Economic Update Kyrgyz Republic No.3 | Spring 2016 Policy Challenges in a Difficult Environment With a Special Focus on the Growing Burden of Public Debt Macroeconomics & Fiscal Management Global Practice Kyrgyz Republic: Policy challenges in a Difficult Environment (With a Special Focus on the Growing Burden of Public Debt) Kyrgyz Republic Economic Update No. 3 Spring 2016 Government Fiscal Year January 1 – December 31 Currency Equivalents Exchange Rate Effective as of April 30, 2016 Currency Unit = Kyrgyz Som (KGS US$1 = 68.42 (KGS) Weights and Measures Metric system Abbreviations and Acronyms DSA Debt Sustainability Analysis EEU Eurasian Economic Union GDP Gross domestic product NBRK National Bank of the Kyrgyz Republic NPL Nonperforming Loan ROE Return on Equity ROA Return on Assets DSA Debt Sustainability Analysis PV Present Value PPG Public and Publically Guaranteed FDI Foreign Direct Investment PIMA Public Investment Management Assessment PIP Public Investment Program PPP Public-Private Partnership HIPC Highly Indebted Poor Countries ATM Average Time to Maturity ii | Contents Acknowledgements ................................................................................................................................................................iv Overview ...................................................................................................................................................................................... 1 A. Recent Political Developments.................................................................................................................................. 2 B. Recent Economic Developments .............................................................................................................................. 2 C. Outlook: Policy Challenges in the New Environment ...................................................................................... 9 Special Focus: The Growing Burden of Debt – Rationale, Drivers and Dynamics ...................................... 12 Tables Table 1: Balance of Payments ............................................................................................................................................. 5 Table 2: General Government Budget ............................................................................................................................. 7 Table 3: Key Macroeconomic Indicators...................................................................................................................... 11 Table 4: Stock of Public Debt, end-2015 ...................................................................................................................... 14 Table 5: Creditor Distribution of External Public Debt, end-2015.................................................................... 14 Table 6: Stock of Domestic Debt at end-2015............................................................................................................ 15 Figures Figure 1: Real GDP Growth .................................................................................................................................................. 3 Figure 2: Contribution to Growth ..................................................................................................................................... 3 Figure 3: Exports and Imports of Goods ........................................................................................................................ 4 Figure 4: External Trade and CA Balances .................................................................................................................... 4 Figure 5: Poverty Rates, 2013- 2015 ................................................................................................................................... 6 Figure 6: Inflation .................................................................................................................................................................... 8 Figure 7: Nominal KGS/USD Exchange Rate and CB Interventions .................................................................... 8 Figure 8: Currency Exposure by Total Debt, end-2015 ......................................................................................... 15 Figure 9: Kyrgyz Republic’s Debt in International Comparison ........................................................................ 16 Figure 10: Redemption Profile, end-2015, Million som ........................................................................................ 16 Figure 11: Debt Sustainability Analysis Summary Charts .................................................................................... 18 Boxes Box 1: Toward a more efficient Public Investment Management System ..................................................... 13 | iii Acknowledgements World Bank Economic Updates are published every six months, in the spring and fall. This edition of the Kyrgyz Republic Economic Update was prepared by Bakyt Dubashov (Economist) and Aurélien Kruse (Senior Economist) with contributions from Saida Ismailakhunova (Poverty Economist). It benefited from the input of Miria Pigato (Practice Manager), and Christos Kostopoulos (Lead Economist). Sarah Babirye (Program Assistant) and Akylai Osmonalieva (Team Assistant) provided editorial support. The first part of the Economic Update analyzes recent macroeconomic trends and presents the team’s assessment of the short- and medium-term outlook. The Special Focus Section delves deeper into an issue of particular relevance, in this case summarizing the challenges that the Kyrgyz Republic faces in boosting critical public investment while maintaining a sustainable public debt path. Miria A. Pigato Practice Manager Macroeconomics and Fiscal Management Global Practice iv | Overview 1. The Kyrgyz economy has remained resilient in the face of continued significant external headwinds in 2015, but sources of vulnerability have increased. While overall GDP growth is estimated to have slowed to 3.5 percent in 2015, this deceleration was mostly on account of lower gold production. Non-gold output growth remained robust at 4.5 percent (essentially unchanged from 2014), although with significant shifts in drivers. Indeed, while most sectors of the economy experienced significant decelerations, or even a contraction in the case of industry, the overall figure was pulled by a very good agricultural harvest. Adverse external conditions, exchange-rate developments, and their impact on the value of remittance inflows, affected both private consumption and investment on the demand side, with net exports driving output growth. 2. The policy stance was broadly appropriate. The monetary authorities responded to substantial pressures on the exchange rate with a sound strategy of letting the som adjust, while preventing sharp swings in its value. On the fiscal side, a lower than expected deficit was recorded (3.0 percent vs 7.3 percent budgeted), but this was on account of one-off non-tax revenues combined with lower than anticipated capital outlays. By contrast tax revenues weakened while public consumption increased. Moreover, although foreign borrowing needs were lower than anticipated, the som value of public debt increased sharply as a result of exchange rate developments, bringing the Kyrgyz Republic closer to the “high risk” threshold of debt distress. 3. Looking forward to 2016 and beyond, economic activity is expected to slow down, with significant downside risks. With gold production expected to decline in coming years, and agricultural output growth returning to historical averages, overall growth is projected to moderate to 3.4 percent and 3.1 percent in 2016 and 2017 respectively. The planned sharp increase in public investment over 2016-17 will not be sufficient to make-up for depressed private demand, as remittance inflows should improve only marginally and the purchasing power of households remain eroded by continued weakness of the som. Meanwhile, the slow recovery expected in the broader region will be insufficient to significantly boost exports. Moreover, downside risks remain elevated. They include external risks, such as further oil price shocks, and internal constraints, namely institutional and technical bottlenecks to implementing large infrastructure projects. 4. For public policy, the main challenge will be to reconcile the objective of supporting economic activity with principles of prudent management. While the planned significant expansion of public investment is justifiable, both with respect to providing a short term boost to the economy and to addressing structural constraints to growth (the country’s large infrastructure gap), the deteriorated debt sustainability outlook implies that it must go hand in hand with major efforts to raise revenues and rein-in public consumption. These constraints would be further exacerbated if recovery fails to materialize both domestically and in the region, affecting revenues and the ratio of debt to income. 5. Indeed, while the Kyrgyz Republic’s debt path remains sustainable, there are good reasons to be concerned over risks of debt distress. The Special Focus section of this Economic Update analyzes the features of the Kyrgyz Republic’s public debt and explains the factors behind the recent deterioration of the debt sustainability outlook. It concludes by pointing out some of the policy steps that ought to be taken in response. |1 A. Recent Political Developments 6. Political instability continued to prevail, despite the successful outcome of parliamentary elections in 2015. The new Parliament that emerged from the October 2015 election re-confirmed Mr. Temir Sariev as Prime Minister in early November 2015, thus ensuring a smooth transition for the work of the Government with no major changes in the country’s development priorities. However, barely six months thereafter, Mr. Sariev offered his resignation on the backdrop of allegations of inappropriate involvement into the selection of a contractor for a major civil works project and related public disagreements within the cabinet. He was replaced by Mr. Sooronbay Jeenbekov, on April 13, 2016. This was the 29th change in cabinet in the past 21 years, highlighting both the vibrancy of the political process and challenges to policy continuity and focus. B. Recent Economic Developments The economy has been resilient in 2015, despite significant external headwinds, thanks mostly to a good agricultural performance 7. Economic growth remained relatively robust in 2015, in spite of significant regional headwinds and depressed gold production. Real GDP growth is estimated to have reached 3.5 percent in 2015, decelerating only slightly from 4 percent in 2014. While gold output declined by 8.3 percent year-on-year, non-gold growth stood at 4.5 percent (Figure 1). 8. Growth was driven, on the supply side, by a significant expansion in agriculture. Agricultural output growth reached 6.2 percent in 2015, up from -0.5 percent in 2014. This good performance reflected favorable weather conditions, a catch up effect, as well as the impact of government programs in support of the sector, including subsidized loans to farmers1. In turn, it compensated for a slowdown in services and construction, and a contraction in industry. Services grew at 3.7 percent, down from 4.6 percent in 2014; construction growth decelerated to 13.9 percent from 27.1 percent, and; industry contracted by 4.2 percent overall (0.5 percent excluding gold) (Figure 2). The contraction in gold output was linked to geological factors, namely lower gold contents in the ore developed at the current stage of exploitation of the country’s main mine, Kumtor. 9. On the demand side, the largest contribution came from net exports, and specifically a sharp contraction in imports. Consumption growth fell to 1.1 percent from 3 percent in 2014, reflecting a significant deceleration in private consumption growth, despite an increase in public outlays on wages, and goods and services. Meanwhile, investment growth also slowed, to an estimated 2.3 percent, on account of both subdued demand of households for new housing and slow implementation of public infrastructure projects. In turn, growth was supported by net exports, following a sharp drop in imports. 10. The contraction in Russia and slowdown in Kazakhstan affected the Kyrgyz economy through exchange rate and trade channels. The most significant shock to the Kyrgyz economy 1 KGS 3.8 billion in 2015 and KGS 5.3 billion in 2014 2| was the sharp depreciation of the domestic currency against the US dollar (amounting to about 20 percent in 2015) and volatility against the ruble and tenge. Exchange rate dynamics created uncertainty in the real sector of the economy, affecting decisions of small and medium companies as well as households, possibly driving the slowdown in private consumption, as well as credit and investment. Meanwhile, the stark depreciation of the Russian rubble affected the real value of remittance inflows (in both som and dollar terms) further exacerbating downward pressures on domestic demand. Figure 1: Real GDP Growth Figure 2: Contribution to Growth (y-o-y, percent) (Percent points) Source: Kyrgyz authorities. Source: Kyrgyz authorities. 11. The lower value of remittance inflows and depressed demand affected specific sectors of the economy such as real estate. On average, real estate prices fell by about 20 percent in 2015, reflecting a reduction in purchases and sales. In turn, this contributed to a slowdown in construction activity, and most likely a contraction of employment in the sector. 12. The depreciation of the som weakened demand for imports without boosting exports. Total imports fell sharply – by 28 percent in US dollar terms-, reflecting a combination of price and demand dynamics (Figure 3). Low international prices for fuel and food significantly reduced the import bill, since the Kyrgyz Republic is a net importer of gasoline, mazut and wheat. But the depreciation of the som and the lower value of remittance inflows also contributed to depress demand for goods traded in US dollars. However, exports failed to respond, on account of both price dynamics (even sharper depreciations relative to the dollar in regional markets for Kyrgyz goods and services) and structural factors (such as challenges in complying with new EEU rules and standards for Kyrgyz firms). Exports are estimated to have fallen by nearly 21 percent in 2015 in US dollar terms, reflecting the decline in gold production and, more importantly, dampened demand for Kyrgyz goods in Russia and Kazakhstan. On balance, given the relative steeper decline in imports relative to exports and their significantly greater relative magnitude, the trade deficit narrowed to 27.6 percent of GDP in 2015 from 37.3 percent a year before. The fall in imports also more than offset the effect of lower remittances (in dollar terms) 2 on the current account balance, which declined to 8.7 percent of GDP in 2015 from 16.7 percent a year before (Figure 4 and Table 1). 2 Remittance inflows increased in rubble terms, however given the sharp depreciation of the Russian currency relative to both the som and the dollar, their real value fell for Kyrgyz recipients. |3 Figure 3: Exports and Imports of Goods Figure 4: External Trade and CA Balances (USD, millions) (Percent of GDP) Source: Kyrgyz authorities. Source: Kyrgyz authorities. 13. The current account deficit was financed by FDI inflows and external borrowing. In 2015, FDI increased by about USD 390 million, reflecting larger re-invested earnings by Kumtor, the main gold mine, and an inflow of capital related to the newly established Kyrgyz-Russian Development Fund. At the same time, public borrowing declined, given slower than anticipated implementation of the public investment program, although it remained the main source of financing of the current account deficit. 14. Indicators for the first quarter of 2016 point to a difficult recovery. Output growth was negative (-4.9 percent, y-o-y) in the first quarter of 2016. To large extent this reflected a major y- o-y decline in gold output (-48 percent), especially salient because gold production in 2015 was untypically frontloaded in the first months of the year. However, the non-gold economy also performed modestly, expanding by 1 percent year on year. While services expanded by 2.5 percent (reflecting, for the first time since 2014, a y-o-y increase in remittance inflows by 15.9 percent in US dollar terms) and agriculture grew 1.5 percent, non-gold manufacturing contracted by 1.9 percent and construction remained practically flat (+0.1). On the external side, preliminary data for the first quarter of 2016 show a continued contraction both of exports (25 percent) and imports (20 percent), the former due to lower gold shipments (while non-gold exports grew robustly at 12.4 percent3) and the latter as a result of lower oil prices. The trade deficit is estimated to have shrunk to 31.5 percent of GDP in the first quarter of 2016 (from 36 percent in the first quarter 2015) and the current account deficit to 8.9 percent of GDP (from 17.6 percent). 3 Although this might also be due to adjustments to the data processing methodology made after the Kyrgyz Republic’s accession to the EEU. 4| Table 1: Balance of Payments (In millions of US dollars) 2013 2014 2015 e Current account balance -1,101 -1,246 -571 Trade balance -2,865 -2,784 -1,816 Exports, fob 2,748 2,507 1,981 Imports, fob 5,614 5,290 3,796 Services -51 -331 -114 Receipts 1,043 897 842 Payments -1,093 -1,227 -956 Income -423 -308 -274 Interest payments -70 -79 -67 Current Transfers (net) 2,238 2,176 1,633 Capital Account 280 66 79 Financial account 706 551 512 Commercial banks -57 -1 -152 Medium- and long-term loans (net) 192 699 422 Disbursement 854 1,110 786 Amortization -663 -411 -363 Foreign direct investment 626 233 622 Portfolio investment 5 0 -128 Other investment -60 -380 -252 Errors and omissions 216 377 -62 Overall balance 101 -253 -42 Financing -101 253 42 Net international reserves -108 251 41 Gross official reserves (–, increase) -91 257 56 IMF -17 -5 -15 Exceptional financing (including arrears) 7 2 1 Source: Kyrgyz authorities and Bank staff estimates. Strong poverty reduction gains in 2014 are expected to come to a halt 15. The significant poverty reduction gains made in 2014 appear to have been partially reversed in 2015. While absolute poverty4 fell by over 6 percentage points (from 37 percent to 30.6 percent) between 2013-14, recently released information from the National Statistical Committee put it at 32.1 percent in 2015. In 2015, around 1.9 million out of a total population of 6 million were estimated to be below the poverty line of 31,573 KGS per year per capita. By contrast extreme poverty 5 estimates remained stable at 1.2 percent, corresponding to about 75 thousand people unable to afford a minimum food basket (estimated to cost 18,234 KGS 4 The headcount index of poverty reflects the percentage of the people whose consumption is lower than the established poverty line. The poverty line is estimated by specifying a consumption bundle with food (including own production) and nonfood items (excluding housing costs). The poverty line was established in 2003 (updated in 2008 and 2011) and it is being adjusted for inflation on an annual basis. 5 Extreme poverty is defined as the monetary equivalent of total consumption insufficient to secure 2,100 calories. |5 per year per capita6). The majority of the poor (about 70 percent) still live in rural areas. There are also significant regional disparities, with poverty significantly higher in the oblasts of Osh, Batken and Jalal-Abad. Figure 5: Poverty Rates, 2013- 2015 Absolute and extreme poverty By regions, 2015 40 37 35 30,6 32,08 30 25 20 15 10 5 2,8 1,2 1,25 0 2013 2014 2015 Absolute poverty Extreme poverty Source: National Statistic Committee of the Kyrgyz Republic. Note: 2015 data are preliminary. 16. The population’s vulnerability to negative welfare shocks is high. Because a significant share of the population finds itself near the poverty line, even small shocks can translate into large movements in or out of poverty. For instance, between 2008 and 2013, some 34 percent of the population crossed the poverty line: 24.3 percent upwards and 9.7 percent downwards7. This high rate of mobility into and out of poverty, or “churning” presents additional challenges for sustainable poverty reduction. 17. Moreover, with poverty trends highly correlated with agricultural income and remittance dynamics, prospects for 2016 are modest. Poverty reduction and income growth across all levels of the welfare distribution are likely to stagnate going forward. Moderate growth in agriculture, combined with modest increases in remittance inflows are expected to translate into limited gains for rural households. Moreover, the real depreciation of the national currency is likely to depress investments into non-tradable sectors (construction, services) which have been a critical source of employment for the urban poor. Fiscal balances have improved but public debt ratios increased with currency depreciation 18. The overall fiscal position of the government improved in 2015, thanks largely to slow capital spending. The fiscal deficit fell to 3 percent of GDP in 2015 (from 3.9 percent in 2014), 6 The food/extreme poverty line reflects the actual food consumption habits of the Kyrgyz population, and, more specifically, it looks at food consumption of low-income households. 7 Indicative numbers based upon a synthetic panel. Source: World Bank. 2016. “Kyrgyz Republic: Poverty Profile for 2013”. Washington, DC: World Bank. Working Paper Report No. 99772-KG. Accessed: http://documents.worldbank.org/curated/en/2015/10/25132209/kyrgyz-republic-poverty-profile-2013 6| with a weaker gross operating balance more than made-up for by a decline in capital expenditures, as a share of GDP (Table 2). Table 2: General Government Budget (In percent of GDP) 2014 2015 2016 Proj. Total revenues and grants 34.4 34.9 32.8 Total revenues 31.9 32.7 30.3 Current revenues 31.8 32.7 30.2 Tax revenues 25.1 24.6 22.8 Non-tax revenues 6.7 8.1 7.4 Capital revenues 0.1 0.1 0.1 Grants 2.5 2.2 2.4 Program grants 1.9 1.7 0.5 PIP grants 0.6 0.5 1.9 Total expenditure (incl. net lending) 38.3 38.0 40.1 Current expenditure 29.3 30.6 30.1 Wage 7.8 8.3 8.7 Transfer and subsidies 3.4 3.5 3.5 Social Fund expenditures 9.2 9.1 8.9 Interest 0.9 1.0 1.1 Purchase of other goods and services 8.1 8.8 8.0 Capital expenditure 8.4 7.3 9.8 o/w foreign financed 6.1 4.6 6.7 Net lending 0.6 0.1 0.2 Overall balance -3.9 -3.0 -7.4 Financing 3.9 3.0 7.4 External 5.5 3.8 6.5 Domestic -1.6 -0.8 0.9 Source: Ministry of Finance. 19. Total revenues of the government increased, thanks to one-off non-tax proceeds. Tax revenues fell by half a percentage point (24.6 percent of GDP in 2015 vs. 25.1 percent in 2014) mostly on account of weaker regional trade with the rest of the world, as the Kyrgyz Republic, under the EEU, is entitled to receive a 1.9 percent share of total customs union external revenues. Likewise, grant receipts also declined modestly, by 0.3 percentage points, as a share of GDP. However, this was more than offset by non-tax revenues, which increased by almost 1.5 percentage points of GDP, thanks to the sale of a mining license and radio frequencies, as well as high profit transfers from the Central Bank. As a result, total revenues including grants increased to 34.9 percent of GDP from 34.4 percent in 2014. 20. While current expenditures increased as a share of GDP, relatively low levels of capital spending drove a decline in overall expenditures. Current spending increased to 30.6 percent of GDP (from 29.3 percent in 2014), driven by higher outlays (as a share of GDP) on both wages and purchases of goods and services. By contrast, capital expenditures fell by more than a percentage point of GDP, reflecting weaknesses in the implementation of public investment projects financed by foreign loans. |7 21. Despite this improvement in fiscal balances, the public debt-to-GDP ratio deteriorated sharply. Public debt, as a share of GDP, increased by almost 15 percentage points (to 68.3 percent from 53.6 percent in 2014), as stock dynamics were dwarfed by the higher valuation in som terms of dollar denominated obligations. Indeed the depreciation of the som explains over 80 percent of the 35.2 percent increase in external public debt in 2015 (with less than 20% due to net borrowing). 22. The fiscal balance was positive in the first quarter of 2016. The government ran a surplus of 3.5 percent of GDP in the first quarter of 2016 (vs 0.4 percent at the same time in 2015). Both revenues and expenditures increased significantly as a share of GDP, given the lower base in the first quarter of 2016 relative to the same period in 2015. Notable increases in non-tax revenues and grants outweighed a sizeable expansion in public consumption and capital expenditure (Table 1). While inflation moderated, monetary policy remained constrained by exchange rate pressures 23. Inflation moderated significantly in spite of the som depreciation. End of period inflation declined to 3.4 percent in 2015 (6.5 percent, average), down from 10.5 percent a year before, suggesting a weak pass-through of the exchange rate to domestic prices, and reflecting the combined effect of tepid private demand as well as lower food and fuel prices. This trend continued during the first quarter of 2016 with inflation falling as low as 0.5 percent as of end-March (Figure 7). Figure 6: Inflation Figure 7: Nominal KGS/USD Exchange Rate and (12-month, eop, %) CB Interventions Source: Kyrgyz authorities. Source: Kyrgyz authorities. 24. However, monetary policy remained constrained by the objectives to smooth exchange rate volatility and mitigate financial sector vulnerabilities. Monetary policy was kept broadly tight to ease pressure on the exchange rate as well as to offset inflationary expectations resulting from the depreciation of the som. The NBRK initially cut its policy rate to 8 percent in July (from 11 percent in January) and then increased it to 10 percent in September in the face of rising exchange rate pressures following the liberalization of the tenge. This, along with stricter loan policies of commercial banks, contributed to significantly lower growth of credit to economy (which declined to 17.3 percent as of end-December 2015 from 43.6 percent in 2014). Moreover, the National Bank intervened heavily and more frequently since mid-2015 on foreign exchange 8| markets (selling some $330 million over the course of the year) to smooth fluctuations in the exchange rate, and in fact –over the last month of 2015 and early 2016- fully stabilizing it (Figure 8). While the central bank interventions withdrew som liquidity from the system, money supply grew significantly at 14.9 percent (from 3 percent in 2014) as the depreciated exchange rate automatically increased the som value of foreign currency deposits. As of end-2015, gross international reserves stood at USD1.8 billion, covering more than three and a half months of imports. 25. Exchange rate dynamics reversed in the first quarter of 2016. The interventionist stance of the NBRK on foreign exchange markets (together with a rebound in the value of the tenge), and commitment to tight monetary policy, appear to have paid-off and stabilized expectations. Increased demand for soms in the first months of 2016 prompted the central bank to act as a buyer of US dollars in the market and resulted in an appreciation of the national currency by 7.7 percent against the dollar as of end-March 2016. Moreover, to support economic activity, the central bank reduced its interest rate to 8 percent at the end of March 2016 further stimulating the demand for money. 26. The financial sector remained healthy in spite of weaker economic activity and volatility in the markets, but lower profitability outcomes may depress credit growth going forward. The banking system remained sound in spite of slower economic activity and a continued volatility of the exchange rate in 2015 and in the first quarter of 2016. While key financial indicators deteriorated over this period, they remained well within prudential norms. Thus, the capital adequacy ratio stood at 24.3 percent as of end-March 2016 (well above the required 12 percent), NPLs stood at 8.5 percent (still manageable though rising from 5.4 percent a year before) and the liquidity level was at 82.7 percent. However, banks’ profitability indicators (ROA and ROE) and foreign currency position have been negative since the start of this year. C. Outlook: Policy Challenges in the New Environment 27. Growth is projected to decelerate marginally to 3.4 percent in 2016 and to 3.1 percent in 2017. On the production side, output growth is expected to be dragged down by lower gold production, which is forecasted to decline by 3 percent and 8 percent in 2016 and 2017 respectively(given the lower gold content of the ore scheduled for exploitation at the country’s main mine). Non-gold output growth is expected to remain around 4 percent, as non- gold industrial activity picks up, growth in agriculture and services remain stable (although lower than in 2015), while construction sector growth decelerates further. On the demand side, stepped- up public investment (as well as a modest increase in government consumption) should only partly mitigate the impact of subdued private demand, while the contribution from net exports is anticipated to be flat. 28. Inflation is expected to pick up, albeit moderately, as the som remains weak and prices of domestically produced agricultural products increase. Under a baseline scenario, which assumes no significant international food price increase, a stabilization of oil prices at current low levels, a modest easing of exchange rate pressures, and a rise in agricultural prices as a result of slower agricultural output growth, inflation is projected to rise to 7 percent in 2016 and remain around that level in 2017. |9 29. The current account deficit is expected to remain elevated over the medium-term. Proceeds from gold exports are expected to decline slightly, on account mostly of volume dynamics. At the same time, continued economic hardship in main trading partners (especially Russia and Kazakhstan) and exchange rate factors should constrain non-gold export growth, given the relative weakness of the ruble and the tenge relative to the som (discouraging exports and stimulating imports, all else equal). At the same time, gradually improved access to the EEU common market, as Kyrgyz firms adapt to EEU standards and regulations, should have a countervailing influence. Meanwhile, the anticipated scale-up of the public investment program over the next two years is expected to drive import growth, given the high import content of large infrastructure projects. Remittance inflows are projected to decline further in 2016 in US dollar terms, although at slower pace -reflecting a more stable ruble- and to rebound in 2017. As a result, the current account deficit is projected to widen to 17.2 percent of GDP in 2016 before falling to 12.9 percent in 2017. 30. Going forward, the main challenge for monetary policy will be to strike a balance between managing exchange rate and inflationary pressures on the one hand, and ensuring enough liquidity to support growth on the other hand. In the absence of sterilization options, interventions by the National Bank to shore up the som have a tightening effect on liquidity, leaving the interest rate as the main variable of adjustment. In turn, the principal challenge is to strike a right balance between the competing objectives of addressing inflationary pressures stemming from the exchange rate –calling for monetary tightening and keeping the interest rate positive in real terms- and supporting the growth of credit to the economy. With low inflation in the first quarter of 2016 and a rebound of the exchange rate the central bank has greater margins of maneuver. Moreover, over time, it is expected that de-dollarization strategies currently implemented will gradually strengthen the interest rate transmission channel and the overall traction of monetary policy. 31. The fiscal challenge over the medium term is to support growth-conducive investment while remaining on a sustainable fiscal path. The fiscal deficit is expected to grow to 7.4 percent of GDP in 2016 due to higher public investment spending. The deficit will largely be financed by external concessional loans, primarily from China. 8 In the medium term, the authorities have committed to fiscal consolidation measures to decrease the fiscal deficit to 4.2 percent in 2017 and 2 percent in 2018. This objective is intended to be achieved through measures to increase tax revenues and curtail current spending, while capital expenditures would remain high. This fiscal effort will entail: (i) implementing tax policy measures to expand the tax base (mainly to encourage businesses to move to the formal sector from the informal sector), reduce exemptions, and increase some tax rates (excise tax rates); and (ii) streamlining current expenditures, mainly through rationalizing non-priority spending (good and services), and undertaking a revision of public wages. After increasing to 71.7 percent of GDP in 2016 and 73 percent in 2017, public debt should begin to decline thereafter. 8 The Ministry of Finance officially reports that the Chinese loans are concessional although the details of the loan terms are never provided to the public. 10 | Table 3: Key Macroeconomic Indicators Selected Indicators 2013 2014 2015 2016 2017 2018 Prel. Projections Income and Economic Growth GDP (current LCU, billions) 355.3 400.7 423.6 476.4 524.3 577.5 GDP Growth (% change, y-o-y) 10.9 4.0 3.5 3.4 3.1 4.1 Non-Kumtor GDP Growth (% change, y-o-y) 5.8 5.0 4.5 3.9 3.9 4.6 Gross Investment ( % of GDP) 26.2 26.9 28.1 29.3 29.3 29.0 Prices and Exchange Rates Inflation, Consumer Prices (% change, y-o-y, end of year) 4.0 10.5 3.4 7.0 7.0 6.0 Inflation, Consumer Prices (% change, y-o-y, period average) 6.6 7.5 6.5 6.5 6.5 6.0 Nominal Exchange Rate (LCU/US$, end of period) 48.44 53.7 75.9 Real Effective Exchange Rate Index (2000=100) 113.1 128.8 116.1 Fiscal (% of GDP, unless otherwise indicated) Revenues 33.4 34.4 34.9 32.8 32.6 33.2 Expenditures (incl. net lending) 38.3 38.0 40.1 40.1 37.2 35.2 Current 29.3 30.6 30.1 30.3 27.7 26.4 Capital 9.0 7.4 10.0 9.8 9.5 8.8 Overall Fiscal Balance -4.8 -3.9 -3.0 -7.4 -4.6 -2.0 Primary Fiscal Balance -2.9 -3.0 -2.0 -6.6 -3.6 -0.8 Total Public Debt 46.1 52.6 68.8 71.7 73.3 72.0 External Accounts (% of GDP, unless otherwise indicated) Export growth (nominal US$, % yoy) 13.5 -8.8 -21.0 -7.1 8.5 12.1 Import growth (nominal US$, % yoy) 16.1 -5.8 -28.2 -4.2 6.7 7.8 Current Account Balance -15.0 -16.7 -8.7 -17.2 -12.9 -11.4 Foreign Direct Investment, net inflows 8.5 3.1 9.5 7.5 5.7 6.1 External debt, total 72.9 81.2 98.1 100.8 100.7 97.9 Source: Kyrgyz authorities and Bank staff estimates and projections. | 11 Special Focus: The Growing Burden of Debt – Rationale, Drivers and Dynamics9 32. The recent significant increase of the Kyrgyz Republic’s debt position has been a source of debate. Over the course of 2013-2015, the public debt-to-GDP ratio, the most commonly used indicator of debt burden, has shot up from 47.1 percent to 66.5 percent, raising questions about the wisdom of such rapid accumulation of liabilities and the sustainability of the country’s debt burden. The purpose of this Special Focus section is to shed some light in this debate by providing key facts and figures about the volume and composition of the Kyrgyz debt as well as by discussing the extent to which such a debt accumulation path is justifiable with respect to both economic development objectives and macroeconomic stability goals. Public debt accumulation: rationale and risks 33. Not only is it common for developing countries to borrow externally, but in many cases it may also be beneficial from an economic development perspective. The textbook rationale for poor countries to borrow abroad is simple. Developing countries tend to have limited amounts of savings available (reflecting both low levels of income and weak financial intermediation10) relative to their investment needs, which are high given the significant scope to profitably expand productive capacity and equipment. This is in contrast to developed countries that tend to have high savings relative to investment opportunities11 (given already high levels of capital and infrastructure) and that can therefore earn higher returns through lending, to finance investments in developing countries. In other words, debt accumulation/extension can be seen as a mutually beneficial exchange between the borrower that is able to exploit productive investment opportunities today, which it otherwise couldn’t afford, and the lender that earns higher returns than would be available domestically. In the case of the Kyrgyz Republic, debt makes even more sense to the extent that loans are generally provided by bilateral and multilateral partners on a highly concessional basis with negative real interest rates (i.e. nominal rates below the rate of inflation) and long maturities. 34. The key question, therefore, is not whether or not to borrow but how much and for what. While in theory debt accumulation by poor countries can be beneficial at the early stages of their development, this is only true to the extent that debt actually goes to finance productive investments. In turn, in the case of public debt contracted to support public investment, this depends on the quality and efficiency of the domestic process by which public investment is managed, from project identification and selection to implementation. In the case of the Kyrgyz Republic, the government’s focus on expanding key public infrastructure (i.e. roads and electricity generation and supply network) makes eminent sense both to enhance the business environment 9 This Special Focus uses information, data and findings presented in reports prepared by the Bank and the IMF technical assistance missions. These reports include the Kyrgyz Republic Mid-term Debt Strategy Note (April 2016), the Kyrgyz Republic Debt Sustainability Analysis (April 2016) and the Kyrgyz Republic Public Investment Management Assessment (March 2016). 10 Although some developing countries, notably in East Asia, proactively encouraged their citizens to save 11 In practice many developed countries are net borrowers, in part reflecting demographic trends. 12 | and to ensure expanded and more equitable access to services. However, a recent public investment management assessment (PIMA) revealed a number of shortcomings (Box 1). 35. Moreover, rapid debt accumulation can also be a source of macroeconomic stress and instability. If well invested, the proceeds from debt accumulation should generate the economic returns through which the principal and interest can ultimately be repaid. However, the theory holds if all else remains constant and the country is not exposed to additional sources of economic stress or shocks. In reality, the sustainability of a country’s debt depends on a host of factors including not only the volume of contracted obligations but also the prospects for economic growth (and public revenues) and for exports and/or remittances (through which the required foreign exchange is earned). Unsustainable debt, in turn, yields painful adjustments including the need for sharp fiscal consolidation (spending cuts) or, in the case where a country defaults, a sudden loss of access to foreign sources of funds, in either case with detrimental consequences for social and economic outcomes. Box 1: Toward a more efficient Public Investment Management System The Kyrgyz Republic has undertaken a significant scaling-up of public investment over the last five years, partly thanks to increasing financing from bilateral donors. Public investment reached 8¾ percent of GDP in 2015 mainly thanks to China, which is financing an ambitious investment program through concessional loans. Nevertheless, public capital ratios are still below peers and there are some inefficiencies. From that perspective, the main weaknesses that should be addressed relate to improving the design and implementation of the institutions already in place:  Planning: (i) plans do not prioritize investments and are poorly linked to fiscal capacity while planning processes are fragmented and (ii) there is little oversight of investment projects of state-owned enterprises undertaken outside the public investment program (PIP).  Allocation: (i) domestically financed projects are not subject to appraisal while PIP projects are only appraised at the donor’s discretion and (ii) there is no a central oversight of appraisals to the extent they are conducted nor standardized process for the selection of projects.  Implementation: (i) there is limited central monitoring of physical and financial progress of projects, no data management system to track down progress external, and audits of domestically-funded projects are not undertaken and (ii) lines of accountability for project implementation are unclear and there is not systematic reviews or processes for project adjustment. Nevertheless, there are a few areas where the Kyrgyz Republic has a strong framework. In particular, coordination between the central and local governments is generally good; most capital spending is undertaken through the budget, and the Public-Private Partnership (PPP) framework has sound underpinnings although it has not yet been tested. Source: Kyrgyz Republic Public Investment Management Assessment. Kyrgyzstan’s public debt in perspective: key facts and trends 36. The public debt of the Kyrgyz Republic has increased significantly. The country has been accumulating debt since Independence, to make-up for the loss of subsidies formerly received from Moscow. Annual public borrowing grew by around 17 percent on average during 1993-2015 and was used to finance budget deficits and investment programs. As of end-2015, public debt amounted to US$3.8 billion or 68.3 percent of GDP. The highest debt- to-GDP ratio, however, was in 2004 when it reached 120 percent of GDP, triggering a round of | 13 bilateral debt restructuring with “Paris Club12” members in 2005 and with Russia in 2014. At the same time, in 2007, the country declined to participate in the Highly Indebted Poor Countries (HIPC) initiative, which envisaged a write-off of the multilateral debt, out of concern that it may damage the country’s reputation in the international arena. 37. External debt accounts for the bulk of Kyrgyzstan’s total debt (Table 3). External public debt amounts to 95 percent of the Kyrgyz Republic’s total debt, and currently consists of some 160 loans, a majority of which on concessional terms. Almost all external borrowing was contracted at fixed interest rates (except for 10 loans contracted from the European Bank for Reconstruction and Development). The remaining 5 percent of total debt is made up of domestic issues of government papers (T-bills and T-bonds). Table 4 illustrates the share of domestic and external debt at end-2015. Table 4: Stock of Public Debt, end-2015 (USD Mln) (% of GDP) (% of Total External debt 3,600.0 62.9 94.6 Domestic debt 204.0 3.6 5.4 Total debt 3,804.0 66.5 100.0 Source: MoF, MTDS team. 38. External debt is concentrated on few creditors. China, the International Development Association (IDA – i.e. the World Bank) and the Asian Development Bank (ADB) represent 69 percent of total external debt, accounting for 36, 18 and 16 percent respectively. These three top creditors are followed by Russia and Japan with 8 and 6 percent, respectively. The outstanding debt to Russia (US$ 300 million), however, is expected to be gradually written off (by US$30 million annually starting in 2016), as a result of bilateral negotiations between the two countries. Table 5: shows the main creditors in the Kyrgyz Republic’s external debt portfolio and their share. Table 5: Creditor Distribution of External Public Debt, end-2015 Creditor Percent US$ million China Export Import Bank 36.0 1,296.1 IDA, World Bank 17.8 639.3 ADB (Asian Development Bank) 16.0 576.0 Russia 8.3 300.0 JBIC (Japan Bank for International Development) 6.4 229.0 IMF ( International Monetary Fund) 5.2 188.2 The Government of the Republic of Turkey 2.7 97.0 KfW Bank (Germany) 2.6 94.0 IsDB (Islamic Development Bank) 1.7 59.5 EBRD 1.1 41.0 Others 2.2 80.0 Total 100.0 3,600.0 Source: MoF, MTDS Team. 12 An informal group of officials from creditor countries, whose role is to find solutions to hardships experienced or anticipated by / for debtor countries. 14 | 39. Kyrgyzstan’s external debt is dominated by US$ denominated instruments. After the currency mix is adjusted to take into account the composition of “Special Drawings Rights”,13 the Kyrgyz Republic’s debt portfolio currency mix is mainly in US$, Euro and Japanese yen (62, 17 and 11, respectively) (Figure 9).14 Domestic debt, for its part is issued in Kyrgyz som. Figure 8: Currency Exposure by Total Debt, end-2015 Source: MoF, MTDS team Note: "Other" includes currencies with a less than one percent share of the total (AED, KRW, KWD and SAR). 40. Domestic debt remains a small percentage of total debt. Despite the announced objective of supporting the development of a more active market for government securities, the domestic debt stock remains limited to about 5 percent of total debt. In addition to 3, 6 and 12 months T-bills, the government issues 2, 3 and 5 year T-bonds. Table 5 below shows the outstanding domestic debt stock by type of instrument at the end of 2015. Table 6: Stock of Domestic Debt at end-2015. (In KGS million) Percent KGS Million T-bills 21.7 3,353.0 T-bonds 70.0 10,837.3 Other (non-marketable debt 8.4 1,293.4 Total domestic debt 100.0 15,483.7 Source: MoF. 41. As a share of GDP, the Kyrgyz external public debt is one of the highest among peer countries. When compared with similar countries in terms of income level, country size and development challenges, The Kyrgyz Republic has relatively high levels of indebtedness (Figure 13 An international reserve asset, used by the World Bank and the IMF to denominate its credits, whose value is currently based on a basket of four major currencies: the U.S. dollar, euro, the Japanese yen, and pound sterling (soon to be expanded to the Chinese renminbi). 14 The dominance of the dollar in the debt currency mix makes sense as most of the K yrgyz Republic’s export earnings are received in dollars. | 15 10). As the country plans to continue to borrow in coming years, the debt-to-GDP ratio could only be reduced by achieving a sustainable high growth rate. Figure 9: Kyrgyz Republic’s Debt in International Comparison Source: World Bank – International Debt Statistics. 42. Due to the high share of long-term highly concessional debt in the portfolio, the refinancing risk, however, is limited. Domestic debt is constituted by short/medium-term securities with an average time to maturity (ATM) of 1.4 year. However, this exposure is compensated by the long maturities of the external debt, whose ATM equals 11.2 years, resulting in an overall ATM of 10.6 years. The redemption profile (Figure 11) is smooth without significant spikes in principal payments. 5.9 percent of the total debt outstanding matures within one year. Figure 10: Redemption Profile, end-2015, Million som Source: MoF, MTDS team. 43. Interest rate risk is also limited since both external and domestic debt have mostly fixed interest rates, and external debt is long-term. In 2015, the share of debt with interest rate to be re-fixed within one year was 4 percent for the external portfolio and 58.3 percent for the domestic debt. However, because of the relatively small share of domestic debt in the total public debt portfolio, the percentage of total debt subject to re-fixing within a year was relatively low at 7 percent. The exposure of the budget to changes in exchange rates remains high at 94.5 percent. Overall, borrowing cost remains low, with a weighted average interest rate of 1.9 percent for total debt –which translates into negative real interest rates-, although higher for domestic debt at 10.2 percent (1.4 percent for external debt). 16 | How sustainable is the Kyrgyz Republic’s public debt? 44. The World Bank and the IMF regularly conduct joint assessments of countries’ debt sustainability. The joint “debt sustainability analysis” (DSA) is done an annual basis as part of regular macroeconomic monitoring as well as to define the terms at which countries can be granted financing support and to help countries to develop borrowing strategies that match their financing needs with current and prospective repayment capabilities. In a nutshell, it assesses the country’s projected debt burden over a 20 period, under standard assumptions for growth, exports, government revenues, exchange rates, etc. as well as its sensitivity to a number of shocks. The debt indicators of a country are benchmarked against indicative thresholds and the risk of debt destress is defined as “low”, “moderate”, “high” or actual when the country is already having repayment difficulties. 45. Exchange rate movements play a critical role in external debt indicators as well as for debt service payments when debt is mostly denominated in foreign currency. For developing countries with floating exchange rate regimes, the main debt indicator –the debt to GDP ratio- is driven by both volume and price dynamics. A depreciation of the domestic currency against the US dollar, translates mechanically into an increase of the debt-to-GDP ratio. In fact, this has been the experience of the Kyrgyz Republic over the past two years. The Kyrgyz external debt in som terms increased by 35.2 percent in 2015 due to a 4.9 percent increase in net borrowing in US dollars and a 29 percent depreciation of the som. As a result the external debt-to-GDP ratio deteriorated to 64.5 percent as of end-2015 from 50.5 percent a year before. 46. The latest Kyrgyz Republic DSA projects a decline in the external debt-to-GDP ratio over the medium term. The baseline scenario assumes growth at 5 percent in the medium term supported by public investments in infrastructure and energy. Inflation is projected to be around 4 percent assuming no significant increases in food and energy prices and prudent monetary policy in the medium term. These projections are also in line with their historical trends. On the fiscal accounts, the assumption is that fiscal deficit would converge to 1 percent of GDP by 2021 with capital spending stabilizing around 4 percent of GDP. Under these assumption, the external debt- to-GDP ratio is expected to rise over 70 percent in the next two years and gradually decline below 60 percent by 2021. 47. The Kyrgyz Republic is assessed to be at “moderate risk of debt distress”, even though risks have increased markedly from the previous DSA. Under the DSA baseline scenario, debt indicators do not exceed the indicative thresholds. The present value (PV) of public and publicly guaranteed (PPG) debt to GDP ratio is expected to reach 46.2 percent in 2016, 46.7 percent in 2017 and stabilize at around 45 percent afterwards, lower than the 57 percent indicative threshold, reflecting fiscal consolidation over the medium term. The present value (PV) of public and publicly guaranteed (PPG) external debt to GDP and remittances ratio is expected to reach 35 percent in 2016, lower than the indicative threshold of 36 percent, before declining slowly.15 The PV of debt 15 The use of the remittances-adjusted thresholds is justified by the large size of remittances: they represented more than 30 percent of the GDP and more than 60 percent of the exports of goods and services on average over the three past years. | 17 to exports and remittances ratio and the PV of debt to revenue, at [62] and [133] respectively in 2016, are expected to remain well below their policy-based indicative thresholds.16 Figure 11: Debt Sustainability Analysis Summary Charts Source: Bank-Fund 2015 DSA update. 48. However, stress tests show that external debt is vulnerable to large shocks or substantially less favorable assumptions. The PV of the debt-to-GDP and remittances ratio rises above the relevant indicative threshold over the medium term under four of the six stress tests: (i) when exports grow at one standard deviation below their historical average over 2016-2017; (ii) when net non-debt-creating inflows over 2016-17 are one standard deviation below their historical average; (iii) when the exchange rate depreciates by 30 percent in 2016 relative to the baseline; and (iv) under a shock over 2016-17 combining lower GDP and export growth, a decline in the US dollar GDP deflator and lower net non-debt-creating inflows. The depreciation of the exchange rate in particular would lead to a significant and protracted breach of the indicative threshold over the medium term. 49. Heightened risks and sources of uncertainty call for a prudent policy stance going forward. The planned sharp acceleration in disbursement of Public Investment Program loans and the continued weakness of the som relative to the dollar are expected to result in a significant rise of external public debt ratios. Although PIP borrowing terms are concessional or near concessional (in the case of some projects financed by China), stress tests suggest that the country is vulnerable to exogenous shocks. Fiscal consolidation and prudent use of concessional loans, in particular for large-scale public investment programs, remain crucial for keeping the debt outlook sustainable. In the framework of the new IMF program, the authorities committed to: (i) full disclosure of the public investment plans and commitments; (ii) refraining from non-concessional borrowing; (iii) grounding borrowing decisions in a medium-term debt strategy; and (iii) reviewing the public investment framework to identify gaps and define an action plan17. 16 The relevant thresholds are 120 percent for the PV of the debt to exports and remittances ratio and 250 percent for the PV of the debt to revenue ratio. 17 This was done with IMF Technical support in March 2015 18 | Kyrgyz Republic Economic Update No.3 | Spring 2016