Executive Summary

For the Kyrgyz Republic, 2003 was the economically most successful year in memory. Macroeconomic stability was solid. Official GDP growth reached 6.7 percent, and real growth might have been even higher. The country is approaching the target of at least 7-8 percent a year and preferably 10 percent a year. Such a growth rate requires an annual expansion of exports of 10 percent or more, which has been accomplished in the last two years. This growth is benefiting the population. Over the last five years, the share of the population living below the poverty line has fallen from 55 percent to 40 percent and inequality has been reduced as well.

These good economic results are underpinned by substantial improvements in economic policy. In the last year, five major policy improvements have been undertaken. First, the central government has been re-organized and further streamlined. Second, a new Customs Code has been promulgated, which should facilitate a reduction of corruption in the customs and better collection of customs revenues. Third, a new liberal Labor Code has passed parliament and should improve the functioning of the labor market. Fourth, physical planning of agricultural production has been abolished. Fifth, in its process of joining the WTO, Kazakhstan has permitted Kyrgyzstan reduced transit fees for trucks through its territory and domestic railway tariffs for transports to and from Kazakhstan, which should greatly facilitate Kyrgyz exports.

This report focuses on three areas, economic development strategy, the elaboration of a new tax code and further improvement in governance. The single most important issue for the next year is that Kyrgyzstan achieves a large reduction of its public foreign debt in the Paris Club in the spring of 2005. Second, as Kazakhstan and Russia join the WTO, Kyrgyzstan needs to make sure that its trade conditions with these two countries are sufficiently liberalized. Kyrgyzstan’s leverage with them will never be as great as at this very moment. Third, the adoption of a new Tax Code should be an occasion to liberalize the tax system. Tax rates should be reduced and the tax system simplified, while actual collection should stay the same as a share of GDP. In particular, simplified taxation for small enterprises should be reinforced; a flat personal income tax of 12 percent should be introduced; the social payroll tax should be sharply reduced; and the profit tax definition should allow for deduction of all real business costs. Fourth, substantial measures are needed to improve governance. At this time, the key priority is to improve the functioning of law enforcement through multiple measures. Fifth, the time appears to have matured to abolish the raion level in the state administration. Finally, payments within the energy system need to be cleaned up through the transition to sheer monetary payments.

List of Contents

  • Executive Summary
  • Introduction
  • 2003: The Year of Take Off?
  • On a Strategy of Economic Development
  • The New Tax Code: Opportunity for Radical Improvement
  • Improved Governance: Key to Success

Introduction

Since 1998, I have worked as an economic advisor to President Akaev, under the aegis of the UNDP. The main component of my work has been an annual economic policy review. This report is based on observations from my visit to Kyrgyzstan from May 20 to 28, 2004, and extensive reading of analytical reports before and after that trip. As usual, I shall focus on issues in economic policy that appear of particular importance at this time.

During this visit, I had the pleasure and benefit of one substantial meeting with President Askar Akaev. Most of all, I want to thank him. Altogether, I had over 40 meetings, including Head of the Presidential Administration Toichubek Kasymov, Secretary of the Security Council Misir Ashirkulov, Deputy Prime Minister for Economic Affairs Djoomart Otorbaev, Deputy Prime Minister Ularbek Mateev, Chairman of the National Bank Ulan Sarbanov, Minister of Labor and Social Protection Roza Aknazarova, Chairman of the Supreme Court Kurmanbek Osmonov, Governor of Jalal-Abad oblast Jusupbek Sharipov, the President’s Special Representative on Foreign Investments Sadriddin Djinbekov, Head of the Economic Department of the Presidential Administration Kubat Kanimetov, Head of the Economic Policy and Forecast Department at the Prime Minister’s Office Tsoi Man-Su, First Deputy Minister of Finance Emirlan Toromyrzaev, First Deputy Minister of Industry and External Trade Sabybrek Moldokulov, as well as many other government officials, numerous businessmen, journalists, representatives of the UNDP, the IMF, the World Bank, the EBRD, USAID, DFID, CASE, the Economic Policy Institute and the American University in Central Asia. I gave a press briefing at AKIpress and a seminar at the UNDP on my findings. I would especially want to thank Deputy Prime Minister Djoomart Otorbaev, Kubat Kanimetov, Marat Tazabekov, Rafkat Hasanov, Kuban Omuraliev, Fred Huston, Roman Mogilevsky, and finally Jerzy Skuratowicz and his collaborators from the UNDP for all their assistance.

I have drawn on studies from the Kyrgyz government and the organizations mentioned, especially the Comprehensive Development Framework of the Kyrgyz Republic to 2010 (CDF), the National Poverty Reduction Strategy (NPRS), the National Anti-Corruption Strategy of the Kyrgyz Government, the Matrix of Principal Measures to Attract Foreign Investment of the Council of the Promotion of Foreign Investment, the April 2004 National Council on Good Governance Strategy of Reform of the System of the State Administration of the Kyrgyz Republic, the UNDP National Human Development Report for Kyrgyzstan 2003, UNDP Millenium Development Goals Progress Report for the Kyrgyz Republic, the IMF 2003 Article IV review under the Poverty Reduction and Growth Facility, the Memorandum of Economic Policies with the IMF, the June 2003 Proma National Business Opinion Survey, and a variety of World Bank documents.

2003: The Year of Take Off?

Last year, I argued that Kyrgyzstan was ready to rise to a higher growth trajectory. Four preconditions had been formed that could provide a basis for a substantial economic take-off, the alleviation of external threats, domestic political stability, financial stability and splendid economic growth in the region. At the same time, many reforms either had been undertaken or were under way.

All these favorable conditions remain in place, and the key achievement in 2003 was a growth rate of 6.7 percent, suggesting that the country has really entered a higher growth path. Admittedly, economic performance remains hostage to the vagaries of one gold company and one electricity company, but the Kyrgyz economy is close to the average growth rate of the nine market economies in the CIS of no less than 8 percent last year. Partly, this growth is spurred by buoyant demand from the swiftly growing adjacent economies of Kazakhstan, Russia and China, partly, by Kyrgyzstan having accomplished a critical mass of market reforms and private enterprise, with limited public redistribution and reasonably open markets. In addition, an abundance of free capacity is still at hand.

Observations with the bare eye suggest that the real economic development is even better and that ever less is being caught by the official Kyrgyz statistics. The car traffic both in the country and on the roads to China and Kazakhstan has obviously multiplied in the last few years. Markets are thriving. At long last, construction has started flourishing in Bishkek. Animal husbandry has evidently greatly recovered in the last few years. There are good, and legal, reasons to believe that actual GDP is rising faster than recorded GDP. First, the economic growth in Kyrgyzstan has been led by small enterprises that pay lump-sum taxes or land taxes, and we do not know how much they actually produce. Nor should we be particularly worried, because they are legal and it is wonderful that they produce so much. Second, the Ministry for Foreign Affairs assesses that 500,000 Kyrgyz live in Russia and 100,000 in Kazakhstan, and the country is clearly benefiting from huge remittances, many of which do not go through official bank accounts. A common guess is that these remittances might amount to $200 million, that is, 10 percent of GDP, but nobody knows. It should be relatively easy to conduct a select poll among Kyrgyz abroad regarding how much they transmit home. Third, a drive on any road to China indicates that the traffic of shuttle traders has evidently multiplied in the last two years, involving tens of thousands. The borders have become easier to penetrate and demand in China is a great growth generator. Again, nobody knows the size of this traffic, but it could easily be another ten percent of GDP.

As a small economy such as Kyrgyzstan only can grow through exports, this is particularly important. For the last two years, the growth has been spurred by rising exports – by 13.5 percent in 2002 and by 9.4 percent in 2003. Considering the apparent swift rise of shuttle trade, real exports have probably increased much more.

Underlying the rising growth is the macroeconomic stability that has been maintained since 2001. Kyrgyzstan has complied with the targets set by the IMF by increasing revenues and reducing expenditures slightly, proving both greater capacity to collect revenues and reliable expenditure control. The gross foreign currency reserves have increased to 4.7 months of imports. Inflation stayed low at slightly over 5 percent in 2003, and the currency revalued for the third year in a row. As a result, Kyrgyzstan is also complying with its Paris Club agreement on debt relief from 2002.

These economic improvements are also meaning something to the population. The share of the Kyrgyz population living below the poverty line has declined from 55 percent in 1998 to 40 percent in 2003. In parallel, the previously very high level of inequality has declined, and the Kyrgyz Republic now has an inequality (Gini coefficient) that pairs inequality in the United States. The decline in poverty and inequality has been facilitated by the strong development of agriculture and small-scale trade.

A number of substantial policy improvements have contributed to these economic results. The most conspicuous is the government reorganization. A number of state bodies were merged into the Ministry of Economic Development, Industry and Trade. They were the former Ministry of Foreign Trade and Industry, the State Anti-Trust Commission, the State Committee for Support of Entrepreneurship, most of Kyrgyzstandard as well as some parts of the Ministry of Finance and the State Committee for Public Property Management. As a result of consecutive government reforms, the central government organs now make up a very reasonable structure. Meanwhile a large number of ministries have undergone functional analysis, spearheaded by the UNDP and other donors. As a result, a large number of government functions have been weeded out, notably business activities, and the government staff has been reduced and streamlined. In parallel, the government has been able to raise the salaries of senior government officials, though salaries remain far too low. The number of central and oblast-level government officials appears sufficiently low now, so reforms can proceed to other levels of government, and efforts can focus on creating a real civil service and improving its quality.

Another important reform is the adoption of a new Customs Code. One vital change is that the new law prescribes pre-loading inspection, which is supposed to reduce the discretion of the customs officials and diminish their opportunities for corruption. The first indications are that customs revenues have risen suddenly this year.

On May 25, a third key law was promulgated by parliament with a large majority. It is a new Labor Code, inspired by the labor code of New Zealand, which will lead to a far-reaching deregulation of the labor market. It reduces severance pay from two months to one month. Individual labor contracts replace collective agreements, and the role of the trade unions diminishes. It becomes easier to lay off labor, and all kinds of poorly-justified social leaves are being eliminated, while maternity leave has been reduced from three to one and a half years. This liberalization should stimulate employment, improve the functioning of the labor market, at the same time as it will better safeguard key rights of workers, such as timely pay in fall. Among post-communist countries, only Estonia, Latvia and Kazakhstan have adopted equally liberal labor codes. Another social reform that is proceeding is the successful health care reform, which raises the efficiency of health care as well as the salaries of physicians.

The so-called indicative planning, which amounted to the planning in physical quantity of agricultural produce, has been abolished. Thus, peasants are finally free to pursue their profession without undue interference from akims.

For years, Kyrgyz exports have suffered from the unwillingness of Kazakhstan to offer decent transit opportunities to Russia and access to its own market. Now, however, Kazakhstan is about to join the WTO, which offers Kyrgyzstan unique possibilities to force Kazakhstan to open its market and transit routes. In December 2003, President Akaev finally managed to attain bilateral agreements with Kazakhstan on reducing transit fees through the country for Kyrgyz exports and domestic Kazakh tariffs for the railway transportation of Kyrgyz goods for transportation to and from Kazakhstan. This was a major breakthrough, which will presumably have a great impact on Kyrgyz export opportunities.

All the reforms mentioned above were recommended in this report last year, as well as in many other places. They show how the Kyrgyz Republic is systematically undertaking one major liberal reform after another.

Parliamentary elections are scheduled for February 2005 and presidential elections for November 2005. Elections will also be held for local self-government and of executives, ail okomotu. This may give the government a one-year political window of opportunity to undertake essential reforms.

Two major tasks need to be completed. As they have been discussed extensively in previous reports and much has already been done to accomplish them, they will just be restated here:

  • Two years ago, the Kyrgyz Republic entered an important Paris Club agreement on the reduction of its foreign public debt service for three years. In the spring of 2005, the Paris Club will meet to discuss Kyrgyzstan’s foreign debt again. The aim should be to achieve a substantial reduction of its actual debt to bilateral creditors, essentially Russia and Japan, so that the public debt service becomes sustainable.
     
  • Kazakhstan and Russia are about to join the WTO not later than 2007. Before then join, each of the 148 members of the WTO, including Kyrgyzstan, must approve of their recognition of WTO rules and principles, which are extensive. This is an extraordinary opportunity for Kyrgyzstan to resolve all its trade problems with these two countries by threatening with its veto. If the Kyrgyz Republic does not approve of their trade liberalization measures, neither of them can be admitted to this important organization.

On a Strategy of Economic Development

In recent years, the Kyrgyz economy has started developing firmly in some directions. This has led to a new demand for industrial policy. The government should facilitate the development of what obviously works and alleviate evident bottlenecks, notably in infrastructure. However, it would be wrong to call for state investment in actual producing enterprises or for state-owned enterprises. Such undertakings tend to be patently unsuccessful.

It is rather easy to formulate a vision for the Kyrgyz economy, and it is remarkably how similar most visions tend to be. The Kyrgyz Republic has three outstanding characteristics. It is small, mountainous and land-locked. The most successful country sharing these characteristics is Switzerland, and its experiences during the last two or three centuries suggest what might lead to the greatest success for Kyrgyzstan.

The first problem is big and not necessarily friendly neighbors. Switzerland encountered that problem by having an extremely open economy with a very liberal trade policy and an equally liberal investment policy. The Germans, French and Italians owned much of Swiss industry in the 19th century, but as the Swiss grew wealthier, they eventually bought up many of the shares on the stock market. Today, Switzerland is prominent because of its many large industrial corporations. The Kyrgyz Republic needs to pursue a highly liberal trade policy and exploit international organizations, notably the WTO, to a maximum to get as open markets as possible. At present, the greatest prospects lie with Kazakhstan, Russia and China. Kazakhstan and Russia are about to join the WTO within the next two years, and this is Kyrgyzstan’s greatest opportunity ever to force them to open their markets. For that purpose, Kyrgyzstan needs to strengthen its representation at the WTO in Geneva. China has already joined the WTO and basically offers an open market. Unfortunately, Uzbekistan remains a state-controlled command economy, which does not easily allow any decentralized foreign trade. Uzbekistan cannot liberalize its trade with less than liberalizing its whole economic system, which would require major political changes. Meanwhile, Kyrgyzstan can unfortunately do little to facilitate its trade with and through Uzbekistan, which especially causes southern Kyrgyzstan major economic damage.

The second problem is high transportation costs. Here, there are hardly any shortcuts. Kyrgyzstan needs to invest for years to join major transport arteries. The Public Investment Program is supposed to contribute, and it is vital that it is focused on transportation. Kyrgyzstan may also persuade neighboring trading partners to alleviate its geographical isolation through transportation investment. Naturally, this severe bottleneck means that Kyrgyzstan needs to avoid expensive transportation. One obvious means is that workers migrate to the labor markets, as was typical for Switzerland in the 19th century. This is currently the case also for Kyrgyzstan. Another way is to focus on services, such as banking and tourism, in which Switzerland excels. Finally, high value-added products, such as gold and high technology, render transportation costs nearly irrelevant.

These two bottlenecks, landlockedness and difficult transportation, mean that Kyrgyzstan, like Switzerland, has to be better than others to compete. So far, Kyrgyzstan has greater freedom than its neighbors, which is an important attraction. Partly as a consequence, Kyrgyzstan probably has a better education system than its neighbors. It should also have lower taxes, but that is not true with regard to Kazakhstan, and a major tax reduction and liberalization of the tax regime are urgently needed. Kyrgyzstan needs to have better governance, too, than its neighbors. Laudably, President Akaev has made that a major focus of his policies in recent years, but much remains to be done to realize that intention.

In one regard, Kyrgyzstan has a better starting position than Switzerland in the 19th century. It has substantial mineral resources, which can be used to give the country a kick-start to a better future.

On the basis of these general considerations, we may get some sense of reasonable policies and expectations for some major economic opportunities in Kyrgyzstan.

Kyrgyzstan has exploited one of its major gold deposits, Kumtor, in a foreign joint venture, but there are at least three more gold deposits that could be exploited. Since the gold price has risen from $280 per ounce to about $400 per ounce, this is a good time to conclude new contracts. For the success of such contracts, transparency is vital. The Kyrgyz state company Kyrgyzaltyn has the disadvantage of being both a producing state company and a regulatory agency. These functions should be split, and clear conditions for new investments by decent foreign gold companies should be established. The decision to float a large share of Kumtor as Centerra on the Toronto Stock Exchange appears a transparent way of generating maximal state revenues from Kumtor for the Kyrgyz state. Special tax holidays should be avoided, while ordinary taxation should be sufficiently mild. In addition, exploration for more minerals should be encouraged by allowing successful explorers standard rights of exploitation.

The Kyrgyz Republic has great opportunities in hydropower, both in the current operations and in future new investments. This can be seen as a three-stage process. First, the Kyrgyz energy system needs to be cleaned up so that it can collect payments in cash. At present, the managers of the state-owned distribution companies appear to be tapping the wealth of these companies through complicated schemes of non-monetary payments. Nobody wants to invest in corporations, whose managers just siphon off money for themselves. Second, Kyrgyzstan needs to resolve its persistent problems with its electricity deals with its neighbors Kazakhstan and Uzbekistan to make them mutually beneficial. This is a difficult task, and it is not obvious how it can be accomplished, as all parties appear to prefer non-transparent barter deals. The third and truly major step will be the development of new untapped hydropower with the building of new long-distance transmission lines. At least three major exportation projects are being discussed. One is to provide electricity to Afghanistan, and the same lines could be prolonged to Iran or Pakistan. Another possible project is to export electricity to China, and a third is electricity for Russia. The construction costs of building two large new dams for hydropower are assessed at some $2 billion, that is, the annual GDP of Kyrgyzstan. The vast cost, the political intricacies, the complicated consequences for water supply in the region and the long-term nature of these projects suggest that the government must be both convinced of their viability and have access to sufficient financing before venturing into any of them. This is a great potential that should be continuously explored, but it is more important for the eventual decision to be well considered rather than early.

A third source of natural wealth is coal. Kyrgyzstan produced significant volumes of coal in Soviet times, but coal mining has regressed to minor manual operations. The main reason is that railway transportation of coal from the mines in southern Kyrgyzstan through Uzbekistan has been disrupted, and it is complicated to reestablish any trade links through that country. With the present high mineral and energy prices, the price of coal has surged too, and neighboring China is demanding ever more energy. Large-scale exports of coal to China are an obvious opportunity. Two prior conditions need to be fulfilled. First, railway connections need to be established between the coal mines and the relevant customers in China. Apparently, only limited distances need be built. It is nearly always too expensive to transport coal by road. Second, strategic investors are required for the re-development of the Kyrgyz coal industry. This should be feasible, but it is naturally dependent on Chinese interests, and it is a large-scale project requiring both transparency and due consideration.

Agriculture dominates the Kyrgyz economy, employing almost two-thirds of the population and generating over one-third of GDP, but it accounts for only one-tenth of Kyrgyzstan’s exports. Agriculture must develop through exports. The current trade liberalization with Kazakhstan, and thus indirectly with Russia, offers Kyrgyzstan a great opportunity. At the same time, shuttle traders quickly boost food exports to China. Not least because of the massive recent development of shuttle trade, food processing might finally take off in Kyrgyzstan. Agriculture has developed well quantitatively, and recently it is particularly noticeable that animal husbandry has come back, but quality needs to improve. The development of processing in Kyrgyzstan should follow initial exports of agricultural commodities, because food processing is the key to agricultural development. It tends to boost the quality of produce, as food processors usually organize suppliers, while prices surge, encouraging producers to invest. Processed food is more valuable and less bulky and thus cheaper to transport. Both railway and truck transportation become feasible. At present, a lot of agricultural processing appears to finally be emerging both for export and the domestic market. The key threat to these burgeoning medium-size enterprises is predatory actions by law enforcement and local authorities, which need to be contained by the central state authorities. The development of sales and purchasing cooperatives in the countryside, as distinct from the old production cooperatives, would be valuable.

A steady concern in agriculture is sudden and unexpected overproduction. The current example is the overproduction of potatoes, which has caused prices to plunge. Examples from recent years have involved onions and beans (fasol). The reasons vary. Typically, a promising export market – Kazakhstan, Russia or Uzbekistan – has just been closed. To some extent, such external causes can be averted through a pro-active trade policy. Sometimes, the cause is a food-processing company that goes bankrupt. More often than not, some government body is a cause of such bankruptcies, which must be avoided. In the end, however, agricultural markets are unpredictable. Farmers usually concentrate on growing the most successful crop of the last season, leading to overproduction the next season. Rather than trying to regulate agricultural production, the Ministry of Agriculture could provide market data on price forecasts, demand forecasts, storage data and sowing data. Kyrgyz farmers need better market information, not more regulation.

With its high mountains and Issyk-Kul, Kyrgyzstan has excellent conditions for certain kinds of tourism. It is important to focus on what is most easily accomplished. Issyk-Kul has an old appeal to people in the neighboring former Soviet Union, and at present Kazakhs and Russians in Siberia have both the money and the inclination to visit its shores. The Chinese have starting coming more recently. Usually, tourism is being developed by enterprises of the countries from which the tourists come, so the selling of hotels at Issyk-Kul to Kazakh enterprises must be welcomed, and the Chinese designs for large investments there should be facilitated. More exclusive mountain tourism should also be welcomed, but its volume should not be overestimated. Yet, given the miserable infrastructure in other parts of Kyrgyzstan, tourism promotion should probably focus on Issyk-Kul. Given Kyrgyzstan’s natural precondition and infrastructure, tourism could realistically generate 10 percent of GDP in five years time.

The economies of Kyrgyzstan and Kazakhstan are complementary, and Kyrgyzstan should develop as a subcontractor of, and service center for, Kazakhstan. Tourism at Issyk-Kul is an outstanding example. At present, the average wage in Kyrgyzstan is about $50 a month, that is, about one-quarter of the average wage in Kazakhstan. The countries have very similar economic systems, cultures and populations, and Bishkek is located close to flourishing Almaty. Therefore, anything that can be done in Kyrgyzstan should be profitable on the Kazakh market, if it is only open to Kyrgyz producers. The supply of food, especially vegetables, fruits, meat and other animal produce, is one line of exports to Kazakhstan, which finally seems to be developing after excessive protectionism. Similarly, the production of the Kant Cement Factory has finally found its way back to the Kazakh market. Kazakhstan has developed the best bank system in the CIS, and now four big Kazakh banks have bought four large banks in Kyrgyzstan. This has already led to an improvement of the Kyrgyz bank system and contributed to a decline in interest rates. In the future, it would be natural that the Kazakh banks move some of their back office activities, which can be undertaken anywhere, to Kyrgyzstan, where labor is so much cheaper. The development of Kazakh banks in Kyrgystan should also attract Kazakh investment in services and subcontracting to Kyrgyzstan.

Kyrgyzstan has many old Soviet industrial enterprises that are more or less standing still. Most of them are probably of little value, but recently successful Russian enterprises have reanimated numerous nearly dead Soviet enterprises all over the former Soviet Union. That has happened also happened in a few cases in Kyrgyzstan. In effect, nobody but Russian investors care about such enterprises, and the Kyrgyz state should try to facilitate further sales of such factories to willing Russian investors.

Considering that Kyrgyzstan is the freest country in Central Asia, it is well placed to become a center for higher education and research. Bishkek has already developed into the capital of higher education in Central Asia, and this is a development that should be further encouraged. In general, it is important to increase the transparency of the universities and bring their financial flows out of the shadows, especially to reduce the selling of places at universities and the buying of degrees, which disqualifies any education. One specific project worth pursuing is the development of an economic masters program at the American University of Central Asia. An old idea that unfortunately does not take off is the development of computer programming in Kyrgyzstan. The labor force was at hand, but the reason for its non-development appears to be the onerous tax system. Instead, skilled workers emigrate to offer their services elsewhere. Ominously, a new concern about shortages of various kinds of skilled labor has arisen because of emigration.

Naturally, there are many other branches of the economy that can and should develop. Yet, some lines of economic development are evident, and it is important to make sure that they are given reasonable conditions for development. This discussion leads to some general conclusions about what policies are important for Kyrgyzstan in the next few years.

  • Kyrgyzstan must undertake a liberal tax reform designed to diminish the tax burden on legal enterprises. It must have a tax system that is better than that of Russia and Kazakh.