduced from 20 percent of GDP in 1997 to under 17 percent of GDP in 2000. The wage bill will be targeted to decline from 7.1 percent of GDP in 1997 to about 6.7 percent of GDP in 2000.

13. Increases in the minimum wage will be strictly limited and real wages of civil servants will only be increased in tandem with a comprehensive civil service reform, which the government intends to undertake during the program period, supported by EU TACIS. The civil service reform will include reviewing and categorizing every civil service position, eliminating all redundant positions, reorganizing ministries, modernizing management techniques, including the rewards system, and strengthening civil servants’ qualifications.

14. The government will reduce transfers and subsidies to public enterprises and the Social Fund, and it will curtail nonpriority public spending. To avoid the accumulation of expenditure arrears, the government will develop a system of commitment accounting at the treasury. To help arrest the deterioration of social indicators and strengthen the prerequisites for durable and sustainable growth, budgetary allocations for health and education will be as a minimum maintained in real terms and further improvements in their targeting and efficiency will be made (see paragraphs 36 and 37). Similarly, capital expenditures are targeted to rise from 4 percent in 1997 to 5.7 percent of GDP in 2000. To improve coordination and effectively prioritize Public Investment Projects (PIP), the government will strengthen the PIP coordination between the Ministry of Finance and the line ministries, following World Bank recommendations.

15. The government is aware of the need for a comprehensive pension reform in order to establish a pension system which, while fiscally affordable, will provide for the needs of the various population groups. In the short run, the government will take further steps to balance the budget of the Social Fund, at the same time as budget subsidies are reduced to zero by 2001. Over the medium term, the government, based on the analytical work to be undertaken with the help of the World Bank, will implement a comprehensive pension reform that will lead to a sustainable pension system. This reform will include measures to: (a) increase the ratio of contributors to beneficiaries; (b) decrease the replacement rate; (c) strengthen the link between contributions and benefits, and (d) gradually increase the number of minimum years required for full benefits.

16. The government understands the importance of smooth relations with sub-national units and of efficient budgetary procedures. To that effect, existing revenue sharing arrangements will be enforced and an early preparation of the budget will be institutionalized. These procedures will include the use of medium-term financial forecasts and the integration of the externally financed PIP and the State Property Fund into the budget. The state budget and the budget of the Social Fund will be presented to parliament simultaneously.

17. The NBKR will continue to conduct monetary policy consistent with its inflation target, while developing better liquidity forecasting techniques and policy instruments and improving accounting practices in line with international standards. The NBKR will expand its data base on banks’ interest rates and further enhance the flexibility, marketability and effectiveness of open market instruments. In order to make monetary policy instruments more effective, the penalty rate for noncompliance with reserve requirements will be increased, while the surcharge for the repeated use of the Lombard facility will be removed.

18. With the aim of strengthening the banking sector further, the NBKR will ensure the observance of prudential norms by improving its capacity to conduct on-site inspections. Similarly, the clearing and settlement system and the system for liquidity management will be improved. The remaining legal steps in the liquidation process of Agroprom and Elbank will be completed and the Debt Resolution Agency (DEBRA) will be closed.

19. In order to facilitate the development of nonbanking financial institutions, appropriate legislation, formulated jointly with the NBKR, will be enacted and implemented, including laws on investment funds, insurance companies, private pension funds, and leasing. The government will continue its efforts, with the support of USAID and the World Bank, to create a framework for the orderly development of the Kyrgyz Stock Exchange in order to increase the listing and trade in privatized enterprises.

20. The NBKR will maintain the current exchange rate policy. Intervention will be limited to smoothing seasonal pressures while strengthening international reserves. Market pressures on the som will be met through tightening credit policies, and allowing a gradual depreciation if pressures persist. To the extent that unexpected capital inflows are associated with an increase in the demand for money, the NBKR will build international reserves above target levels. Otherwise, the NBKR will allow the som to appreciate in order to preserve the inflation target. The foreign exchange auctions have already been reduced to once per week and will gradually be replaced by dealings in the interbank market.

21. The government will maintain the Kyrgyz Republic’s liberal trade regime. It will continue its efforts to obtain full membership in the WTO and is prepared to remove any obstacles that may hinder this endeavor. Furthermore, it will phase out economically nonviable Free Economic Zones and strengthen control of the remaining ones. Also, in order to initiate the elimination of state trading monopolies, the government will submit to parliament the privatization plans for the gas and electricity companies.

22. The government recognizes the need to improve external debt management, given the already high level of external debt and the projected increase in key debt ratios over the medium term. To this end, the government will restrict all external borrowing to loans on concessional terms; nonconcessional loans will be allowed only as specified under the program and only in areas of high priority, such as the energy sector or infrastructure. In compliance with the Law on the Treasury, the role of the Minister of Finance as the sole signatory of external borrowing agreements or guarantor of such contracts will be strengthened. The government will continue to enhance the external debt management unit at the Ministry of Finance that will comprehensively analyze the feasibility of each proposed project. The unit will incorporate in its recommendation the analysis of the NBKR and report directly to the Minister.

23. The government attaches great importance to governance issues, in both the public and the private sector. To improve governance in the public sector, the State Property Fund will be incorporated in the budget and government-wide procurement and audit reforms will be initiated. A comprehensive government strategy will be developed to emphasize the concept of individual accountability and define sanctions and penalties for abuse. A similar program to improve corporate governance is being implemented with the support of the ADB. Within this framework, guidelines in line with international standards for accounting and disclosure and the statutory mechanisms for the enforcement thereof will be developed.

24. The government is committed to accelerating the development of a land market by ensuring that the right to use land is legally safeguarded and transformed into a property right that can be used as a basis for collateral. In this respect, the Law on Land Registration, the Mortgage Law and the revision to the Land Code will be enacted, all firmly based on market principles. Steps will be taken, with the assistance of the World Bank and USAID, to consolidate and complete the introduction of an immovable property registration system, and to develop a framework for auctioning the holdings of the Land Redistribution Fund and other land still in state hands.

25. In the area of privatization and private sector development, the government intends to complete by 2000 the privatization or liquidation of large state enterprises and the remaining enterprises in the service and social sectors. It will also privatize three of the remaining ERRA-enterprises.² The government is also committed to help accelerating the development of small- and medium-sized enterprises by identifying and removing the remaining impediments to their growth in the areas of taxation, external and internal trade and in the national and local regulatory framework.

26. Emphasis will be given to improving corporate governance with the support of ADB. In particular, the government will enforce hard budget constraint by phasing out budget loans to all enterprises, and strictly limiting rolling-over and rescheduling arrears to the tax authorities, the budget or the employees. Liquidation procedures will be initiated for those enterprises unable to meet arrears within a specific time frame. Simultaneously, the government will facilitate restructuring of enterprises by adopting new labor legislation to decrease the cost of hiring and firing employees.

27. The government will give priority to private agricultural development by facilitating competition in the markets for inputs and outputs, supported by the World Bank and the ADB. Funds will be provided from the budget to secure inter-farm irrigation infrastructure, but efforts will be made to increasingly cover operation and maintenance costs from user fees. To help the newly created private farms undertake profitable farming, the government will establish a network of farm advisory services which will make available knowledge with regard to small scale farming, accessing credit and input supply, and output markets. Advice will also be provided regarding techniques of farming.

28. With respect to financing of the agricultural sector, the government will take steps to improve financial intermediation in rural areas, while phasing out direct budgetary support. This will in part be done by increasing the activity of the Kyrgyz Agricultural Finance Corporation (KAFC) at interest rates that will gradually become market based. Also, in order to develop community-based financial intermediaries, the establishment of credit unions will be supported in all oblasts, with the support of the ADB, and a small credit outreach program will be implemented by KAFC.

29. The legal and regulatory framework requires further strengthening. To this end, the government will enact the remaining outstanding laws needed for a well-functioning market economy. Furthermore, efforts will be made to build a judiciary system capable of implementing legislation in a transparent and predictable manner throughout the country. In this respect, adequate resources will be dedicated to the judiciary, court procedures will be streamlined, and judges and other legal experts will undergo training regarding specific laws, with the support of the World Bank, the ADB and USAID. Finally, the government intends to take the necessary steps to make the public more aware of its rights and obligations under the new legislative framework.

30. The government intends to rationalize domestic energy use and explore new energy sources. In this respect, increasing utility tariffs, introducing a new rate structure, and improving billing and collection performance are key elements in the efforts to recover costs. Collection performance will be raised gradually by replacing KyrgyzEnergo subsidies to low income households with direct budget transfers and by ensuring payment compliance of all budgetary institutions. In addition, the government will implement the already designed restructuring and privatization strategy for the energy sector with a view to attracting private investors.

31. In the area of environmental protection, the government will focus on a sustainable use of natural resources by reversing the deterioration of water infrastructure that is responsible for significant water losses. This will be done through a community-based rehabilitation in the areas of water supply, sanitation, and mini-hydro-power plants, supported by the ADB.

32. A comprehensive reform of the communication sector is being undertaken with the support of the EBRD and the World Bank. The government is committed to implementing the necessary regulatory and policy framework aimed at ensuring the sector’s orderly development and attracting foreign investors. This includes establishing a regulatory agency which will oversee the adjustment of tariffs to eventually cover 100 percent of operational and maintenance costs. The Kyrgyz Telecom will cease all direct and indirect transfers to the postal service, and, before any new investments are undertaken, will prepare sound evaluations of the future demand.

33. As regards urban transportation, the government will strive to meet the demand of the urban population. In this respect, the government, supported by the World Bank, will formulate and implement a reform strategy for the urban transport sector.

34. The government recognizes the importance of further improving the quality of statistics, with a view to laying the basis for sound economic decision making. The government has approved and will implement a comprehensive plan with the General Data Dissemination System (GDDS) as the guiding standard. Implementation of this plan will be supported by the IMF, the World Bank, and other donors. In this context, the publication of a Kyrgyz page in the Fund’s IFS will be given high priority. Also the compilation of an export price index will be completed and work will continue to finish the implementation of the new chart of accounts in the banking sector. The NSC will move from universal to sample-based data collection for all sectors of economic activity, including the informal sector, and the NSC will be reorganized to accommodate the roles of regions in data flows.

35. The government is committed to arresting and reversing the deterioration of key social indicators. It will continue to improve the targeting, efficiency, and reliability of essential social assistance in order to ensure that the most vulnerable groups receive at least 60 percent of benefits. The safety net for the poor will be maintained, with emphasis on means tested targeting of resources and programs that promote a quick re-entry into the labor market. To monitor developments in social indicators, the annual household surveys will be continued.

36. A healthy and well-educated population is a key prerequisite for sustainable growth. The government will keep spending on health services at least constant in real terms over the medium term. To improve the quality of the health services to the population, the government will continue to take the steps needed to increase the effectiveness of health care, with a special focus on restructuring health facilities and primary and preventive health care. In this respect, pharmaceutical management and health financing will be reformed, and special focus will be given to the rural population, people living in remote areas, and the most vulnerable. The medical care provided payment system, which changes the way health care providers are paid, will be extended from Issyk-Kul to Bishkek and Chui. On the financial side, the compulsory medical insurance will be strengthened and its revenue devoted towards the provision of a basic package that is universally guaranteed.

37. The government will keep spending on education at least constant in real terms over the medium term. In order to improve the quality of education, the government has been implementing its educational reform with support from the ADB. This reform preserves the high enrollment rates for primary and secondary education, but updates the curriculum to reflect the changes that the country has undergone. Based on ADB recommendations, the reform will also ensure that funding be based on the number of students rather than teaching positions.

38. The government will continue its efforts to reduce rigidities in the labor market. This will be achieved by revising the labor law and ensuring that revenues collected by the Employment Fund are spent solely on labor market programs. The effectiveness of the unemployment benefit system will be improved by tightening eligibility to avoid participation in multiple periods, and by adjusting benefit levels to avoid arrears buildup.

39. The government’s program will need to be supported by considerable assistance on concessional terms from the international donor community. Such assistance is essential in the government’s efforts to create and maintain a market-based economic recovery with sustainable real growth. To that effect, a Consultative Group (CG) meeting was held in May 1998 to elicit donor pledges for the medium term. Under the program's medium-term projections, the non-interest current account deficit (before grants) is estimated to be reduced from about US$149 million (8.8 percent of GDP) in 1997 to about US$120 million (5.6 percent of GDP) in 2000. With a targeted increase of foreign exchange reserves and scheduled amortization of foreign debt, it is estimated that the gross financing requirement will be about US$921 million for 1998–2000 (Table 4). This is expected to be mainly covered from international financial institutions in terms of BOP support and from bilateral donors in the form of grants. After identified concessional assistance and projected official grants, but before prospective IMF disbursements, the financing gap over the program period is expected to be about US$134 million. Over the medium term, the debt-to-GDP ratio is expected to stabilize at around 64 percent (Table 2). However, as most of this debt is at concessional terms, the net present value (NPV) of the debt will be less than 50 percent of GDP. The NPV-of-debt/exports ratio and the debt service ratio will peak in 2000 at about 129 percent and 14 percent, respectively, before beginning to gradually decline. Based on these projections, and provided that sound policies continue, the Kyrgyz Republic should not experience problems in servicing its external obligations.

40. The World Bank and the IMF will continue to provide technical assistance to the Kyrgyz authorities during the programs supported by a successor three-year ESAF arrangement, including the resident representatives of the IMF and the World Bank, as well as long-term resident advisors in a number of areas. In addition, both the IMF and the World Bank have offered technical assistance in a variety of areas, and government officials have been invited to participate in Fund training courses.

41. The Kyrgyz authorities are firmly committed to continuing the transformation of the Kyrgyz economy to a market economy. Under the successor ESAF arrangement, the government and the NBKR will vigorously pursue the necessary reforms to consolidate the significant progress that has been achieved so far and to create an environment for sustainable growth driven by the private sector. This commitment to macroeconomic and structural reforms is pivotal to improve the living conditions for the growing population. Under the program, reforms will be targeted in such a way that the poorest segment of the population will be protected during the transition period so that the reform agenda will continue to carry the approval of the general public.