An IMF mission, led by Edward Gemayel, visited Bishkek during September 16-29, 2015 to conduct the first review under the Extended Credit Facility (ECF) and hold the 2015 Article IV consultation discussions. The mission met with Vice-Prime Minister Dil, Minister of Finance Kasymaliev, Chairman of the Central Bank Abdygulov, other senior officials, and representatives of the private sector, civil society, and the diplomatic community. Discussions centered on policies necessary to steer the economy through a difficult environment and promote inclusive growth including: (i) shifting from fiscal stimulus to consolidation to ensure debt sustainability; (ii) strengthening central bank independence and financial sector resilience; and (iii) carrying out structural reforms to promote diversified and equitable growth.

Outlook and Risks

1. In recent years the Kyrgyz Republic’s economy has been resilient, but its growth momentum has waned due to a difficult international economic environment and spillovers from regional conflicts. Non-gold GDP growth is expected to slow down this year to about 3 percent, as a result of the slowdown in major trading partners, turbulence in regional currency markets, and uncertainty surrounding the economic impact of the recent accession to the Eurasian Economic Union (EEU). Inflation dropped to 5.8 percent in August, but is expected to increase in the coming months driven by the som depreciation and the impact of higher EEU import tariffs. The overall fiscal deficit would rise to 2.6 percent of GDP by the end of the year, reflecting lower-than-projected revenue and higher-than-budgeted spending. With declining exports as well as falling remittance inflows, the external current account deficit would rise to 18.4 percent of GDP in 2015,

2. The economy is expected to improve going forward, but there are critical downside risks. Economic growth is expected to average about 4 percent over the medium term. However, several risks prevail: dependence on gold, remittances, and foreign aid leaves the economy exposed to external shocks and unable to generate broad-based prosperity; further regional economic slowdown could hurt economic activity; a loose fiscal policy combined with additional investment projects could undermine debt sustainability; and high credit growth, coupled with high dollarization and som deprecation, could create risks for financial sector stability.

3. Progress has been made toward completing the first review, but additional efforts will be needed. All end-June 2015 quantitative performance criteria and all indicative targets were met. All but two structural benchmarks were also met. The draft law for strengthening of the VAT by reducing the number of exemptions and gradually phasing of the sales tax was submitted to Parliament in August instead of June. Due to protracted inter-agency deliberations, the audit of DEBRA will not be finalized in October 2015. The enactment of the Banking Code has also seen delays relative to program commitments. Despite the progress, further efforts will be needed to complete the first review, including strong commitments to the program with respect to the 2015 supplementary budget and the 2016 budget. The mission team will remain in close contact with the authorities in the coming weeks.

Fiscal Policy

4. The recent fiscal expansion, justified on cyclical grounds, should be succeeded by fiscal consolidation starting 2016 to maintain debt sustainability and rebuild buffers. The 2016 budget should target an overall deficit of no higher than 3.3 percent of GDP. To meet this target a fiscal effort of at least 2 percentage points of GDP is needed—excluding expected EEU customs revenues which should be saved to gradually rebuild fiscal buffers. Expenditure measures could include containing wages and domestically financed capital spending and cutting spending on goods and services. Further efforts are needed to improve the efficiency and targeting of social spending. Revenue efforts should focus on fairer taxation by eliminating exemptions and improving tax administration.

5. Fiscal expansion, in combination with currency depreciation, could undermine debt sustainability. As a result of the recent currency depreciation, public debt is expected to surge to 68 percent of GDP by year-end and peak at 71.5 percent of GDP by 2017. While public investment can relieve infrastructure bottlenecks and increase growth potential in the medium term, it adds to government debt. Also, elevated spending on wages, goods and services and other expenditures strain public finances as revenues stagnate. In order to gradually bring back public debt to sustainable levels, the primary balance needs to reach about 1 percent of GDP by 2018, and prudence should be exercised when contracting and guaranteeing new debt.

Monetary and Exchange Rate Policy

6. Monetary policy should maintain the current stance to contain inflationary expectations. Despite significant currency depreciation, the National Bank of the Kyrgyz Republic (NBKR) has succeeded in keeping inflation in single digits. Going forward, it will be essential to keep the policy rate positive in real terms, and adjust it in line with emerging inflationary and exchange rate pressures. All available instruments should be deployed to achieve monetary policy targets and enhance traction of the interest rate channel.

7. Greater exchange rate flexibility is crucial to reducing external imbalances and safeguarding foreign exchange reserves. During 2015 to date, the som has depreciated by about 17 percent relative to the dollar. This has helped to protect reserves and competitiveness. Going forward, the NBKR should continue to limit interventions to smoothing excessive fluctuations while allowing the currency to absorb external shocks. The tightening effect of foreign exchange interventions should be monitored to avoid stifling credit and by extension economic growth.

Financial Policy

8. High dollarization coupled with volatility of som is increasing vulnerabities in the banking sector. Careful monitoring of the financial sector is critical, particualrly following the recent depreciation of the som. Measures aimed at increasing stability and reducing dollarization of the financial sector should only be pursued through market means.

9. The adoption of the Banking Law is essential to strengthening central bank independence and improving financial sector resilience. The law will enshrine central bank independence and autonomy and enhance safeguards, particularly the audit process. This long-outstanding law should be approved as a priority once the new parliament convenes. In the meantime, every effort should be made to preserve financial sector stability. With respect to the audit of DEBRA, an auditor should be selected in November with a view to finalising the audit by the end of March 2016.

10. Financial sector development will be crucial to promote growth and provide shock absorbers. Expanding financial intermediation and the number of instruments offered will help in mobilizing of savings, promoting credit, reducing cash in the economy, and providing longer-term financing sources for investments.

Structural Reforms

11. The structural reform agenda is progressing, but further efforts are needed to promote rapid and inclusive growth. In particular, diversifying the economy and maximizing benefits from EEU accession require improving the business climate and combating corruption through removing bureaucratic obstacles and streamlining the process for establishing, running, and closing businesses. Speeding up public financial management reforms—including budget forecasting and a transition to the single treasure account—and tax administration are critical. In this regard, we welcome the authorities’ reaffirmed determination to press ahead with a broad-based structural reform agenda.

The mission thanks the authorities and other counterparts for their warm welcome, excellent cooperation, and candid and constructive discussions during the visit, and reaffirms the IMF’s support to the government’s efforts to implement their economic reform program.