Vision for Kyrgyzstan

Source: Carnegie

This report has been written at the request of H.E. Askar A. Akaev, President of the Kyrgyz Republic. My work has been financed and administered by the UNDP. My task consisted of two tasks. The first task was to undertake a review of the progress on my recommendations a year earlier. The second task was to formulate a vision of the Kyrgyz state and suggest key focuses of further reforms.

In my final report to President Akaev of September 7, 1999, I left a total of 112 recommendations, pertaining to four areas ? governance, macroeconomic stability, measures for economic growth, and social policy. Some kind of action has been taken with regard to 69 recommendations or 62 percent of all recommendations. A great deal has been done in several spheres, in particular: parliamentary governance, the development of property markets, the encouragement of small enterprises, improvements of the payments system, and pension reform.

However, in four of the most important areas relatively little has been accomplished. A first and immediate problem is the reduction of the fiscal deficit from almost 10 percent of GDP to some 7 percent of GDP, and then further to a sustainable level. A related problem is to get the external debt service under control. Second, the tax system remains the biggest concern of entrepreneurs by far. The tax burden is excessive on those enterprises that actually pay taxes, driving many entrepreneurs underground. Third, the fundamental problem is the functioning of the state apparatus. Reform of the government apparatus and the reining in of the state and judicial apparatus as is necessary for the creation of a well-functioning of a market economy. Finally, as all post-Soviet states, Kyrgyzstan has half a dozen of powerful state-owned natural monopolies, which do little to improve their efficiency and service but cause the poor state unnecessary costs. All these problems are characteristic of post-Soviet countries. The reason why they have not been solved is that they are some of the hardest political issues, involving strong vested interests.

In order to restore the macroeconomic balance, the government must cap the budget deficit instantly and renew its good relationship with the IMF. The most obvious objects of cuts are the Public Investment Program needs to be reduced by about half and remaining subsidies in the budget that should be minimized. In the medium term, public service employment should be reduced by at least 40 percent.

The government should commit itself to avoid arrears, and it should insist on bankruptcy, when enterprises do not pay substantial amounts to the tax authorities and the Social Fund. State guarantees to enterprises must be minimized, and the volume of treasury bills should be kept to a minimum.

The liberal tax reform must be taken further. In general, the number of taxes should be reduced, the tax base should be broadened, the highest tax rates reduced, and tax collection improved. The road tax and the tax for the emergency fund, should be abolished. Local taxes should be consolidated into one or two taxes.

Kyrgyzstan should aim at reducing the contribution to the pension fund by 3 percentage units each year. The maximum income tax could be reduced to 20 percent. The profit tax should be reduced substantially to some 20 percent, while the land tax should be raised and extended also to urban land. Simplified taxes should be further extended, but tax exemptions should be reined in. The consistency of the tax system must improve. At least for small enterprises with simplified taxation, accounting should be simplified and preferably minimized. Tax collection must be improved. The legal rights of taxpayers should be reinforced, so that an honest taxpayer can feel safe.

The greatest task is governance and government reform. At the top, a fundamental choice which needs to be made is whether the President or the Prime Minister should lead the government, and most of the President's Administration and the Prime Minister's apparat need to be merged. A clear division between political and civil service jobs should be done. The Kyrgyz Republic needs a comprehensive civil service reform. Strict central state regulation should specify what fees various state organs are allowed to charge, and the utilization of special means by regulatory and inspection bodies should be strictly forbidden. The top salaries should be raised several times, and average salaries should be raised on the basis of lay-offs. Providers of health care and education should be encouraged to attract grants and sell services for money beyond what they should supply the public for free, and they should be allowed to keep this money with little taxation. No bonuses or commissions should be given to individual inspectors in relation to the amount of taxes collected. No inspection of a home or an enterprise could be undertaken without an official warrant. Any government official who stops the work of an enterprise should be subject to penalties for the damages caused by law. Many regulations should be abolished, notably most licensing. To the extent that licenses persist, there should always be three authorities that can issue any license that exists. Any decentralization must be accompanied by democratic elections.

As all post-Soviet countries, Kyrgyzstan has great problems controlling its large state-owned natural monopolies. Regulation of Natural Monopolies. They need to be regulated in line with a competitive market, be deprived of state investment and state subsidies, be divided into economic entities and privatized.

For its future, Kyrgyzstan needs to be guided by its assets and the experiences of other countries in similar situations. Kyrgyzstan is a small, land-locked country, with moderate assets of mineral wealth, but a great human capital. The most successful country with such characteristics is Switzerland, and it is a good model for Kyrgyzstan. It shows that such a country can be rich, stable and blessed with peace. A small land-locked country has no choice but to have an open economy with a liberal foreign trade policy, as Kyrgyzstan already has. In Europe, Switzerland stands out as the country with the lowest taxes and state revenues, and Kyrgyzstan needs to do the same. The state must accept both economic and political restrictions on how much it may interfere in the life of people. Kyrgyzstan has an eminent human capital, and it is vital to maintain it, as well as a comparatively high health standard. In the nearest future, it is vital that the real capital is better utilized. The main effort of the government should be the development of property markets and stricter bankruptcy practices, imposing hard budget constraints on all enterprises. The tax authorities and the Social Fund should see as one of their tasks to bankrupt bad enterprises. Fully-fledged private ownership of land must be established to develop a land market. The work on a state property register should be completed speedily to facilitate land transactions. Property ownership must be fully-fledged so that it can be used as collateral. Permits for the construction of commercial buildings should be simplified to stimulate construction. Another concern is that the promotion of foreign direct investment must improve. The government should set a goal for how much FDI it wants to attract, such as 10 percent of GDP each year. Rather than offering individualized tax incentives, Kyrgyzstan should lower its profit tax generally to a maximum of 20 percent for all, which would be a strong incentive for foreign investors. Foreigners could be relieved from pension fees. It is important to privatize those enterprises and assets that can really attract serious foreign investors, notably telecommunications and energy.

This report has been written at the request of H.E. Askar A. Akaev, President of the Kyrgyz Republic. My work has been financed and administered by the UNDP. My terms of reference requests me to write a report with two components:

• Review the progress made on earlier recommendations from my and Professor Marek Dabrowski?s missions;
• Identify major bottlenecks in the implementation of these recommendations;
• Provide a plan to overcome these obstacles and start implementation including concrete follow-up recommendations with proposed deadlines to UNDP.

• An overview and assessment of the current role of the State;
• A Vision of the State defining the role of the State during the transition and in the long term;
• Key obstacles to attaining the Vision;
• Road map to the Vision, including short, medium and long-term actions;
• Analysis of the long-term impact of a successful implementation of the Vision on the economy, state budget, enterprise environment, social sector and sustainable human development;
• Recommendations for follow-up action.

This report is based on extensive reading about the current situation in Kyrgyzstan from materials provided by the Kyrgyz government, the UNDP, the IMF, the World Bank, CASE and TACIS. In particular, I have taken into consideration the UNDP Sustainable Human Development Strategy, The UNDP Report on Civil Service Reform in the Kyrgyz Republic, the IMF Economic Review, and the World Bank private Sector Review. I spent November 15-22 in Bishkek. During this trip I had over 40 meetings and visits, including meetings with the President, the first Deputy Prime Minister, the State Secretary and other leading officials in the President?s Administration, the Deputy Prime Minister and Minister of Industry and Trade, the Minister of Justice, the Minister of Labor and Social Protection, the Minister of the Social Fund, the acting Governor of the National Bank, the Chairman of Goskominvest, the First Deputy Minister of Finance, a Deputy Minister of Agriculture, a Deputy Mayor of Bishkek, many other Kyrgyz officials, representatives of the UNDP, the IMF, the World Bank, the EBRD, USAID, TACIS, the German Embassy and several businessmen (my program in Bishkek is enclosed see attachment 1). I also met with senior officials at the IMF, the World Bank and the US National Security Council in Washington in preparation for this trip.

Kyrgyzstan has an impressive record of state-building and economic reform. The country has proceeded far in democratization and the building of a market economy, based on private property and the rule of law. A large amount of democratic and market economic legislation has been promulgated with substantial additions adopted in the last year. Macroeconomic stabilization was accomplished in 1995. Kyrgyzstan has an open public debate. Privatization has gone very far with 65 percent of GDP originating in the private sector. In 1996 and 1997, Kyrgyzstan achieved substantial economic growth.

However, in 1998 the whole of the CIS was hit by the international financial crisis in general and by the Russian financial crisis in particular. The Russian crisis has multiple effects on the Kyrgyz Republic. First, Russian demand and demand from adjacent export markets dried up. Second, in the wake of the financial crisis, the main trading partners of Kyrgyzstan, notably Kazakhstan and Uzbekistan, undertook various protectionist measures, further hampering Kyrgyz exports. Third, Russia devalued the ruble by 75 percent, forcing most members of the CIS, including the Kyrgyz Republic, to devalue their currencies by about 50 percent. As a result of its devaluation, the Kyrgyz foreign debt rose above 100 percent of GDP and aggravated the foreign debt service as a share of GDP and thus as a share of the budget. Fourth, the international financial crisis deterred foreign investors from the region, eliminating foreign portfolio investment and minimizing foreign direct investment. Hence, major privatizations were stalled. Fifth, the National Bank of the Kyrgyz Republic was compelled to raise interest rates to a very high level and the demand for treasury bills dried up, while dollarization gained momentum. As a consequence, GDP rose by barely 2 percent in 1998, and Kyrgyzstan fell off an IMF program for the first time in the spring of 1999, which further aggravated its international financial position.

With minimal growth and persistent crisis management, it is difficult to maintain momentum in the process of restructuring, while it is becoming all the more vital. Kyrgyzstan might be approaching a serious macroeconomic crisis, if major efforts are not undertaken soon. The Kyrgyz Republic has undertaken very substantial reform efforts. It is impressive how much good reform legislation has been adopted. However, the fundamental dilemma persists as shown by the EBRD Transition Report that is just out. Enterprises cannot act independently of government officials, who persistently and harmfully interfere in the work of enterprises. The state officials are clearly the main impediment to growth in Kyrgyzstan, while a highly educated and diligent labor force remains underemployed and underutilized. Kyrgyzstan?s dilemma is not only to achieve a sustainable macroeconomic situation but to create a good enterprise environment, allowing enterprises to arise and grow to the benefit of the country and its population.

In my final report to President Akaev of September 7, 1999, I left a total of 112 rather concrete recommendations. The recommendations pertained to four categories ? governance, macroeconomic stability, measures for economic growth, and social policy. Some kind of action has been taken with regard to 69 recommendations or 62 percent of all recommendations (see attachment 2). The President issued a decree with a 19-point action plan related to my recommendations (some given earlier after my visit in May). I have received 29 presidential or governmental decrees that comply with my recommendations. In addition, many of my recommendations have been in line with what the government has done in any case. My summary list of suggested measures or principles is enclosed. I have added indications of the extent to which each measure has been undertaken. Naturally, this is a matter of judgment, so views may differ. Mostly, something has been done in line with my recommendations, but the change might have been marginal rather than substantial. Moreover, a limited number of points are principles rather than measures. Even so, it is striking how many of the measures have been undertaken. This is not to suggest that the measures are necessarily inspired by me. My report did not claim to be original on all points, and many of the changes have been brought forward by a broad consensus.

1. Governance

Of 37 recommendations on governance, only 10 have been left unaddressed, though in most cases the measures require lasting efforts. Fundamental questions about the functioning of the state remain unanswered, and how to improve the efficacy of public services is an eternal query. The governance of the state involves fundamental political questions. It would not be appropriate if the government took all actions on the basis of a consultant?s report, so part of the issues are rather contributions to an open-ended discussion. All my 7 recommendations on parliamentary governance have been essentially adopted, notably the change of the size of the chambers and the enhanced role of political parties. Similarly, the government has acted in line with my 5 recommendations on the judicial system, to the extent that the government can decide on them. Alas, the effectiveness of these measures appears limited as yet. On regional and local self-government, I encountered disagreement on my preference for the election of governors and mayors at the current stage, and nothing has been done on local taxes. The most controversial part is naturally government reform, where 8 of my 20 recommendations have not led to any action. The further merger and abolition of government bodies is being discussed as well as substantial cuts of staff, though the mood has moved towards the total abolition of certain bodies rather than generalized cuts. The main problem concerns how to get government officials out of enterprises. Quite a few measures have been undertaken, such as limitations on rights of inspection, but more is needed. On the financial side of governance, more has been done, but the problem of "special means" remain.

2. Macroeconomic Stability

Most of my macroeconomic recommendations have been considered to some degree. Only 12 of 34 recommendations have not been implemented. The financial crisis has set the stage. Some of the recommended measures became necessary, while the financial crisis made it very difficult to fulfill some. On the positive side, several measures of caution were considered. However, the budget deficit remained too large, and arrears could not be reined in. Little screening of concessional loans has been undertaken, while non-concessional loans have been minimized. In the payment system, substantial measures have been taken against barter, though not quite as Draconian as I proposed. The legal rights of taxpayers have not been reinforced, but simplified taxation has been extended. On the whole, taxes have only been marginally adjusted, because of the strained fiscal situation and IMF concerns about tax cuts. The three most important issues in this sphere remain: to reduce the budget deficit, to rein in the foreign debt, and to strengthen the rights of the taxpayers.

3. Measures for Economic Growth

Altogether, 15 of 41 proposed structural measures have not been acted upon, but the picture varies greatly. The greatest headway has been made in the development of property markets. Through a referendum, the Kyrgyz have adopted the private ownership of land. Only one of 9 recommendations concerning property has been left without action. The most important proposals for the support of small enterprises have resulted in a new draft law on enterprise registration and the proliferation of lump sum taxes for small enterprises. Only one minor recommendation has been disregarded. On foreign trade, Kyrgyzstan has stood by free trade and the WTO as recommended, and all seven recommendations have been acted upon. In particular, the Customs Committee has been reined in under the Ministry of Finance, and the abolition of visas and customs declaration for business travelers has been curtailed. With regard to the promotion of foreign direct investment, the equal treatment of foreign and domestic investors has been accepted, but general improvements of the conditions of business have barely occurred. The Free Economic Zones have been brought into some order. The worst part is the suggested reforms in infrastructure. My suggestions amounted to raising tariffs for cost coverage, to opening for competition and open privatization. In fact, four of five recommendations have not been complied with, and the regulation of these large state monopoly companies remains a major concern. The measures proposed for enterprise restructuring largely amounted to various ways of hardening enterprises? budget constraints by activating bankruptcy. While certain improvements have occurred, they have been marginal, and budget constraints remain rather soft. Primarily the Social Fund has started using bankruptcies more actively. Five of 7 recommendations have not been carried out.

4. Social Reforms

While the status is not very clear on several points, 6 of 23 recommendations on social policy have been disregarded. A significant pension reform has taken place, though the reform recommended was more radical. Only one minor recommendation on the pension reform was turned down. Of the seven measures suggested on education, some steps have been taken in the direction proposed on all but one point. A liberal, competitive and comparatively well-funded education system is developing. With regard to health and the improvement of the social safety net, there has been some but limited movement in the direction of my recommendations. Only one idea has been clearly disregarded, namely to abolish categorical benefits, which tend to go to the privileged. This issue appears politically sensitive.

Marek Dabrowski?s report contains 33 general conclusions and recommendations. However, as they are longer and more complex in their formulation, or analytical rather than normative, it is more difficult to say whether the government has acted upon them as yet. Moreover, several of his recommendations are of a distinct long-term nature. Several recommendations have clearly been complied with, for instance, concern over excessive differentiation of import tariffs, a suggestion for the reduction in the number of free economic zones, and a reduction of arrears. In most cases, it seems too early to judge the impact of these recommendations.

Altogether, only 43 recommendations out of a total of 112 have been disregarded. A great deal has been done in several spheres, in particular:

• parliamentary governance;
• the development of property markets;
• the encouragement of small enterprises;
• improvements of the payments system, and
• pension reform.

Surprisingly many technical improvements have either been legislated or been promulgated by government decree or presidential decree. With regard to the parliament, the Kyrgyz Republic seems ready to accept real political parties. In parallel, civil society and independent media appear to have grown stronger. Similarly, land reform has been carried out and quasi-property rights have grown so strong that people are ready for real property rights. Now, it is vital to establish a land market soon. Small enterprises seem to have acquired a critical mass so that they can function and be socially acceptable. The improvements of the payments system have possibly been supported by the fear caused by the financial crisis, as people want to be paid in real money in times of uncertainty. The success of the pension reform is a positive surprise, to which the new regime of the Social Fund should be congratulated.

However, most of the most important issues have generally not been handled. In general, they are:

• Reform of the government apparatus;
• Regulation, taxation and privatization of natural monopolies;
• Improvement of the enterprise environment;
• Improvement of the judicial system;
• Reduction of the fiscal deficit;
• Control of the foreign debt;
• Liberal tax reform.

The current problems of the functioning of the Kyrgyz state have been well analyzed in a number of studies, notably by the World Bank and the EBRD. They have given us a pretty clear idea of which problems are major and minor. Similar conclusions have resounded in my conversations with Kyrgyz officials and businessmen and foreign experts in Kyrgyzstan. Therefore, I shall only summarize what appears to me to be the four key problems in the Kyrgyz economy today, which can be seen as a summary of the key systemic changes that have not been accomplished so far.

1. An immediate problem is to reduce the fiscal deficit. Kyrgyzstan cannot continue with a budget deficit of almost 10 percent of GDP. The IMF has now demanded a reduction to 7 percent of GDP, but that is hardly enough, as the foreign debt now exceeds the annual GDP. In the longer term, Kyrgyzstan needs to bring down its budget deficit to a level that is sustainable and can be financed with foreign grants, that is, about 2 percent of GDP. To reduce the fiscal deficit and control the foreign debt requires hard political choices. Few countries are ready to do so until it turns out to be absolutely necessary.
2. The tax system remains the biggest concern of entrepreneurs. A poll of 233 enterprises in the recent World Bank Private Sector Review showed that 69 percent perceive taxation as the greatest problem of their firm. The tax burden is excessive on those enterprises that actually pay taxes, and taxation practices are perceived as arbitrary. Entrepreneurs are driven down into the underground rather than entering the official economy.
3. The fundamental problem is the functioning of the state apparatus. Reform of the government apparatus and the reining in of the state and judicial apparatus, as is necessary for the creation of a well-functioning of a market economy with a benign enterprise environment, imply the reduction of the power and wealth of many members of the elite, but many of them are not ready for this. Without that, the enterprise environment cannot improve much. A substantial improvement in the regulation of the parliament has occurred, but the government apparatus continues to malfunction. The problems are of many kinds. At the top of the government, the functions of different offices have not been clarified. The government apparatus and total public employment are too large, while salaries are too low, and wage differentials too small. No clear division between state functions and enterprise management has occurred. Unjustified inspections and licensing persist. Officials do not respect the rights of enterprises. Hence, a fundamental reform of the government and state apparatus is needed.
4. As all post-Soviet states, Kyrgyzstan has half a dozen of powerful, state-owned natural monopolies. They cause many problems. First of all, rather than providing the government with revenue, they cause the poor state unnecessary costs, typically not charging sufficiently high prices and collecting little of their charges and hence not paying much in taxes. Second, they do little to improve their efficiency and expand their sales. Third, they do not provide sufficient services, even though they extract public investment. Because of their size, they are also a potentially great political force that needs to be put on firm private enterprise footing.

Kyrgyzstan has done a great deal in terms of democratic and market economic reform. My survey of what has been done in the last year shows that a great many reform decisions have either been undertaken or prepared in the last few years. However, during these years of relative stability, the government has refrained from facing up to the four great problems outlined in the section above. Kyrgyzstan is approaching both parliamentary and presidential elections next year. Little major action can expected before the elections, but this is a good time to determine major measures are needed to put Kyrgyzstan onto the track of economic stability and sustained economic growth for a program of action after the elections. The fiscal problem, however, is so serious that it needs to be partly dealt with before the elections. Therefore, this report focuses on proposals to amend the four key problems mentioned above, that is, fiscal tightening, government reform, tax reform, and the regulation of natural monopolies. In addition, I want to add the aspect of strategy for economic growth. With regard to social issues, I think that my suggestions from last year still hold, and they are of a long-term nature. Therefore, I have little to add to my report from last year.

1. Restore Macroeconomic Balance

After several years of financial stability and complying with long-term IMF programs, Kyrgyzstan was caught off balance by the Russian financial crisis in 1998. The consolidated state budget deficit was over 9 percent of GDP in 1998, while the deficit agreed with the IMF was 7 percent of GDP. As a result, Kyrgyzstan has been cut off from IMF funding since the spring of 1999. The Russian crisis also forced Kyrgyzstan to devalue the Som, and as a result the already large foreign debt has come to exceed Kyrgyzstan?s GDP. This situation is not tenable. If the Kyrgyz Republic does not swiftly adjust its fiscal policy, not only the IMF but also the World Bank and the Asian Development Bank will be compelled to cut off most lending to Kyrgyzstan. Then, the country will not be able to manage its foreign debt service of $83 million in 2000, although most of the foreign loans have been given on highly concessional terms of 0.5-1.5 percent a year. Therefore, Kyrgyzstan must undertake a swift fiscal adjustment with the budget for 2000.

Total state revenues are projected to rise to 17.1 percent of GDP in 2000, according to the budget the government has agreed upon with the IMF and, if grants are added, total revenues will amount to 18.9 percent of GDP. If anything, this is too much, because the cost of the marginal taxation is very high to the economy. It would be better to aim for total revenues including grants of 17 percent of GDP. Substantial improvements of the tax system are urgently needed, as discussed below, but in order to make it possible to undertake a substantial tax reform, the budget should not be too tight. Therefore, the budget must be balanced through measures on the expenditure side.

Kyrgyzstan has already tightened its budget substantially, and the budget for 2000 implies a primary surplus of 1.9 percent of GDP. Ho

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