Current Account Imbalance of the Kyrgyz Republic
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Current Account Imbalance of the Kyrgyz Republic
A country’s current account is a critical indicator of the economy’s health and delineates the difference between a nation’s investments and savings. Being the sum of the balance of trade, net current transfers and remittances from abroad, a current account has the potential to indicate to investors that whether a country relies on borrowing to funds its operations or lends to others for the same reasons. The objective of this paper is to critically evaluate the current account imbalances of the Kyrgyz Republic, identify the economic contributors to the imbalances and recommend corrective measures through policy development and implementation.
The current account deficit can largely be described as a significant percent of a depressed level of the Gross Domestic Product (GDP). Since the deficit emerged early after the country’s transition into an independent state from the Soviet Union, it is largely attributed to the alarming situation where the capital inflows in the country were larger at the beginning of the transition but have since leveled off. In addition, the high demands for imports and exposure of the country to external shocks are among the factors that have caused the country’s foreign exchange reserves and foreign direct investments to declines. These result in a balance of payment crisis that are further exacerbated by the financial sector that requires comprehensive reforms.
There have been numerous economic, social and political changes since the country’s independence that have continued to exert pressure on the country’s ability to sustain its populations’ living standards. The economic environment in the country has faced various challenges that has sent the country continue depending on foreign aid and borrowing in order to sustain its economic programs. Particularly, the dependence on remittances from Russia, gold, metals and agricultural exports have caused the country to suffer significant deficits since these factors are influenced by regional stability which has progressively fluctuated. The identification of factors that influence the country’s economic growth is critical since it will enable the development of policy frameworks that can propel Kyrgyz Republic’s economy forwards.
Kyrgyz Republic Economic Overview and Growth
In the period between 2001 and 2012, Kyrgyz Republic has experienced an average annual growth of 3.9% in spite of the various challenges that it continues to face. Though the country has repeatedly experienced significant growth, economic and political events in the country and the region have continued undermine it; hence the current account imbalances. Though the Kyrgyz Republic expected growth to increase to beyond 7% in 2014, such level of growth can only e realized if there is economic and political stability, and diversification foreign investments.
The republic underwent a challenging transition after it gained its independence in 1991. The disintegration of the soviet payment systems of trade among former republics, withdrawal of subsidies and overall economic decline in the region caused significant disruption to the Kyrgyz Republic’s economy which was considered as among the poorest countries in the region. Soviet republics that had hydrocarbon resources could export gas and oil to their previous trade partners and adjust their economies to world markets (Aristovnik, 2006); however, Kyrgyz Republic experienced a precipitous decline in industrial and agricultural output since the traditional markets for products and sources of raw materials were quickly disappearing.
In addition, the Kyrgyz Republic geographical location has placed significant disadvantages in terms of trade since it is a land locked country that depends on entry routes through other countries from the seaports. The long distance from seaports threatened the country’s ability to compete in the international markets since its exports integrated significant transport costs which affected the potential for growth and increased its susceptibility to external economic shocks (Collier & O’Connell, 2007). In addition, the country did not have adequate resources; therefore, it needed replace the subsidies that were previously provided by the Soviet Union that accounted for 10% of the country’s GDP. The Kyrgyz Republic’s policy makers opted for development strategies that were based on the market economy pegged on a democratic political system. Through embarking towards a democratic political system, Kyrgyz Republic became a model nation in international community that was characterized by economic liberalization and a free market as among its key policy goals.
Kyrgyz Republic made various policy reforms in the early 1990s that included decrees, laws, an ambitious privatization program and creation of new institutions. Towards the end of 1994, 68% of the country’s construction business assets, 82% of trading companies’ assets and 40% of assets in industry were privatized and registered to private investors (ADB, 2014). Though these reforms were significant for the economic turn-around that the country needed, they were not augmented with the much needed restructuring of former state enterprises as a result of the rigidity in the country’s financial systems. Additional failures of the reform were the relatively constrained capacity of local governments causing the outcome of the reform to be particularly disappointing in agriculture. Evidently, the outcome of the reforms disappointed policy developers from creating follow-up reform measures that would have ensured that they achieved sustainability.
Once the Soviet Union disintegrated, the Kyrgyz Republic’s economy declined significantly to the extent that outputs were reduced by 50% resulting in negative current account. The country’s recovery began to be evident in 1996 after a 7% growth in the GDP. The country’s GDP continued to grow in 1997 when the largest gold mine in the country began to operate (NSCKR, 2011). In the next decade, economic growth was erratic and significantly influenced by global financial crisis and political instability in the country (ADB, 2012). In the period between 2001 and 2013, Kyrgyz Republic experienced growth in its GDP of 7% or higher in five out of ten years, and negative digit growth in three years in the same period. Consequently, the average GDP was 4.4% which was among the lowest compared to countries such as Kazakhstan, Moldova and Armenia among others (World Bank, 2014). In addition, its independence was necessary as a trigger for various strategies towards the restructuring of the economy and transformed it from a rural economy to an economy that re-exports consumer goods to Russia and central Asia. Gold being a key resource in the country has continued an estimated average of 7% of the country’s GDP in 2001 to 2012 which has been critical in creation of external trade and accounted for 34.6% of the country’s exports in 2001 to 2012 (ADB, 2013).
However, in 2011, gold exports accounted for 43% of the exports as a result of the high prices. The production of gold has been erratic on the basis of technical and geologic factors, and influences of external prices. For instance, in 2012, Kyrgyz Republic faced a significant decline in gold production as a result of geologic factors that had a net effect of reducing the country’s GDP by 0.1% (ADB, 2013). The 1998 financial crisis that affected the Russian federation had significant impacts on Kyrgyz Republic’s economy; however, the end of the crisis resulted in re-establishment of macroeconomic balances and the country experienced growth in the period between 2001 and 2005 only to be affected by the Tulip revolution and a significant accident at the Kumtor gold mine in 2005 and 2006 respectively that caused a steep reduction in the current account balance (World Bank, 2014). The subsequent period of growth was 2006 to 2010 that was significantly influenced by the service sector expanding especially in re-exports trade. The period between 2011 and 2014 experienced significant variations in the country’s economy.
The economic volatility of the Kyrgyz Republic continued in 2008 especially as a result of the delayed impacts of the global financial crisis of 2008-2009 that slowed economic growth from 8.4% to 2.9% in between 2008 and 2009. In addition, the uprising experienced in 2010 has a negative effect on the country’s economic growth and caused the private sectors confidence to be weakened. Hence the GDP reduced by 0.5% in 2010 while the on-and-off opening of the border with Uzbekistan and Kazakhstan escalated the contractions in transport services, tourism and external trade. This trend has continued to 2014 where border disruptions and closures continue to impact some oblasts (ADB, 2014).
The economic performance of Kyrgyz Republic was strengthening in 2013 leading to 10.5% growth. The current account deficit declined in the same year as a result of lower fuel and food prices in addition to a recovery in gold output. At the end of 2013, Kyrgyz Republic had experienced 4% decline in the twelve-month inflation while core inflation did not exceed single digits. The decline in inflation is attributable to the monetary and fiscal policies implemented by the National Bank of the Kyrgyz Republic. These policies included the modernization of operational framework for monetary policy and progressive support of a prudent fiscal policy that aimed to keep inflation at a lower rate.
The country’s economic growth moderated to 3.5% in 2014 from January-august from a 10.5% growth in 2013.This in spite of expectations of a rise in inflation as a result of depreciation pressure experienced at the beginning of 2014. However, growth was expected to increase to 5% in the medium term while depreciation stabilized at 6%. The sluggish growth is attributable to pressure exerted on the country’s current account from the intensive public infrastructure investment program that should support significant growth once completed.
The political disruptions of 2005 and 2010 were both caused by public dissatisfaction with the escalation of corruption and political capture among other factors. Evidently, the unrest has had significant and long-lasting negative impacts on economic growth and effectively contributed to the decline of the current account balance. The Political Stability and Absence of Violence Index, published as part f the World Bank’s Worldwide Governance Indicators dataset placed the Kyrgyz Republic among the lowest quintile for the 8 years between 2003 and 2012 (World Bank, 2015). While various surveys identified political and government instability as by far the most significant problems investors and businesses faced in the Kyrgyz Republic during 2010–2013, these were replaced by corruption as the biggest hurdle in later surveys (ADB, 2013).
The country’s weak enforcement of property rights allowed hostile takeovers and incidents where private investors without the protection of political elements are forced to sell their businesses at extremely low prices to the politically connected (Mogilevsky & Omorova, 2011). Additional challenges to property rights include the lack of judicial independence and the failure or lack of capacity of the judicial system to resolve commercial disputes in an expeditious, fair, and cost-effective manner. However, the rising number of disputes with foreign investors, mainly in mining, has made the enforcement of contracts a vital source of fear for potential investors. in spite of the merits of concerns about contracts negotiated with previous regimes, the hope that every new incoming parliament or administration will conduct a review of all contracts is a disadvantage to the country’s ability to interest credible investors in developing the country’s significant mining resources. Particularly, the Kumtor gold mine concession was renegotiated twice during 2001–2010; in 2011, a parliamentary commission was set up to review it yet again. Contract review procedures seemed to have been politicized, which could impose significant costs on the economy (World Bank, 2013).
The country’s monetary policy attempts to create a balance between the slowing economic growth and the increase in inflation. The increase in inflation had reached 7.4% in July 2014 from December 2013 accompanied with corresponding increase in consumer prices as the domestic currency continued to depreciate against the US dollar in 2014. Higher fuel prices from Russian plants continued to increase exerting more pressure to oil prices in Kyrgyz Republic. The impact of these increments in prices was further deterioration of the current account since foreign expenditure was increasing while national income declined. The NBKR opted to mitigate the rising inflation and prices through implementation of a 50 basis points increase in its main policy rate in 2014. This action brought the discounting rate to 6.5% which had little impact on the country’s monetary situation. Essentially, the NBKR’s actions had little impact on the current account since persistent inflation continued to cause higher costs of imports and reduced reserves (NBKR, 2014).
Though the fiscal deficit in Kyrgyz Republic is projected at 4.2% of the country’s GDP in 2014, the consolidated of the fiscal policy is still a priority for the government. The implementation of administrative reforms, prioritizing non-current expenditures and tax policy reforms are among the strategies that are needed for the fiscal consolidation initiative and subsequent balancing of the current account. In the fourth quarter of 2014, Kyrgyz Republic’s current account deficit amounted to US $ 643.20 million and averaged a deficit of US $229.75 million in the period between 2007 and 2014 (Trading Economics, 2015).
The Russian and Ukraine crisis has had significant impacts on Kyrgyz Republic’s especially since Russia has sponsored various economic projects in the country including oil and gas infrastructure (Forbrig, 2015). The impacts of the Russian-Ukraine crisis are among the key factors that have influenced the Kyrgyz Republic’s economy and decline in its current account. According to the World Bank, (2015), the Russia-Ukraine crisis led to sanctions being imposed on Russia causing a significant slowdown in the Russian economy. The slowdown which was at 0.7% in 2014, accompanied by falling oil prices, depreciation of the Russian ruble, capital flight and loss of accessibility to international markets has caused the Russian economy to decline significantly which as affected countries that relied on remittances such as Kyrgyz Republic among others (World Bank, 2015). The decline in oil prices and reduced remittances from Russia which accounted for 29% of the GDP has pushed inflation to higher levels and kept it at double digits. Though policy actions such as a raise in social benefits and public sector wages have been implemented, their effect to counteract the effects of the Russia-Ukraine crisis is inadequate (World Bank, 2015).
The country’s economic relationship with Russia has impacted the economy significantly considering that the Russian economic slowdown is influencing Kyrgyz Republic’s current account balance with an increasing deficit. The high dependence on remittances and grants especially from Russia have led to significant decline in the country’s growth characterized by lower national savings and escalating prices as a result of the depreciating currency which has e negative impact on the country’s current account balance. Since the Russian economy is experiencing a slowdown, the remittances and grants have declined significantly causing growth in the Kyrgyz Republic to be derailed. In addition, the high investment program that the country has embarked on has resulted in an increasing in the nation’s debt level (Mogilevsky & Omorova, 2011). The investments in infrastructure and energy sector through external borrowing has increased the country’s debt and reduced national savings causing a double digit negative balance on the current account. The increasing current account deficit is attributable to the increase in borrowed funds for investments, high level dependence on imports and a slowdown in the Russian economy that has resulted in decreased remittances. In the event that the trend continues, the country’s current account balance will continue to experience negative growth causing the country to suffer more costs in an attempt to turn around the economy.
The increasing rate of inflation that began to rise in early 2014 as a consequence of the depreciating currency is among the outcomes of the Russian economic slowdown. This has exerted inflationary pressure on the economy with the inflation rate rising to over 10% by the end of 2014. The impact of this situation is an increase in prices causing the real and nominal exchange rates to increase which have an impact of increasing the current account deficit. Since the future of the Russian economy is likely to experience further slowdown as a result of the international trade sanctions imposed on the country as a result of the Russia-Ukraine conflict; the Kyrgyz Republic may also continue to experience the negative impacts of the slowdown. In the event that the Kyrgyz som continues fall as a result of the falling Russian ruble, the country’s inflationary pressure will definitely increase to the detriment of the country’s balance of trade and an increase in current account deficit (IMF, 2015). In addition, increased investments in a time that the country is experiencing economic downturn could result in higher levels of debt that have an impact of increasing the country’s debt pressure and further straining the current account balance. Since the Kumtor goldmine experienced problems that impaired the country’s economy in the past, any further problems could derail the level of gold exports bearing in mind they are the primary source of foreign reserves that are needed to finance various investments and pay the costs of imports. However, investments by countries such as China in the Kyrgyz Republic’s economy could have significant impacts in aiding the country to eliminate the infrastructure gap (IMF, 2015). The country’s authorities must ensure that the debt is managed in a prudent manner such that it becomes beneficial in the long term after the infrastructural and energy projects come to maturity.
Savings and Investment
The Kyrgyz Republic’s investment rate declined rapidly beginning in 2000, to as low as 11.8% in 2005, before rising to 28.9% in 2008. It declined gradually from its 2008 level to25.4% in 2011. Like many low-income countries, the Kyrgyz Republic has had low and even negative savings rates since the onset of significant remittance flows. However, the growth episodes in the economy were not strongly related to the investment rates, partly because factors unrelated to investment, such as changes in the terms of trade and fluctuations in gold production, play important roles in driving growth. In addition, investments in the gold sector can take many years to contribute to production and economic growth hence the appreciation of the current account may take longer time (Mogilevsky & Omorova, 2011). Finally, the weak correlation between investment and growth suggests low efficiency of investment in the Kyrgyz Republic. Both savings and investment rates were significantly below those of the benchmark countries (Moldova, Russian Federation, Mongolia, Armenia, India, PRC, Georgia, Kazakhstan, Uzbekistan and Tajikistan) despite some improvement in those rates over the latter half of the 2000s. While there are concerns about the reliability of the statistics and methodology used in estimating national accounts, the available data support the view that returns on investment and the contribution of investment to economic growth have been limited. Growth has been driven instead by consumer spending and imports. The problem of low returns on investment is explicitly considered in the model.
There was a significant shift in the composition of fixed investment between 2009 and 2010 (NSCKR, 2014). The share of fixed capital investment spending in mining rose from 10.8% to 35.7% and remained at about a third of the total since then, mainly because of the exploration in recently licensed fields. Before 2009, investment was focused on the services sector, with about one-third going to transport and communications, mostly for roads and cellular communications. The share of agriculture and manufacturing remained small throughout.
Another measure of the efficiency of investment is the incremental capital output ratio (ICOR), which is the ratio of investment to growth, or the inverse of the marginal product of capital. The ICOR can be thought of as a measure of the efficiency with which capital is used. In most countries, the ICOR is about 3.0. The Kyrgyz Republic had an average ICOR of 6.3 between 2003 and 2013, implying that it had to garner a greater amount of investment than most countries to generate the same amount of growth during the last 10 years. In fact, data show that the Kyrgyz Republic’s ICOR increased from 3.8 during 2000–2005 to 5.4 during 2006–2011. Thus, the Kyrgyz Republic’s ICOR was high compared with those of the benchmarks countries (Moldova, Russian Federation, Mongolia, Armenia, India, PRC, Georgia, Kazakhstan, Uzbekistan and Tajikistan) and other economies in Asia (NSCKR, 2014); although it is below that of Mongolia, which has also received substantial investments in natural resources.
Financial System
The very low gross domestic savings rate has been one of the factors in the slow development of financial savings instruments in the Kyrgyz Republic. Even after 20 years of reforms, formal financial intermediation is still in its infancy. The ratio of domestic credit to GDP (including lending by nonbanking institutions) was estimated at 20% in 2013 (NSCKR, 2014), which is low by international standards. Commercial banks dominate the finance sector, with about 80% of assets. There are no significant capital markets, which is also true in the benchmark countries. The insurance industry in the Kyrgyz Republic is also small, and its development has stagnated. These factors have limited the country’s ability to generate internal revenues that could contribute significantly towards increasing the country’s reserves and increasing the current account balance to positive digits.
The banking system has displayed fragility over recent years, although a major crisis has been averted. The global financial crisis significantly impacted Kazakhstan’s banking sector, which had ownership interests in banks in the Kyrgyz Republic. An aggressive expansion of consumer loans and mortgage lending in the Kyrgyz Republic between 2006 and 2008 also contributed to a deterioration of portfolio quality. Low confidence in the banking system was exacerbated by a banking crisis that was sparked by a run on the banks during the political upheaval in 2010. There was a large outflow of foreign currency deposits. The National Bank of the Kyrgyz Republic temporarily took seven banks under conservatorship, including the largest bank, Asia Universal Bank, which had over 20% of the country’s total deposits. To mitigate bank-run risks, the authorities nationalized Asia Universal Bank and split it into two entities: a “good bank” and a “bad bank” (NBKR, 2014).
The good bank, called Zalkar Bank, had Asia Universal Bank’s remaining assets. However, a forensic audit suggested that Asia Universal Bank had been used for large-scale criminal activities, and had likely been insolvent before the 2010 events, indicating significant shortcomings in the oversight by the National Bank of the Kyrgyz Republic. Then, unclear rules and legislation resulted in a prolonged conservatorship for four of the banks, including Zalkar Bank, which were finally sold off in May 2013. There was also litigation by shareholders, so the conservatorship was prolonged pending a court decision (NBKR, 2014). The lack of comprehensive banking framework makes it difficult to implement a monetary that will restore confidence in the country’s financial institutions. Instead people have held cast instead of investing it in banks which reduces national savings and deteriorates the current account balance.
Despite the avoidance of a major crisis, bank loans remain costly and difficult to obtain. Nominal lending rates have remained high despite the fluctuations in the real rates, which had resulted from rising inflation in 2008. The average interest rate that banks charged on their portfolios in 2013 was 18.4%, which was high compared with those in most of the benchmark countries (NBKR, 2014). The difference between the spreads the banks charged and the risk premiums diminished.
While the bank spreads and risk premiums converged at about 10% in 2011, the risk premiums started to increase again. They stood at 11.2% in 2013 (NBKR, 2014). Considering that collateral requirements are high, these spreads likely reflect the risk premiums for economic sectors or for the country, rather than those for individual borrowers. This conclusion is substantiated by the fact that the lending rate differs significantly by sector. The rates for industry and construction are significantly below average, indicating a lower risk assessment for well-established companies with predictable cash flows. The differences by industry suggest that companies pursuing profitable opportunities outside of established sectors will find it difficult to fund investments (World Bank, 2014).
If limited access to finance is a constraint, then improved access should lead to a substantial increase in investment. However, the statistical relationship between the cost of finance (measured by the real loan interest rate) and investment is not strong; the magnitude of the effect is relatively small, although the coefficient has the expected sign. The possibilities are that (i) the changes in the interest rate have not been large enough to induce a sizeable response; (ii) issues other than cost constrain access to finance, and/or (iii) issues other than access to finance are more important in determining investment (World Bank, 2014).
Therefore, it is important to examine other determinants of access to finance. In addition to high interest rates, bank loans have short maturities, which are unsuitable for financing investment projects with long gestation periods. In addition, more than half of all bank loans in the Kyrgyz Republic are denominated in foreign currencies. According to the results of the 2013 World Bank Enterprise Survey, 89% of the firms that received loans had to provide collateral averaging 187% of the loan value, and ranging from an average of 164% for firms in the services sector to an average of 237% in manufacturing (World Bank, 2014). As a result of these shortcomings, banks provide only a small fraction of financing for investment. In the 2013 enterprise survey, only 29.2% of firms surveyed indicated that they had a bank loan or line of credit. Instead, much of the country’s investment financing comes from the retained earnings of existing enterprises and from household savings, which together account for 60% of total investment and 88% of private investment. Bank loans are a negligible source of investment financing, amounting to 7.2% of total investment in 2010 and 0.6% in 2013 (NBKR, 2014).
In addition, the country has adopted a dollarized banking system that used for both lending and deposit transactions; however, the recent slowdown in Russia and weakening of the Kyrgyz som has exacerbated the system. The high dollarization of the country’s banking system and addition to the rapid credit increment by the financial institutions in view of the weakening domestic currency presents a significant risk to the economy and increases the potential to further increase the current account deficit. This is premised on the fact that the country borrows funds in terms of dollars while its income is measured on terms of its depreciating domestic currency that is essentially losing value, there is a significant probability that the country will not be able to service its debt as expected; hence reduce the national saving as a result of high level of loan repayments that deplete the country’s reserves.
In order to counter the impacts of the economic slowdown in Russia, the Kyrgyz Republic secured US $92 million loan from the International Monetary Fund (IMF) towards financing a reform program that aims to bolster the country’s resilience to external shock especially the outcome of the Russia-Ukraine conflict. Though the country had initiated reforms under a different program sponsored by the IMF that expired in 2014, the new financing is expected to extend for a period of three years under the extended credit facility granted by the IMF (IMF, 2015). The expected impact is to reduce the current account deficit through a reduction of inflation and subsequent prices of imports and stabilization of gold prices that are expected to earn incremental incomes. In addition, the country expects to derive economies of scale through enhanced competitiveness and exposure to wider market that is insulated against external shocks after joining the Eurasian economic Union (IMF, 2015).
The current account deficit balance narrowed as the country made lower imports and gold exports increased in the first half of 2014. This resulted in a decline of the current account deficit from 29.9% of the GDP in 2013 to 17.4% of the GDP in 2014. The decline is attributable to an increase in exports by 4.3% that included a 34.4% increase in gold exports. The impact on the current account is a significant reduction of the current account deficit moving it towards positive digits. However, the slowed activities in the economy and disruption of fuel supplies entering the country through Kazakhstan in the same period led to a 10.4% decline in imports (World Bank, 2014).
Social Returns in Investment
Social returns (or returns to society) are determined by the availability of human capital, infrastructure, and other public goods to complement private investment. An abundance of these complementary resources will boost the productivity of the factors of production, which, in turn, will increase the incentive for the private sector to invest (ADB, 2013). An inadequacy of public goods, however, will dampen the productivity of the factors of production and increase the cost of doing business, thereby decreasing the incentive for the private sector to invest.
It is difficult to directly estimate social returns on investment. However, estimates of Total Factor Productivity (TFP) growth can provide some insight (ADB, 2013). TFP growth refers to growth in output that is not attributable to increases in labor or capital inputs. This growth captures efficiency gains from technological progress such as better production management methods, better customer support, and better distribution channels for delivering goods and services. It also reflects any other factors affecting the efficiency with which inputs are used, such as changes in working hours, hidden employment, labor hoarding, capacity utilization, and changes in resource allocation, as well as changes in the accuracy with which inputs and outputs are measured. Estimates of the TFP by the Conference Board for a large number of countries show that the Kyrgyz Republic experienced very low, often declining, TFP growth (ADB, 2013).
Remittances and Foreign Direct Investment
Poor access to finance would have been a far more serious impediment to investment growth had it not been for remittance flows, which have propped up national savings since 2003. Remittance flows facilitated an increase in the investment rate by about 10 percentage points during 2006–2010, compared with the previous 5-year period, while maintaining high consumption levels and relatively manageable current account deficits (World Bank, 2010). The relationship between the remittances–GDP ratio and the investment rate for 2004–2011 is statistically significant, supporting the view that workers’ remittances played a key role in substituting for low domestic savings, given that other flows into the Kyrgyz Republic’s economy were limited. The strong relationship between workers’ remittances and the investment rate is evidence that lack of access to finance can indeed be considered a constraint to growth. The fact that the relationship between remittances and investment is much stronger than that between interest rates and investment is, in itself, an indication of the shortcomings of the financial system (Rodrik, 2010).
The Kyrgyz Republic’s access to international finance has been limited, a problem that it shared with most of the benchmark countries during 2006–2010 (World Bank, 2010). Access to private international financing has been only in the form of equity investments, except for some bank loans from Kazakhstan before the global financial crisis. Even then, the contribution of FDI to the Kyrgyz Republic’s economy was a fraction of real sector investments, below the amounts in the benchmark countries, except for the Lao PDR, Pakistan, and Uzbekistan until 2007. FDI inflows increased to $694 million in 2011 compared with the pre-crisis annual average of $144 million for 2005–2007. After dipping to $293 million in 2012, FDI inflows climbed to $758 million in 2013, accounting for 39.6% of gross fixed capital formation (National Bank of the Kyrgyz Republic, 2014). Investment climate surveys conducted by various organizations validate the conclusion that problems of financial intermediation in the Kyrgyz Republic, including the high cost of finance and inadequate access to credit, are constraints to growth. Increased domestic savings, further financial deepening, and the development of the finance sector are therefore prerequisites for future growth.
A nationwide survey of 1,200 businesspeople conducted in 2011 ranked lack of access to finance as the third main obstacle to economic growth. Of those who ranked it as a key problem, 9% complained about high interest rates, 26% said that the lack of government financing was the biggest problem, 20% said it was the excessive collateral requirements, 17% said it was the lack of financial information, and 8% pointed to the lack of financial institutions in their regions. The International Business Council Investment Survey in 2012, covering 50 small, medium-sized, and large companies from over 15 sectors of the economy, also ranked “availability of finance” third among the top problems (International Business Council, 2012; World Bank, 2014). This survey in 2014, however, showed that finance factors such as interest rates and procedures for getting a loan ranked below the problems related to governance, property rights, and skilled personnel shortages (International Business Council, 2014).
According to the 2008 Business Environment and Enterprise Performance Survey, 21% of surveyed firms identified access to finance as a major obstacle, and 7% as a very severe obstacle. The 2013 Enterprise Survey revealed that 26.4% of firms considered access to finance as a major constraint. Against 17.7% of firms in manufacturing, 30.8% of the firms in services sector considered finance a major constraint. The same survey shows that access to finance was a more important problem for large and medium-sized firms (33.6% and 28.6%, respectively) than for smaller firms (20.6%). Interviews conducted by the ADB mission in Bishkek, Osh City, and five oblasts with more than 60 stakeholders, also confirmed these observations (ADB, 2014).
According to the World Bank report, Doing Business 2012, the global ranking of the Kyrgyz Republic for ease of getting credit was a surprising 8th out of 183 economies, while Moldova ranked 40th, Kazakhstan 78th, the Russian Federation 98th, and Tajikistan 177th, against the Eastern Europe and Central Asia average rank of 50th (World Bank, 2012). This ranking is based on a composite index of credit information sharing and legal rights of borrowers and lenders, and is focused on procedural issues such as the coverage of credit information. However, this component of the Doing Business index may not capture all aspects of business financing in the Kyrgyz Republic, such as the extent to which relevant laws and regulations are actually applied. Interestingly, the Kyrgyz Republic ranked 1st among 144 countries in legal rights in the finance sector, but its ranking for the other seven financial market indicators ranged between 131 and 139 (Schwab, 2013). Because external finance is costly or inaccessible, firms in the Kyrgyz Republic tend to rely on retained earnings.
To some extent, the availability of internal funds can relieve the constraint to financing. However, firms take time to accumulate sufficient internal funds to expand or to fund new ideas, and the firm’s reliance on internal funds may reduce their willingness to invest in innovations or take risks. Coupled with the evidence that access to credit differs substantially by sector, this reliance on internal funds also has implications for the inclusiveness of economic growth.
The Impact of the Real Exchange Rate and Foreign Reserves
The open economy dynamic of the Kyrgyz Republic makes it significantly vulnerable to external shocks. The country’s external trade is among the highest among the commonwealth of independent states (CIS) measuring up to 140% of the GDP in comparison to 78% average of the other CIS countries in 2010. Similarly, in 2012 trade amounted to 150% of the GDP in comparison to the average 100% for the CIS countries and 62% for the entire world (IMF, 2013). While this openness has attracted higher trade returns that other countries, it exposes the economy to various external shocks that can have negative impacts on the country’s current account stability (World Bank, 2015). The prevalence of fluctuations in commodity prices and changes in demand among partner countries are among the factors that can have significant impact on the economy and subsequently the current account’s sustainability. Since gold production dominate Kyrgyz Republic’s exports, it is responsible for more than 30% of the exported value of goods. Meanwhile, the country’s main exports include manufactured goods and commodities; therefore, these impacts prices on both import and exports in the Kyrgyz Republic (IMF, 2015).
During the fuel and food price shocks experienced in the 2007-2008 period, the prices for imports in the Kyrgyz Republic increased by 20%. These prices eventually receded in 2009 only to rise again in 2010 by 25% corresponding to global prices. The increase in prices of imports had a direct impact on the country’s current account given the resulting high import bill. The current account deteriorated to the extent of a 9% deficit of the GDP in 2008 (IMF, 2011). However, in 2010, the high gold prices mitigated the effect of higher import prices resulting in little effect on the current account balance. Import and export prices picked strongly in the period after 2009 and growth in prices was more than 18% and 14% in 2010 and 2011 respectively. The import and export prices fell by more than 1.5% in 2012 creating a violate trend that contributed to the current account imbalance that was reflected in the country’s economy. In spite of the volatility of import and export prices, the current account has remained in the negative position since 2006 (IMF, 2013).
In order to smooth volatility of the exchange rate, the NBKR increased its interventions in the foreign exchange market. The sharp depreciation of the Russian currency proceeded by the Russia-Ukraine conflict, economic and trade sanctions imposed against Russia and the subsequent economic slowdown in the region placed the Kyrgyz som under pressure. Since the NBKR has a policy to only intervene in foreign exchange market for the purpose of smoothing sharp fluctuations in the exchange rate, it increased its intervention beginning April 2014 and sold up to 9% of the international reserves (NBKR, 2014). The impact on the current account was stabilization from further deterioration; however, the current account continued to appreciate as the country’s exchange rate continued to stabilize and the currency began appreciating. This outcome is attributable to stabilization of the Russian ruble and the recovery of the regional economy towards the second quarter of 2014 (World Bank, 2014).
Nominal Exchange Rate Flexibility
The recent events in the Kyrgyz Republic characterized by fluctuations in prices of commodities and manufactured goods illustrated the need for a flexible exchange rate regime for the economy. The implementation of a policy for nominal exchange rate flexibility with enforces limited interventions towards smoothening of the numerous fluctuations is essential for the Kyrgyz Republic economy. While the prices increased in 2008 and 2010 and the current account balance continued to deteriorate, pressure in the exchange rate increased. Kyrgyz Republic’s authorities allowed the nominal exchange rate to depreciate in line with the policy of nominal exchange rate flexibility. The depreciation of the exchange rate aided in offsetting the negative outcomes of the shocks and strengthened the competitiveness of the country’s exports. The exports proceeded to gain market share through the fuel and food price increase period of 2007-2008 in spite of the problems arising from the political instability and closure of borders in 2010 (IMF, 2011).
The limited intervention of NBKR in the implementation of the flexible exchange rate regime has enhanced the country’s competitiveness in the region. The right exchange rate regime of the Kyrgyz Republic’s som is floating with tailored interventions to smooth instances of large fluctuations. The flexibility of the nominal exchange rate has served the Kyrgyz Republic effectively in the stabilization of external shocks while maintaining competitiveness. The depreciation of Kyrgyz Republic’s exchange during the global financial crisis that occurred in 2008 and beginning 2009 through 2011 has critical impacts on the current account balance. It sustained the growth of the country’s exports in a period that experienced weak external demand and significantly high domestic prices. The exchange rate was largely stable in the 2011-2012 periods in spite of the substantial widening of the current account deficits in 2012 (IMF, 2013).
The Real Exchange Rate
The impacts of a flexible nominal exchange rate have contributed towards making the real exchange rate stable in the Kyrgyz Republic. Since 2000 to the beginning of the fuel and food price increases period in 2007, the Real Effective Exchange Rate (REER) appreciated by a rate of 5%; however, as the shocks began, the country’s central bank intervened in the foreign exchange market with the aim of smoothing excessive exchange rate volatility in a time that prices were increasing. Consequently, the nominal depreciation did offset the imported inflation entirely; hence the REER appreciated by 22% between 2007 and 2008 (IMF, 2013). Beginning early 2009, the appreciation of the real exchange rate began to be reversed as the inflation receded. Although the current account deficit has widened significantly, the nominal; exchanged rate experienced 2% depreciation in 2012 with the support of strong capital inflows from official assistance. The NBKR intervened in 2012 in the exchange market given the low volume of net foreign exchange sales in contrast to those observed in 2011. However, the progressive current account balance deficits present a challenge for the stability of the balance of payment. Evidently, the large current account deficit that has persisted in the recent past illustrates that the Kyrgyz Republic has insufficient savings relative to investments that are supported by considerable external resources. Though supporting investment is essential for economic growth, the accompanying large current account balance deficit increases the country’s susceptibility to external vulnerabilities.
Reserves
The Kyrgyz Republic’s Gross International Reserves (GIR) has increased over six times in the last ten years even though from a significantly low base. Beginning with the initial amount of US $285 million in 2001, the international reserves have been increasing gradually since that period. By the end of 2012, international reserves had grown to US $ 20161million though the growth was at a much slower pace after 2011 (IMF, 2011; IMF, 2013). In spite of the initial low reserves for the country, the increasing build up of reserves illustrates the Kyrgyz Republic’s open economy, a favorable regional and international environment. The increasing gross international reserves have had the impact of reducing the current account balance deficit that continues to persist as a result of economic and political challenges that influence the country’s economic dynamic. In spite of the increase in positive growth of reserves, the growth reverted to negative digits immediately after the occurrence of the global crisis setting back further the country’s current account balance.
Kyrgyz Republic’s Gold exports, office development aid and remittances are among the key contributors to the country’s reserve accumulation. Evidently, gold exports that are largely supplied by a single foreign-owned entity make more than 25% of total exports of goods and services in the country. The other exported products include agricultural, chemical and textile products. More than 95% remittance inflow is derived from Russia amounting to more than 30% of the country’s GDP (IMF, 2013). In 2010, the political instability in the country led to high rates of emigration mostly to Russia leading to an increase in remittances. In addition, official development aid through project and program loans are among external inflows that contribute to the country’s reserves and have averaged 8% of the GDP in the last decade. However, imports of fuel and food are among the factors that drain the country’s reserves. The high cost of foods and fluctuating prices of fuel in addition to the decline in gold exports led to a decline in the country’s reserves in 2012 (IMF, 2013).
The country’s gold exports that make up close to 50% of the country’s GDP are the main sources of foreign reserves for the country (IMF, 2013). The foreign reserves have a significant impact on the country’s current account balance; however, the increase in foreign reserves that is expected to reduce the current account deficit is often counteracted by the heavy reliance on foreign reserves for the country’s fuel and food imports whose prices are always fluctuating making it unreliable in sustaining the current account balance as observed in the recent past. Though Gold exports, remittances and official development aid have an impact towards the reduction of the current account deficit; these are not enough given that the country imports all its fuel and a significant percent of consumables from other countries. The net effect is that the current account deficit imbalance continues to persist especially since the countries demand for imports is higher than its supply of exports to the global market.
Policy Recommendations
The implementation of mitigating measures towards the reduction of the current account deficit can be undertaken in various fronts. The fiscal approach recognizes that the Kyrgyz Republic’s economy faces a challenging situation especially as a result of the economic slowdown experienced in the region in the wake of the Russia-Ukraine crisis. It is necessary that the country pause its plans for fiscal consolidation with the aim of minimizing the impacts that shocks to the economy can have; however, fiscal consolidation can be resumed at a future date to mitigate the recent surge in the country’s debt levels. Since the country’s debt is currently sustainable, the authorities should ensure that it remains that way to prevent further in economic slump.
On the monetary aspect, Kyrgyz Republic’s authorities should implement measures for monitoring the increased inflation and tighten the policy rates as needed through the NBKR adjustments of the interest rate. Though the authorities have been allowing the currency to depreciate as a measure to absorb economic shocks, they have often intervened in the determination of the exchange rate with the aim to smooth volatility of the currency. This imitative has been effective since defeats the implications of a fixed rate that can result in loss of the country’s competitive edge and reserves.
The country should develop and implement a medium-term debt management strategy that would make adequate assessments of debts with the aim of maintaining it at sustainable levels. The country should restrict borrowing to only those projects that promote social development and enhance growth. In addition, this strategy would ensure that borrowing is anchored to the medium-term; hence ensuring that the current account deficit is not projected to longer periods and with the consistency in macro-economic stability, the deficit can be reduced significantly.
Infrastructure projects should be evaluated to determine their importance in order to make a decision whether financing will be derived from internal or external borrowing while assessing the affordability of interest rates. The country should execute public investments reviews that are geared towards the identification of infrastructural gaps and establishment of priorities while assessing whether investment projects are capable of enhancing growth. These measures will aim to increase national savings and reduce costs that contribute to the current account deficit.
Significantly, the Kyrgyz Republic should join the Eurasian Economic Union (EEU). The potential benefits from joining the union is that the country will include being part of a trading block that will remove those existing trade barriers between the member countries that include Russia, Belarus, Armenia, and Kazakhstan. In addition, the high level of exposure to external shocks experienced by the Kyrgyz Republic will be reduced once it becomes a member of the Union. Though the country may experience rising prices especially since it will be required to raise tariffs to the union’s levels, the long-term impacts are favorable for the country’s growth. In addition, joining the EEU will have a positive outcome for the current account since there will be more stable pricing mechanisms in both exports and imports reducing the persistent fluctuations in prices that contribute to the current account imbalances.
In spite of the Kyrgyz Republic’s immense endowment of hydropower, the electricity supply in the country is highly unreliable. Power interruptions, outages, and fluctuations in voltage are a daily occurrence that often impairs business and industrial process in the country. Even though electricity tariffs in the Kyrgyz Republic are among the cheapest in the world, the uncertainty of the power supply is among the most prevalent concerns of businesses, and a progressive barrier to growth. The whole power generation, transmission, and distribution system needs extensive and comprehensive physical rehabilitation. The country’s power system is also marred by incompetent and poor management, corruption, poor quality in service delivery, and underinvestment, and the lack of an effective and reliable regulatory. Essentially, it is a microcosm of the wider issues of governance affecting the country. It is evident that, critical power assets must be rehabilitated, and these should be allocated resources on a priority basis. Regrettably, the government has been spending resources and time and attempting to attract funding for new assets, rather than focusing on rehabilitation which could have higher returns in the medium-term and long-term. These could contribute significantly towards the realization of a positive current account balance through enhanced economic growth.
In addition, the escalating costs of finance, especially the limited availability are among the factors that have constrained economic growth and have kept the current account balance at negative digits. Kyrgyz Republic has a low level of total domestic savings that are estimated at approximately one third of GDP despite the significant inflows of remittances. Evidently, the decline in remittances contributes to the current account balance deficit. Therefore, it is recommended the country should limit its reliance on remittances as identify alternative sources of income.
Conclusion
Kyrgyz Republic is facing difficult development challenges. The country is trying to establish democracy while working to achieve stable growth in an uncertain economic environment. The challenges are exacerbated by the Kyrgyz Republic’s dependence on workers’ remittances and external assistance, and its limited resources, make the country even more vulnerable to risks and disruptions in the global economy. The future may be further complicated by the burden of short-term adjustments accompanying the country’s integration into the EEU Customs Union.
Similar to other developing countries, a number of constraints have hindered private investment and economic growth in the Kyrgyz Republic, and these are not limited to the binding constraints of corruption, poor infrastructure or political instability. However, unless the binding constraints are removed or alleviated, growth is unlikely to be ignited, making the current account to remain at negative digits. Therefore, the binding constraints must take priority. A more realistic assessment of the list of national investment projects is needed to see whether they represent the best possible use of resources, and whether the efforts to mobilize the resources to finance these projects are the most effective. Most of the megaprojects on the list are unlikely to generate many jobs in the long run, but they may contribute to the GDP during their construction phases.
Much of the Kyrgyz Republic’s transport infrastructure is in need of upgrading and rehabilitation. However, the existing infrastructure does provide workable links to neighboring countries and beyond, and has proven capable of handling major increases in traffic flows and international trade volumes, demonstrating the Kyrgyz Republic’s potential to be a key link in regional trade networks. For these reasons, the state of the country’s transport infrastructure is not viewed as a binding constraint to growth.

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