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The IMF has approved a $92 million loan to the Kyrgyz Republic to back a reform program aimed at bolstering the country’s resilience to the slowdown in Russia and other external factors.

 

The landlocked country in Central Asia faces considerable challenges: a weak regional environment, high public debt stemming from an ambitious investment program, and heavy reliance on remittances, gold, and foreign aid.

The new financing package, which extends for three years under the IMF’s Extended Credit Facility, aims to address vulnerabilities that have recently emerged. The Kyrgyz Republic had already begun to implement reforms under a previous IMF program that expired in July 2014.

In the following interview, Edward Gemayel, Kyrgyz mission chief for the IMF, discusses the economy’s current challenges and potential for growth as the country prepares to join the Eurasian Economic Union later this month.

IMF Survey: Why is the economy growing below its potential?

Gemayel: Various factors are affecting economic activity. The country has strong ties to Russia, so the slowdown there has had a major impact. The Kyrgyz Republic is highly dependent on remittances—which represent about 30 percent of GDP—and grants from other countries, mainly Russia. The level of these grants and remittances are now lower, affecting growth.

The country also has a high level of debt, as a result of a huge investment program it recently embarked upon. In recent months, they’ve invested heavily in infrastructure and the energy sector by borrowing externally, mainly from China, and this has created an increase in debt. The country also has a high current account deficit partly as a result of these investments, which require a lot of imports.

Another factor is inflation, which has picked up since early 2014, mainly because of the depreciation of the som, the domestic currency. The som’s weakening has created inflationary pressure in the economy, with inflation going above 10 percent at the end of last year. And the vulnerability of the banking sector is also having a negative impact.

IMF Survey: How is the banking sector being affected by high dollarization—the fact that many people use dollars rather than the local currency?

Gemayel: The country has always had a dollarized banking system, on both the deposit side and the lending side, but that has been exacerbated by the recent slowdown in Russia and the weakening of the domestic currency. This high dollarization—combined with very high rapid credit growth by the banks in the context of a weakening domestic currency—poses a significant risk. If you're borrowing in dollars but your income is in the domestic currency, which is losing its value, then there is a greater likelihood that you won’t be able to repay your loan.

IMF Survey: How does the new program address the country’s banking sector issues?

Gemayel: The program aims to strengthen both the legal framework and supervision of the banking system.

On legislation, a comprehensive banking code that has been in the making for some time, which will strengthen the financial system by bolstering the independence of the central bank. This code will also create a strong banking resolution mechanism, so that if a bank has a solvency problem, the new mechanism will swiftly address the problem before it impacts the rest of the banking sector.

We are also advising the authorities to strengthen banking supervision. In a situation of rapid credit growth and high dollarization on the one hand—and depreciating currency and weakening regional economies on the other—the authorities need to be careful. We are also advising them to introduce macroprudential measures, which rely on prudential tools to limit systemic risk. An example of such measures would be to increase provisioning requirements on foreign exchange loans, or to introduce limits on how much credit an individual or company can access.

IMF Survey: What are the IMF's recommendations for reducing some of the country’s other vulnerabilities, such as the high debt?

Gemayel: We are advocating measures on multiple fronts. On the fiscal side, we recognize that they currently face a difficult economic situation due to the regional slowdown. For 2015, we are therefore recommending a pause in fiscal consolidation, so as to minimize the impact of the shock on the economy. However, in 2016 and 2017, they will have to resume fiscal tightening to counteract the recent surge in debt. For now, their debt is still sustainable. But they need to make sure that it stays that way.

On the monetary side, we are urging the authorities to monitor the double-digit inflation and tighten, as needed, the policy rate (the central bank’s main interest rate). They have been willing to let their currency depreciate, which helps absorb the shock, but they’ve intervened occasionally in the exchange rate to smooth volatility. This strategy has worked well, and that's what we’ve advised them to do—as opposed to sticking to a fixed exchange rate, which would result in the loss of reserves and competitiveness.

Finally, we have also advised the authorities to develop a medium-term debt management strategy with the aim of maintaining debt at sustainable levels. This strategy would restrict borrowing to projects that enhance growth and promote social development. It would also ensure that any borrowing is anchored in the medium-term fiscal framework and is consistent with macroeconomic stability

IMF Survey: How can the government build the infrastructure it needs to develop and still keep debt at a sustainable level?

Gemayel: In addition to the fiscal strategy I just discussed, we are working with the authorities on preparing a new medium-term debt management strategy. Under such a strategy, the government would evaluate the importance of an infrastructure project, determine whether to borrow externally or domestically, and decide on an affordable interest rate. A debt management strategy would be critical to avoiding future surges in debt. We also recommend they do a public investment review to look more closely at their investments to pinpoint the infrastructure gaps, establish priorities, and see if potential investment projects are growth enhancing. Finally, the government should try to borrow strictly on concessional terms.

IMF Survey: How will the Kyrgyz Republic benefit from membership in the Eurasian Economic Union, which it is slated to join shortly?

Gemayel: The Eurasian Economic Union (EEU) is an economic union of states located primarily in northern Eurasia. A treaty aiming for its establishment was signed on May 29, 2014, by the leaders of Belarus, Kazakhstan and Russia, and came into force on January 1. Armenia recently joined, and the Kyrgyz Republic is about to join. They want to form a trading bloc to open the barriers between these countries.

Over the short term, the impact of joining the EEU is expected to be mixed for the Kyrgyz Republic. Prices will likely rise because the Kyrgyz Republic will have to increase its tariffs to the Union’s level. But the long-term effect of full EEU integration should be beneficial for growth prospects.

IMF Survey: What does the IMF see as the main risks to the outlook of the country?

Gemayel: One risk is a further slowdown in Russia, which would definitely have a negative impact. The continued fall of the som in the wake of the falling ruble could increase inflationary pressures. Additional investment projects could tilt the debt level towards higher risk of debt distress. Renewed problems with the Kumtor gold mine, and a further drop in gold prices, could have budgetary implications and hurt growth. And with parliamentary elections scheduled for the fall, there is some political uncertainty in the Kyrgyz Republic, which could affect the economic reforms that require parliamentary action.

There are also potential gains to the economy. China’s investments are helping the Kyrgyz Republic close the infrastructure gap, so if the authorities manage the debt prudently, this could help the economy over the long term. Another potential boost is the $1 billion Russia-Kyrgyz Development Fund that has been set up.

But the authorities will also have to make progress on reforms to improve the business environment and address corruption, which could jumpstart the kind of private-sector-led growth the country really needs.