IFG Development Initiatives Ltd. 7 Portland Place, London W1B 1PP, United Kingdom Tel. (+44) (0)20 7038-3983 Fax. (+44) (0)20 7038-3984 Registered in England and Wales No. 3790692

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ASIAN DEVELOPMENT BANK

Report prepared for the Asian Development Bank under TA-4705 (KGZ): Support to Development and Implementation of NPRS-II.

Private Sector Development in the Kyrgyz Republic: Issues and Options

21 January 2007

Dr. Cyril Lin IFG Development Initiatives Ltd. (UK)

cyril.lin@developmentinitatives.com

No part of this report may be reproduced, cited or used in any form without the authorisation of the ADB and the Government of the Kyrgyz Republic.

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ABBREVIATIONS AND ACRONYMS ADB Asian Development Bank BEEPS Business Environment and Enterprise Performance Survey CAR Central Asian Region CDS Country Development Strategy (of Kyrgyz Republic) CIS Commonwealth of Independent States CPI Consumer price index CSPM (State) Committee for State Property Management CTC Chamber of Tax Consultants EBRD European Bank for Reconstruction and Development EURASEC Eurasian Economic Community FSU Former Soviet Union GATS General Agreement on Telecommunication Services IBC International Business Council IFC International Finance Corporation IMF International Monetary Fund IOSCO International Organisation of Securities Commissions IPO Initial public offering KAFC Kyrgyz Agricultural Finance Company KSE Kyrgyz Stock Exchange JCSS Joint Country Support Strategy JSC Joint-stock company LLC Limited liability company MCO Microcredit organization MOEF Ministry of Economy and Finance MOF Ministry of Finance (now integrated with MOEF) NBFI Non-bank financial institution NBKR National Bank of Kyrgyz Republic NGO Non-governmental organisation NOE Non observed economy NPRS National Poverty Reduction Strategy (of Kyrgyz Republic) NSC National Statistics Committee (of Kyrgyz Republic) PROMA Project Management Agency QUANGO Quasi-autonomous non-governmental organisation REER Real effective exchange rate SAFSA State Agency for Financial Supervision SAMC State asset management company SCSM State Commission on Securities Market SSC Savings and Settlement Company SME Small and medium enterprise SOE State-owned enterprise TCBD Tripartite Commission for Business Development WRD Water Resources Department WUA Water Users Association WTO World Trade Organization UNDP United Nations Development Programme

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TABLE OF CONTENTS Executive Summary Preface 1. CHALLENGES IN ECONOMIC DEVELOPMENT 1.1 The Imperative of Economic Efficiency and international Competitiveness 1.2 The Pattern of Economic Performance

1.2.1 Investment 1.2.2 Economic Structure and Diversification 1.2.3 External Sector 1.2.4 Productivity and Competitiveness

1.3 Recent Development Objectives 2. THE ECONOMIC LANDSCAPE AND PRIVATE SECTOR 2.1 Size and Role of the Private Sector

2.1.1 Agriculture 2.1.2 Industry and Infrastructure 2.1.3 The Financial Sector

2.2 The SME Sector 2.3 The Informal Economy 3. LEADING ISSUES IN PRIVATE SECTOR DEVELOPMENT 3.1 Agriculture and Industry

3.1.1 Agriculture 3.1.2 Mining 3.1.3 Textiles and Clothing

3.2 Infrastructure and Services 3.2.1 Energy 3.2.2 Transport and Communications 3.2.3 Tourism

3.3 External Sector 3.4 Financial Markets 3.5 Business Environment and Investment Climate 3.5.1 Voice of the Business Community 3.5.2 Government Initiatives 3.6 Privatisation Policy 4. OPTIONS IN PROMOTING PRIVATE SECTOR DEVELOPMENT 4.1 The Problematic in Private Sector Development 4.2 Private Sector Development Strategy 4.3 Establishment of a Tripartite Commission for Business Development 4.4 Strengthening Oversight in Public Administration and Implementation 4.5 State-Owned Holding Company 4.6 Accelerated Privatisation of Infrastructure 4.7 Strengthening the Regulatory Framework for Competition 4.8 Accelerated National Privatisation Programme 4.9 Economic Diversification and Export Development 4.9.1 Interindustrial and Interregional Policy Analysis 4.9.2 Rural Market Infrastructure Development and Long-Term Financing 4.10 Local Pilot in Improving the Business Environment Appendices References

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List of Tables and Boxes Table 1: Selected Transition and Economic Performance Indicators for the Central Asian Region, 2005 Table 2: Key Macroeconomic Indicators, 1991-2005 Table 3: Indices of Output Recovery, 1990-2004 Table 4: GDP and Sectoral Growth Rates, 1991-2005 Table 5: Sectoral Composition of GDP and Structural Change, 1995-2005 Table 6: External Sector Development, 2001-2005 Table 7: Productivity and Competitiveness Indicators Table 8: CDS Macroeconomic Development Targets, 2006-2010 Table 9: State and Private Sector Shares of GDP, 2004 Table 10: Share of SMEs in GDP and Sectoral Output, 2000-2005 Table 11: SME Sector Employment, 2001–2005 Table 12: Regional Distribution of SMEs, 2004 and 2005 Table 13: Mining Industry Development Impact Scenarios Box 1: Summary of Selected Findings in the UNDP Informal Economy Study Box 2: Summary of Issues and Options in Trade Promotion Box 3: INEXIMBANK: Issues in Growth of Lending Box 4: IBC Business Agenda: Priorities for Improving the Economy (Summary) Box 5: Recent Legal Reforms in Business Environment Table and Boxes in Appendices Table A1: Macroeconomic Performance Indicators 2001-2005 Table A2: Commodity Composition and Direction of Trade (% distribution) Table A3: Privatisation by Sector and Types of Property, 1995–2006 (cumulative) Table A4: Share and Sectoral Distribution of Private Sector Employment, 2000 and 2004 Table A5: Enterprises by Size of State Shareholdings and Sectors, 2006 Table A6: Percentage of Privately-owned SMEs, 2002, 2004 and 2005 Table A7: Number and Sectoral Distribution of SMEs, 2000–2005 Box A1: Summary of Findings from National Business Opinion Survey (May 2004)

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PREFACE This report has been prepared as an update to the ADB’s Private Sector Assessment (PSA) for the Kyrgyz Republic completed in 2003. The preparation of PSAs (as well as country governance assessments) for borrowing member countries is an ADB Board requirement. The purpose of a PSA is to describe the status and dynamics of private sector development, identify the key issues and constraints and propose interventions which could inform the development of the ADB’s country strategy and programme. This update to the PSA for the Kyrgyz Republic, however, has the additional purpose of providing inputs to the formulation of the Joint Country Support Strategy (JCSS) for the Kyrgyz Republic that is being developed jointly by a number of donors including the ADB. For this reason, the discussion of national economic development issues and some sections dealing with private sector issues in various sectors of the real economy are somewhat longer than is usual in typical ADB PSAs. This report is based largely on a desk review of existing reports, documents and other literature on the Kyrgyz economy prepared by various donors (principally the World Bank, IMF and the ADB), the Government of the Kyrgyz Republic and business associations in the Kyrgyz Republic. Most of the economic statistics used in the report were provided by the National Statistics Committee and other relevant economic agencies of the Government of the Kyrgyz Republic. The report is also based on information collected during two fact-finding visits by the author to the Kyrgyz Republic (in May and September 2006). The author wishes to express his gratitude to all those from the Government, donor and business community that met with him during his field visits. The author wishes in particular to thank the staff of the ADB Resident Mission who provided invaluable assistance for the preparation of this report, as well as Ms. Hartova and Mr. Hasanov who, as domestic consultants on this assignment, helped the author to obtain essential factual information and gain a better understanding of the Kyrgyz economy. Any error or omissions are of course the responsibility of the author’s alone. The views expressed in this report are those of the author’s and may not necessarily reflect those of the ADB, its Board or officials.

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EXECUTIVE SUMMARY Challenges in Economic Development The challenges faced by the Kyrgyz economy are more formidable than in most transition and emerging market economies because of the country’s physical and economic characteristics of a small domestic market, remote geographic location and relatively poor natural resource endowment. Its need to rely on foreign direct investment (FDI) and export-led growth means that it must achieve levels of productivity and international competitiveness that are appreciably higher than its competitors in the region (who have better natural resources) and elsewhere to compensate for its adverse initial conditions. Economic efficiency is similarly compelled by the country’s need in the long-term, again due to its resource conditions, to rely on technology-intensive and higher value-added production for a process of intensive growth (based primarily on increased factor productivities) rather than on extensive growth (based largely on increases in factor inputs). However, the stylised facts of Kyrgyz economic performance since positive growth resumed in 1996 strongly suggest that the imperative of economic efficiency and international competitiveness has yet to be fulfilled. The country’s record in market transition in terms of institutional change is one of the best in the region and among transition economies. Yet its growth record is one of the weakest. This paradox can be explained in part by its adverse initial conditions and shortcomings in economic policy. However, it is explained mainly by structural and institutional factors: namely, low levels of economic efficiency and competitiveness in a weak private sector which now dominates the national economy. In analytical terms, weaknesses in the private sector can be conceptualised as a consequence of an inefficient and dysfunctional market mechanism that is manifested in a poor business environment and investment climate. The country economic under-performance is evident from its pattern of development. GDP growth betrays a declining tendency with the average annual growth rate declining from 5.7 percent in 1996-99 to 4 percent in 2000-05. GDP and sectoral growth rates display sharp annual fluctuations even if external shocks (such as the Russian financial crisis in 1998) and the volatility of gold output are factored out. The level of investment is low at 19.3 percent of GDP in 2000-05, financed to a significant extent by official foreign borrowing that has led to a large external debt. FDI was significant in the late 1990s but have since slowed considerably. The lack of economic diversification means that the economic base remains very narrowly and highly concentrated in a handful of sectors. The process of de-industrialisation following the collapse of the Former Soviet Union (FSU) has yet to be reversed with industrial output (including gold) in 2004 still over 50 percent below the pre-independence level. The growth rate of manufacturing (excluding gold) been sluggish at 0.2 percent in 1996-99 and 2 percent in 2000-05, or at annual rate of just over 1 percent during the entire period. The under-performance of the external sector is evident from one of the lowest total trade/GDP ratio in the region. A very low level of labour productivity has rendered the Kyrgyz economy uncompetitive despite low nominal wages and an improved real effective exchange rate (REER). Labour productivity has grown at only one-third the average rate for several of its competitors in the region. All these shortcomings reflect, and are a result, of a weak private sector that has been unable to deliver supply responses to exploit more fully the growth in domestic demand and especially in external demand from rapidly growing neighbouring economies. The recent address to the nation by the President of the Kyrgyz Republic on 28 September 2006 and the draft Country Development Strategy (CDS) set ambitious development targets

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for the 2006-10 period. The rate of (investment and export-led) GDP growth is to accelerate to an annual average of 7.5 percent with corresponding acceleration in the rates of investment and exports. The targeted growth rates for output, investment, productivity and exports have never previously been attained in the Kyrgyz Republic. A shortfall of $4 billion in the financial resources needed to underwrite the development efforts in 2006-10 is to be met overwhelmingly through increased private and foreign investment. The efficiency and productivity gains as well as the increased levels of investment that will constitute the main source of growth are contingent upon improving the business environment and investment climate for private sector firms. Achieving the ambitious development targets will therefore depend on the extent to which the potential of the private sector can be harnessed. The Private Sector and Economic Landscape The private sector in the Kyrgyz economy now accounts for 75 percent or more of GDP and about 80 percent of national employment. The agricultural and service sectors are overwhelmingly private, with over 90 percent of output in agriculture and in key service sub-sectors such as trade, repairs, hotels and restaurants accounted for by the private sector. But the state sector remains significant in industry and dominant in infrastructure due to repeated delays in the implementation of plans for their privatisation. Almost all of infrastructure remains fully or majority state-owned, with the “big four” state-owned infrastructure enterprises (Kyrgyz Telecom, Kyrgyz Energy, Kyrgyz Gaz and Kyrgyz Airline) together reportedly accounting for 80 percent of the country’s total capital stock. Almost all mines (except for a few in gold mining) remain owned or controlled by the state. Numerous SOEs regarded as strategic, defined using out-dated Soviet-era concepts, are still exempted from privatisation. The size, role and impact of the state sector in the national economy are greater than suggested by its 25 percent share of GDP. Aside from production of goods and services in state-owned enterprises, a large “informal and extra-legal state economy” operates through the country governance and public administration apparatus where extensive rent-seeking and corruption occur. Part of this apparatus in a sense has been hijacked by some politicians and poorly paid civil servants, and transformed into an effectively stealth state economic sub-sector for private and illegal gains. This stealth but sizeable state economic sub-sector, with an excessive regulatory regime used and abused for rent-seeking, official corruption and political patronage, crowds out the private sector and distorts the functioning of the market mechanism. The financial sector is now also almost entirely private but the sector is small and shallow with a low level of intermediation. The sector comprises essentially the banking system where 20 of 21 commercial banks are privately owned and account for 95 percent of sector assets at end-2005. The level of foreign participation in Kyrgyz commercial banks is very high with 15 banks having foreign shareholdings. The one state-owned bank, the Savings and Settlement Company (SSC), is mainly engaged in payment, transfer and savings services but accounts for about half of all bank accounts in the country. It is scheduled for privatisation in 2006 but this is unlikely to occur for another few years. The small and medium enterprise or SME sector, which is almost entirely private, grew dramatically in number by 160.5 percent between 2000 and 2005 with the increase due almost entirely to growth in the number of individual entrepreneurs and farms. There is a trend towards increasingly smaller scale of operations, compelled by an adverse business environment which becomes worse as the size of economic entities increases. The SME sector’s share of GDP grew only very slightly from about 43 percent in 2000 to 43.6 percent in 2005. Excluding farms, SMEs accounted for the major share of sectoral output in agriculture and services but for only a small share in industry and communications, reflecting the dominance in these sectors by large enterprises which are mainly state-owned. Despite its not

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insignificant contribution to output, the sector (excluding farms) accounted for only a relatively small share of national employment at 12.6 percent of total employment. A recent UNDP study estimates the informal sector at 45 percent of GDP. Among the study’s findings were that most enterprises in the formal sector conceal and under-report part of their actual volume of economic activities, incomes and wage bill to avoid punitive taxes and social fund contributions, and to escape from an excessive state regulatory regime which is increasingly an obstacle to business as the size and scale of operations increase. Official corruption, together with tight inspections and supervision by the state, were key factors compelling enterprises to engage in informal activities and to remain small. Leading Issues in Private Sector Development The fundamental problematic in private sector development in the Kyrgyz Republic is a dysfunctional market mechanism, due primarily to excessive state intervention and shortcomings in public administration, that is manifested in a poor business environment and investment climate. This is the fundamental first-order constraint to private sector development generic to all sectors and spheres of the national economy. Some other constraints, such as the lack of finance, infrastructure weaknesses and poor management and marketing skills, are also generic to the national economy while others are specific to sectors, such as irrigation and water resources in agriculture. But these are basically second and third order problems whose resolution cannot be substantively achieved without an improvement in the business climate. Although the share of agriculture in GDP is now smaller than services, it remains the foundation of the national economy because of its major role in providing employment, food security and consumer price stability. Recent deceleration in the agricultural growth rate needs to be reversed by raising factor productivity and crops yields as well as development of the considerable potential in agri-businesses in food, cash crop and horticultural processing that provide inputs for light industry and opportunities for exports. This will involve diversification towards high value-added production and a wider range of better quality processed products. Achieving these objectives require improved water management and irrigation services, development of the value chain and rural market infrastructure, strengthening private property rights in land ownership and facilitating sale and use of land as collateral. These measures are highlighted in the draft CDS and many are already being supported by donors. The mining industry is dominated by one metal (gold) at one mine (Kumtor) whose quarry reserves has been exhausted since 2004 and where gold production will cease in a few years’ time. The authorities believe that the country has rich mineral resources that offer significant development opportunities. However, the actual potential remains to be more rigorously and independently verified. Low level of private and foreign investments in the sector (outside gold) may be due to its poor commercial prospects, but it has also been hampered by serious shortcomings in the legal framework governing exploitation of resources (including inadequate safeguards on and enforcement of property and contractual rights) and widespread corruption. State mining companies dominate the industry and enjoy subsidies and preferential treatment from the state. The Government now intends to fully privatise through competitive sales sub-surface resources to encourage foreign investment. In the energy sector, the coal industry is highly inefficient and its development is constrained by backward technology and high cost of transport to markets and final users. The industry runs at a loss and is subsidized through the state budget. Initial restructuring measures did not improve the efficiency and financial performance of the energy industry because of incomplete restructuring and privatisation, the failure to adapt to a market or

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commercial orientation in management and operations and weaknesses in the legislative and regulatory framework. Energy losses due to thefts and inefficiencies in transmission amount to over 40 percent of output. The huge accumulated quasi-fiscal energy deficit amount to 7.6 percent of GDP in 2005. The authorities’ stated long-term objective for the energy sector is to eradicate losses and achieve energy security by 2025. Achieving this objective will require privatisation most likely to a foreign strategic investor who can recapitalise and restructure the industry and introduce modern market and commercially-based management methods. No regional energy cooperation arrangement is in place, with each Central Asian Region (CAR) country seeking to use its own energy and water resources domestically although a joint use and trade of these resourced would yield greater mutual economic benefits. Exports of hydropower to countries within and outside the region will require huge investments in new generation and transmission facilities as well as regional and bilateral agreements on transit facilities and access. The Kyrgyz Republic currently lacks a single authority for the development of the fuel and energy complex. It is difficult to see how the energy sector can be developed without progress in privatisation. The authorities’ objective for the development of telecommunications focuses on high-tech telecommunication and internet services that would accelerate the integration of the country into global information systems. The privatisation of Kyrgyz Telecom is to be accelerated. The poor road transport infrastructure is one of the most serious constraints to economic development. The main transport corridors are in generally poor condition and results in high freight transport costs that add considerably to production and marketing costs. The main objective in transport development, as stated in the CDS 2006-10, is to improve access to both regional and local markets. Funding for road transport development, however, will continue to face severe constraints with donor contributions meeting large shortfalls in domestic in investment resources. An ADB-supported strategy for the road transport sector suggests that the priorities should lie in maintenance with increased participation of private sector contractors. Private investment in the sector should also be encouraged through modalities such as toll roads. Under the draft CDS 2006-10, the service sector is planned to grow cumulatively by 150 percent during 2006-10 and to account for 45 to 47 percent of GDP. The share of trade is targeted to increase from 43 percent of sectoral output in 2005 to 53 percent in 2010. The challenges in the development of the external sector in the Kyrgyz Republic are two-fold: first, more effective and fuller exploitation of existing opportunities, and second, development of new opportunities and markets through greater economic diversification. Crucial to meeting both these challenges is raising enterprise efficiency and international competitiveness, accompanied by significant improvements in the soft infrastructure relating to policy, regulations, standards, etc., and in the hard or physical infrastructure for trade such as transport and warehousing. External barriers to integration into regional and global markets are formidable due mainly to prohibitive transit and transport costs, both formal and informal. Safeguard measures and technical barriers, which are pervasive in CIS countries and elsewhere, remain potentially problematic. They will need to be addressed before they become binding constraints as Kyrgyz exports begin to – as they need to do so – diversify into non-preferential markets and/or embody a higher level of processing. Domestic policies that have impeded exports, such as a tariff schedule creating distortions for certain sectors, customs administration, excessive and cumbersome standards regime and weak regulatory capacity in services administration also need to be addressed. The World Bank recommends that the Kyrgyz Republic’s membership of WTO and the Eurasian Economic Community (EURASEC) should be leveraged to address domestic and external foreign trade constraints.

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Underdeveloped and inefficient financial markets in the Kyrgyz Republic are both a cause and consequence of a weak corporate sector in the country. The banking sector is characterised by a segmented and underdeveloped banking system, small deposit base and insufficient progress in improved enforcement of a basically sound regulatory and supervisory framework. Incentives for firms to operate in the informal sector and outside the banking system result in low monetary depth and high costs of bank lending. The Kyrgyz ratio of banking assets and deposits to GDP is among the lowest for transition economies and in Central Asia. The low level of intermediation is largely explained by supply side constraints: a low funding and depositor base due to the lack of confidence in the banking system and reluctance of businesses to operate in the formal sector which would make them liable to a high tax burden and an excessive regulatory regime. The cost of creating collateral in the Kyrgyz Republic is one of the highest in the world (at 12.4 percent of per capita income) and foreclosure procedures are unpredictable because of weaknesses in the judiciary and official corruption. On the demand side, the financial health of many Kyrgyz businesses are weak and most lack the financial and business track record and information to render them eligible for low cost finance. The problem of adverse selection is pervasive and applies throughout the entire economy. Aside from strengthening enforcement in regulation and supervision, measures needed to develop the banking system include those that would: (i) increase the availability and quality of financial information; (ii) enhance competition which could lower borrowing costs as well as improve services and product ranges (iii) improve banking technology and skills of commercial banks in credit and risk management and in developing and managing a wider range of financial products and services; and (iv) enhance confidence by introducing a formal deposit insurance system once banking sector legislation, regulations and enforcement are strengthened. The microfinance sector will need to go through a process of extensive consolidation and to develop its capacity in mobilizing savings to ensure a sustainable basis for credit provisions. Capital markets have hardly developed in the Kyrgyz Republic and play a negligible role in financing. The development of the securities market in the Kyrgyz Republic is constrained by a weak regulatory and supervisory framework, the lack of firms suitable for listing, poor corporate governance and tax disincentives. The country at present does not comply with any of the 30 principles set by the International Organisation of Securities Commissions (IOSCO) on investors’ protection and mitigation of systemic risks. Tax policies appear to be deliberately designed to enable government securities to crowd out corporate securities. Development of non-bank financial institutions (NBFIs) such as insurance, pension and investment funds, and of the capital market can only occur if there is a developed and well-regulated capital market (especially in fixed incomes necessary for pension funds and insurance companies to minimise risks). The constraint to securities market development is primarily on the supply side: a weak corporate sector with very few profitable firms with strong growth prospects. Private firms operate within a business environment and investment climate that is not just poor, but is hostile and adverse to entrepreneurship. Although basic market-based economic and legal institutions have been established (albeit often in a formal rather than in a substantive manner), a Soviet-era system of administrative micromanagement and economic controls has been retained and public administration is weak. In reality the plethora of extensive state regulations and controls results in little effective enforcement of standards because they are mainly used for rent seeking and corrupt practices that allow firms to evade regulations. The result is that business often operates in a more or less effectively wild environment. Kyrgyz business is equally at fault as officials for extensive corruption. Transparency International ranks Kyrgyz Republic as one of the most corrupt countries in the world, at 118th and 126th places in 2003 (out of 133 countries) and 2004

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(146 countries) respectively. The Kyrgyz Republic’s ranking fell further from 134th position (out of 158 countries) to thev145th position (out of 163 countries) between 2005 and 2006. Enterprises held hostage to an overbearing and corrupt system of state regulation have to succeed not because of such an environment, but in spite of it. The World Bank’s (2006) Doing Business Report for 2005 found that the Kyrgyz Republic ranked 84th out of nearly 150 countries in ease of doing business. The country’s overall ranking is creditable, but the real issue is whether this is sufficient to enable to Kyrgyz enterprises to attain levels of productivity and international competitiveness necessary to attracting FDI and to achieve vigorous export growth. The Economic Forum on Removing Barriers to Business held in May 2006 in Bishkek highlighted the main obstacles to business as: (i) excessive and extreme government interference in business activities; (ii) an excessively large corpus of laws, regulations and rules; (iii) a growing multiplicity of regulatory bodies, with an unjustified growth in their functions and powers; (iv) growth in number of inspections, leading to the subordination of laws to secret rules and private arrangements; (v) high cost of market entry, due to cumbersome registration procedures and processes, resulting in growth of rent-seeking and the informal economy as well as weakening market competition; and (vi) extensive infringements of private property rights. The priorities for Government action according to the Kyrgyz business community include: reform of tax system and reduction in tax rates; eradication of official corruption and bribery; reduction in number of business permits required; greater availability of cheaper finance; and reduction in number of inspections. Among businesses engaged in exports, the priorities are simplifying customs and transit controls, easier access to foreign markets and timely and reliable reimbursement of VAT for exports. Options in Promoting Private Sector Development Most Kyrgyz policy-makers are aware – often more so than the international financial institutions (IFIs) and foreign experts – of the issues and constraints in the country’s private sector development and the policies and measures needed to address them. Although policies and measures have tended to be piecemeal, lacking priorities and sequencing, the key problem is weak policy implementation. The options proposed in this report are therefore mainly focused on mechanisms and modalities that could increase the effectiveness of policy implementation in improving the business environment and investment. In descending order of priority, these options are as follows.

(i) The formulation of an integrated and holistic private sector development strategy, with a single Government agency or a non-governmental body tasked for this purpose, which would clarify key objectives, prioritise and sequence policies and measures and facilitate coordination and monitoring of policy implementation. An overall objective in the strategy could be the attainment of improved indicators of the investment climate set out in the draft CDS.

(ii) The creation and mandating of a Tripartite Commission for Business

Development (TCBD) as a semi-autonomous Governmental body, enjoying an arms length relationship with the Government and insulated from political interference, to formulate and implement selected and specific policies aimed at improving the business environment and investment climate. In addition to other responsibilities, the TCBD could be delegated with monitoring progress in implementing the private sector development strategy and with resolution of official and other malpractices undermining the efficient functioning of businesses

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and private/foreign investment.

(iii) The strengthening of an independent mechanism for the oversight of the performance of public administrative bodies, empowered to assess the performance (performance audits) and effectiveness of the main agencies with responsibilities in areas with the greatest impact on the business environment such as tax and customs administration and the standards regime. This initiative could involve the strengthening of the Chamber of Accounts in terms of its political independence, operational autonomy, institutional capacity and the widening of its current mandate.

(iv) The creation of a state-owned holding or asset management company,

operating without political interference on a purely commercial basis, to improve the Government’s capacity to exercise its ownership and corporate governance rights and functions in fully and partially state-owned firms. The mission of the state holding company (SHC) would be to maximise shareholder value for the state, with state-invested companies subject to international best practice in corporate governance and full market discipline. Investments to be undertaken through the proposed Government’s Development Fund could be undertaken through the SHC. Such an initiative would be contingent upon a Government commitment to accelerate the privatisation of infrastructure and other industries.

(v) An accelerated programme for the privatisation of key infrastructure

industries, based on a more market-oriented paradigm and methods and modalities of divestiture including public-private partnerships (PPPs). Under this initiative, a staged process of divestiture would aim to maximise value creation in partially divested enterprises rather than on securing maximum proceeds from initial sale. This initiative could include donor assistance in a pilot PPP for a selected infrastructure enterprise involving a foreign strategic investor.

(vi) The strengthening of the regulatory framework for competition, involving the

development of competition policy and the legal framework as well as clarifying the respective responsibilities and functions between the Anti-Monopoly Committee (or a newly created overarching competition agency) and industry regulators. The focus of this initiative would be on strengthening regulation in the infrastructure industries to be privatised.

(vii) An expanded and accelerated programme of privatisation of other

industries. This initiative is aimed at the full divesture of state ownership in all non-essential enterprises and industries, with technical assistance provided to enable the Government to determine the most appropriate modalities for privatisation and mechanisms for mitigating the social impacts.

(viii) Support for the development of value-chains and rural market infrastructure

to promote economic diversification and exports, comprising assistance to strengthen inter-industrial and interregional economic policy analyses and a facility for long-term financing for SMEs engaged in these activities.

(ix) A pilot at the local level to improve the business environment and

investment climate through integrated and cross-cutting reforms which could also assist the Government in developing the governance and public administration reforms necessary for the decentralisation of economic decision

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making to local levels of government, in line with the national decentralisation strategy.

The proposed options are intended to form a single, coherent package which could serve as components of a discrete ADB programme of assistance focused on private sector development. They should be seen as complementing initiatives to enhance private sector participation being undertaken (or scheduled) through various sectoral development strategies and projects. The proposed initiatives are inter-related and mutually-reinforcing, with potential synergistic and multiplier effects. They are presented in this report in the form of concepts that will need to be developed into operational projects should the ADB and the Government decide to pursue them further.

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1. CHALLENGES IN ECONOMIC DEVELOPMENT The Kyrgyz Republic faces formidable challenges in achieving robust and sustainable economic growth in the long term. These challenges are more formidable in the Krygyz Republic than in most other transition and emerging market economies due to the peculiarities of the country’s initial conditions in terms of size, geography and natural resource endowment. The economy is in a sense caught in a low-level equilibrium trap, characterised by a vicious circle of sluggish growth rates, low levels of investments, economic efficiency, productivity and international competitiveness. The economy is often finely balanced on a knife-edge where poor performance in one single sub-sector (gold) in has a disproportionately large and amplified adverse impact on the GDP growth rate. The central arguments of this report are that the Kyrgyz economy in general, and the private sector in particular, has under-performed and that this under-performance is characterised and caused by poor levels of efficiency, productivity and international competitiveness that are attributable to an inefficient and dysfunctional market mechanism that is manifested in a poor business environment and investment climate. Weaknesses in the Kyrgyz economy are essentially equivalent to weaknesses in the private sector that now dominate the national economy. The underlying problematic in private sector development is the pervasive and excessive role of the state. Although the private sector now accounts for 75 percent of official GDP in the Kyrgyz economy, the size, role and impact of the state sector in the national economy is greater than indicated by its 25 percent share of GDP. Aside from production of goods and services in state-owned enterprises, a large but hidden or informal “stealth” state economy operates through the country governance and public administration apparatus. Part of this apparatus has been hijacked by some politicians and poorly paid civil servants and transformed into an effectively stealth state economic sub-sector for commercial and illegal gains. This stealth but sizeable state economic sub-sector, with an excessive regulatory regime used and abused for rent-seeking, official corruption and political patronage, crowds out the private sector and distorts the functioning of the market mechanism. The economic predicament in the Kyrgyz Republic is serious and failure to resolve it in a committed, tenacious and effective fashion could lead to increased political and social instability. But just as a cloud may conceal a silver lining, the counterpart of this harsh overall assessment of the Kyrgyz economic situation is that the latent potential of the Kyrgyz economy – and of the private sector in particular -- remains largely untapped. The economy is operating at well below potential, and relatively straightforward and obvious policy and institutional reforms – if effectively implemented – can deliver very sizeable reform dividends in the form of sustained and robust growth in GDP and living standards. 1.1 The Imperative of Economic Efficiency and International Competitiveness The Kyrgyz Republic was one of the poorest republics in the former Soviet Union (FSU). Its pre-independence economic system was configured as an appendage of the FSU economic machine upon which it was highly dependent for intermediate inputs, markets and net financial inflows. Following the dissolution of the FSU, the Kyrgyz Republic suffered a collapse in national output of nearly 50 percent and in industrial output of 73 percent. It also suffered losses of 7.5 percent of GDP in tax revenues and direct fiscal transfers from Moscow of about 13 percent of GDP. The transformational recession in the country was one of the most severe not only among the Commonwealth of Independent States (CIS) but also in modern economic history. The economic system inherited from the FSU period was inefficient, technologically backward and structurally ill-equipped to compete in an

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increasingly globalised international economy. De-industrialisation in the post-independence period resulted in a very narrowly based economy dominated by agriculture and a handful of services sub-sectors. Structural imbalances and disproportions in the national economy were further exacerbated by a significant deterioration of the physical infrastructure, particularly in the transport and energy sectors. To achieve sustainable and robust growth in the long-term, the Kyrgyz economy faced the twin challenges of systemic transition to a market economy based on private ownership and of a comprehensive restructuring and rebuilding of its industrial system. These challenges are not different from those faced by other transition economies. But it is important to stress that these challenges are significantly more formidable in the Kyrgyz Republic because of the country’s unfavourable initial conditions in terms of the small size of its economy, its remote and inaccessible geographic location and its relatively poor resource endowment. Some countries in the region face one or two of these unfavourable characteristics, but only the Kyrgyz Republic faces all three. The Kyrgyz Republic’s small population of just over 5 million means a very small domestic market and limited potential in economies of scale in production. The country needs to rely primarily on exports as an engine of economic growth, yet its land-locked geographic position poses significant problems in international trade and transport. The Kyrgyz Republic, however, is surrounded by Kazakhstan, Russia and China whose economies are growing rapidly and offer major export opportunities for the country. But these countries are major producers of commodities that comprise the Kyrgyz Republic’s traditional exports. Exploiting these and other markets is therefore contingent upon the ability of the Kyrgyz economy to diversify its economy and export structure, and to raise its international competitiveness. Trade and transit in the region are also hampered by weaknesses in both the physical and policy (or soft) trade infrastructure, with some of its neighbours adopting explicit or implicit protectionist measures. Security problems have also exacerbated difficulties in regional trade and cooperation. In both absolute terms and relative to its competitors in the region, the Kyrgyz Republic is resource-poor. Reserves of oil, gas and coal are small and their shares of industrial output are miniscule at 1.1 percent and 0.5 percent respectively of (an already small total) industrial output in 2004. The country’s two major natural resources are gold and hydropower. However, quarry reserves in the country’s main gold mine, Kumtor, have been exhausted since 2004 and output is expected to cease in 20081. The potential for exports of its sizeable hydropower resources is limited not only by the fact that many of its immediate neighbours (such as Kazakhstan and Russia) are abundant in and are net exporters of energy, but also by difficulties in regional cooperation in energy. Huge investments in generation and transmission infrastructure will be needed to tap potential export markets elsewhere. The lack of foreign direct investment (FDI) to this sector to date may be due in part to the lack of privatisation and a poor investment climate, but it could also mean that private investors regard the sector as lacking in commercial prospects. Despite the authorities optimistic expectations, the extent to which this sector can attract sizeable FDI and become a major source of economic growth remains unclear. The most promising prospect lies in regional energy cooperation schemes, which, for example, could develop facilities for energy transmission from Central Asia to South Asia. A number of governments, international financial institutions (IFIs) and private investors have expressed interest in such an initiative. These characteristics define the basic challenges in Kyrgyz’s economic development. Enhancing the country’s export potential will require, amongst other things, the development

1 Efforts are being made to develop deposits at Taldy-Bulak, Levoberezhnyi, Kuran-Zhailoo and Jerui but their reserves are uncertain.

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of an internationally competitive and diversified industrial structure. FDI is essential to this effort not only to overcome the constraints of severely limited domestic financial resources to meet the huge investments needed, but also as a means of technology transfer, management development and access to export markets. Attracting FDI, however, poses the greatest challenge for the country. Aside from location-specific investments in infrastructure which serves a captive (albeit small) domestic market, why should foreign business invest in the Kyrgyz Republic when the country lacks a competitive edge in terms of a sizeable domestic market for manufactured products, favourable geographical location for trade and transhipment or abundant natural resources? Given this predicament, the most effective means through which the Kyrgyz Republic can meet the challenge in competing for FDI is to gain a competitive edge in terms of providing investors with a superior economic policy and institutional environment that can offer higher returns through higher levels of productivity and a more attractive business environment compared with its competitors in the region. This strategy, however, can only succeed if the business environment and investment climate in the Kyrgyz Republic is markedly superior such that the benefits or rewards from investing in the country outweighs the potential risks of investing in an economy with the unfavourable physical characteristics described above. In other words, a business environment in the Kyrgyz Republic that is simply comparable to or just as favourable as its competitors in the region would not be sufficient to gain the country the competitive edge necessary in competing successfully for FDI, since its competitors enjoy inherent advantages of better resource endowments and larger internal markets2. It is important to emphasise this point because its competitors in the region have had greater success in attracting FDI despite broadly similar or even marginally worse business environments3. Economic efficiency is also singularly critical to the Kyrgyz Republic’s long-term growth prospects because of the country’s small population and scarce natural resources. Its resource endowment means that long-term growth has to be of an intensive nature, i.e., growth based primarily on increased factor productivities, as opposed to an extensive pattern of growth based primarily on growth in factor inputs. The relative scarcity of labour, land and natural resources implies that in the long term economic growth will need to be increasingly capital and technology intensive, characterised by efficient resource use, high qualitative levels of human capital and labour productivity. The Kyrgyz Republic therefore needs to gain a competitive and comparative advantage through high levels of labour productivity in selective industries that can out-perform labour surplus, low labour cost economies such as Uzbekistan in the region and China and India further afar. In the short term this will invariably be in low-skilled labour-intensive activities such as agri-business, textiles and other light manufactures. In the medium and longer term, however, the country will need to rely more on technology intensive and higher value-added production in which a high level of human capital and economic efficiency is a prerequisite. The pace of progress from low to high value-added activities and from labour to technology/capital intensive production will need to be fairly rapid given the fact that its regional competitors (such as Kazakhstan, Russia and Azerbaijan) as well as global competitors (such as India and China) are already ahead or making faster progress in this transition.

2 Investors making a risk-reward calculus will seek a higher reward to compensate for a higher risk premium in investing in the Kyrgyz Republic due to the country’s unfavourable physical characteristics. 3 As will be discussed in later sections of this report, World Bank and EBRD surveys of business environments show that the Kyrgyz Republic compares favourably with its regional competitors in a number of business environment indicators. Despite this, the level of FDI in the Kyrgyz Republic is one of the lowest in the region.

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While efficiency and international competitiveness are essential to all economies in the long term, the analysis above suggests that they are far more critical – and needed earlier in the development process -- in the Kyrgyz Republic because of the country’s physical and economic peculiarities. Economic efficiency is contingent upon the effective functioning of competitive markets, based on private ownership, conducive to resource allocative efficiency at the macroeconomic level and X-efficiency or efficiency in the use of inputs at the level of the firm. The imperative of achieving high levels of economic efficiency in the Kyrgyz Republic therefore translates into an imperative for creating a policy and institutional environment that allows competitive markets and private firms to operate efficiently. The extent to which progress is made in developing an efficient market mechanism and private sector is a key determinant of the Kyrgyz Republic’s economic performance. The stylised facts of the Kyrgyz Republic’s economic performance since independence, however, strongly suggest that the country has made insufficient progress in improving its level of economic efficiency and international competitiveness to enable it to realise more fully its growth and export potential. Its record of market transition presents a curious paradox. The country made significant and impressive progress during the immediate post-independence period in laying the foundations of a market economy and was generally regarded as the pioneer in both governance and economic reforms in the Central Asian Region (CAR) in the 1990s. Its record of macroeconomic stabilisation, economic liberalisation and privatisation is also one of the best in the region. The European Bank for Reconstruction and Development’s (EBRD) Transition Report shows that the Kyrgyz Republic leads the region in areas such as privatisation and liberalisation of the price, trade and foreign exchange systems (see Table 1). As the first CAR country to become a member of the World Trade Organisation (WTO), it has one of most liberal trade and investment regime in the region. Its officially reported share of the private sector in GDP (75 percent) is also the highest in the region and amongst the highest among the Commonwealth of Independent States (CIS)4. Although less progress has been made in corporate governance, enterprise restructuring, financial market development and reform of the infrastructure sector, the country’s achievements in these areas are no worse – if not better -- than most other countries in the region. Despite these impressive achievements in policy and institutional reforms during the 1990s, the Kyrgyz Republic’s overall growth performance to date has been creditable but clearly well below potential -- comparing unfavourably with other CAR and CIS economies. Its average real GDP growth rate of 5.7 percent in 1996-99 was higher than in most CIS countries (averaging 3.1 percent over the same period). However, its subsequent average growth rate in the 2000-05 period fell to 4.0 percent and was markedly lower than the average of 7.2 percent achieved in other CIS countries. The country’s trend GDP growth rates and levels of foreign trade and FDI are among the lowest in the region and its external debt burden the highest. It is only one of two CAR economies whose GDP level has yet to recover to pre-independence levels5. Slower growth relative to competitors in the region and elsewhere in Asia means that the country is falling behind, making it increasingly difficult for

4 The 75 percent share of the private sector in Kyrgyz GDP must be qualified. As will be discussed below, the methodology used by the Kyrgyz authorities in calculating this figure exaggerates the share of the private sector in GDP. 5 Double-digit growth rates in the past few years have recently enabled Azerbaijan to exceed its pre-independence level of output. The only other country besides the Kyrgyz Republic not to have recovered to pre-independence output levels is Tajikistan.

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the country to catch-up. A decade and a half into transition, the Kyrgyz Republic has yet to enter into the “take-off” stage of sustainable growth. Table 1: Selected Transition and Economic Performance Indicators for the Central Asian Region, 2005 AZB KAZ KGZ TAJ TKM UZBPopulation in mid-2005 (million) 8.3 15.1 5.1 6.5 6.5 26.0 Transition Indicators Private sector (% share of GDP) 60 65 75 50 25 25 Large-scale privatisation 2 3 4- 2+ 1 3- Small-scale privatisation 4- 4 4 4 2 3 Enterprise governance/restructuring 2+ 2 2 2- 1 2- Price liberalisation 4 4 4+ 4- 3- 2- Trade and foreign exchange system 4 3+ 4+ 3- 1 2 Banking reform & interest rate 2 3 2+ 2 1 2- Securities market & NBFIs 2- 2+ 2 1 1 2 Infrastructure 2 2+ 2- 1+ 1 2- Performance Indicators Average GDP growth 2000-04 (%) 8.5 10.4 5.0 9.7 11.5 4.0 GDP level in 2004 (1989=100) 72 103 80 69 112 115 Cumulative FDI 1989--2004 (mln US$) 9,829 21,301 573 495 1,951 1,104 Trade/GDP ratio 2004 (%) 85.9 84.5 74.2 104.4 144.5 60.0 External debt/GDP 2004 (%) 18.6 78.6 95.3 39.7 30.1 36.9 Acronyms: AZB (Azerbaijan), KAZ (Kazakhstan), KGZ (Kyrgyz Republic), TAJ (Tajikistan), TKM (Turkmenistan) and UZB (Uzbekistan). Notes: Transition indicators range from 1 (representing little or no change from a centrally planned economy) to 4+ (indicating standards of an industrialised market economy). Performance indicators for 2004 are EBRD estimates. Source: EBRD Transition Report 2005. Stronger growth among its neighbours in the region can be explained in part by the advantages they enjoy in terms of better resource endowment. But a closer examination of the Kyrgyz Republic’s pattern of economic performance shows that it also reflects the country’s insufficient progress in meeting many of its key economic challenges. Given that the private sector now dominates the Kyrgyz economic landscape, weaknesses in the country’s economic performance not only reflect shortcomings in private sector performance but they are also consequences of them. 1.2 The Pattern of Economic Performance A wide-ranging series of policy and institutional reforms in the immediate post-independence period stabilised the economy and enabled positive GDP growth to resume in 1996 following an output collapse of nearly 50 percent in 1991-95. Real GDP grew by 5.7 percent in 1996-99, propelled by strong growth in agriculture in 1996-97 due to reforms that included land redistribution, price liberalisation, restructuring of state-owned farms and the elimination of state controls over product markets and export duties. GDP growth in this period was also fuelled by the double-digit growth rate of construction and the onset of gold production following significant FDI at the Kumtor mine. However, growth decelerated sharply from 9.9 percent in 1997 to 2.1 percent in 1998 and 3.7 percent in 1999 when the economy was subjected to external shocks from the Russian financial crisis. Despite the dissipation of the adverse effects of the Russian crisis, the Kyrgyz economy has not been able to return to the

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relatively high growth track it appeared to have embarked on in 1996. The average GDP growth rate in 2000-2005 declined to 4.0 percent. Major factors behind the deceleration included zero growth in 2002 due to a major decline in gold output and negative growth of 0.6 percent in 2005 as a result of the turmoil surrounding the Tulip Revolution in March. Table 2: Key Macroeconomic Indicators, 1991-2005 (In percent of GDP unless otherwise indicated) 1991- 1996- 2000- 2001- 1995 1999 2005 2003 2004 2005 Real GDP growth (%) -12.6 5.7 4.0 4.1 7.0 -0.6 Nongold growth (%) -12.5 4.3 4.5 4.4 7.8 1.5 Inflation (%) 884.0 25.4 6.5 4.0 4.1 4.3 Gross investment 14.9 20.1 19.3 18.5 20.9 21.8 Fiscal deficit -15.1 -10.3 -5.5 -5.2 -4.1 -4.0 External current account balance -9.6 -17.7 -4.2 -2.8 -3.4 -8.3 Exports 32.2 36.9 39.7 38.5 42.6 38.6 Imports 50.1 53.9 47.6 42.8 50.9 57.2 FDI inflows 3.6 4.4 2.2 1.0 7.9 3.4 External debt 40.3 90.9 104.3 107.5 95.2 87.5 Debt service/export ratio (%) 10.7 20.2 21.2 24.5 9.7 13.6 Notes: Increase in FDI in 2004 due to a one-off investment in Kumtor gold mine. Source: IMF 2006b. The authorities have largely succeeded in restoring and maintaining macroeconomic stability through pursuing prudent monetary and fiscal policies together with reforms in the public financial management system. Important progress has been made in achieving price stability with inflation falling from 32 percent in 1995 to below 10 percent in 2000 and to an average of 4 percent in 2001-03 before growing slightly in 2004-05. Preliminary figures from the National Bank of the Kyrgyz Republic (NBKR) show that the annualised rate accelerated to 5.0 percent in July 2006.6 The recent increase in producer price inflation from 6.9 percent in December 2005 to 18 percent in July 2006 also indicates underlying weaknesses and vulnerability. The inflation rate is likely to rise to nearly 6 percent in 2006. The NBKR is forecasting an inflation rate of 4.5 to 5.0 percent in 2007. The main challenges to macroeconomic stability and sustainable growth are high levels of public expenditure and external debt. Other threats include slow progress since 2000 in privatisation of large enterprises, in strengthening the banking system, in capital market development and in corporate and public governance. The latter is characterised by weak institutional capacity and extensive corruption. Tax revenue is low at 18 to 19 percent of GDP although it is commensurate with other small, low-income countries at the Kyrgyz Republic’s stage of transition. Progress has been made in reducing the fiscal deficit through public financial management reforms which included the phasing out of directed credits, sharp curtailment of the domestic financing of the budget deficit and closure of large state-owned banks. Improved macroeconomic management since 2000, including fiscal consolidation, has stabilised the debt ratio. The fiscal deficit has been reduced from 12

6 According to the National Bank of the Kyrgyz Republic (NBKR), the inflation level excluding fruits and vegetables (whose price level increased by 3.1 percent) reached 2.9 percent during the first 10 months of 2006.

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percent of GDP in 1999 to 3.9 percent in 2003 and 3.9 percent in 2005. It is expected to decline further to 3.2 percent in 2006. The overall budgetary balance has continued to improved and fell further to a negative 4.2 percent of GDP in 2005 despite a severe recession. The country’s external imbalances pose the biggest threat to economic stability. Previous progress made in improving these balances was undermined in the late 1990s by the Russian financial crisis, fiscal laxity and poor debt management. The Russian crises resulted in the widening of the current account deficit from 8 percent in 1997 to 23 percent in 1998. Exchange rate stability has been restored and maintained since the Russian financial crisis. In nominal terms the exchange rate (Soms per US dollar, average) increased from 48.4 in 2001 to 43.7 in 2003 and to 41.0 in 2005. The real effective exchange rate index (taking 1995 as the base year or 100) fell slightly from 73.7 in 2003 to 72.1 in 2005. But output has been unable to respond more vigorously to growing export opportunities despite exchange rate stability. Sluggish net exports have resulted in persistent and growing trade and current account deficits which deteriorated sharply in 2005. The trade deficit grew sharply from $171 million in 2004 to $419 million in 2005 and the current account deficit worsened from 3.4 percent of GDP to 8.1 percent. It is projected to reach 11.0 percent of GDP in 2006. Gross FDI grew from $90.1 million in 2001 to $210.3 million in 2005, and from minus $1 million to a positive $60 million in net terms. External debt grew from about one-third of GDP in 1995 to over 100 percent of GDP in the early 2000s7. It has since improved, declining to 88 percent of GDP in 2004 and to 79 percent in 2005. Debt relief that may be provided under the World Bank and IMF’s Heavily Indebted Poor Countries (HIPC) Initiative could reduce the country’s external debt burden significantly, allowing the country to allocate more resources to poverty reduction and growth8. Growth has enabled the Kyrgyz Republic to achieve progress in poverty reduction. Per capita GDP increased from $278 in 2000 to $436 in 2004. The level of overall poverty fell from 62.6 percent to 45.9 percent in 2000-04, with extreme poverty level falling from 32.9 percent to 13.4 percent. Extreme poverty affects about 13 percent of population. Poverty remains high in rural areas where three-quarters of the poor or 1.8 million people live. However, income inequality has worsened. The Gini index as measured by per capita consumption increased to 32.8 percent in 2004 from 30.3 percent in 2000. There is a close causal relationship between growth and poverty reduction with greatest progress in poverty reduction recorded in years (2000, 2003 and 2004) when growth was highest. The elasticity of coefficient of changes in extreme poverty level was 4.7 for extreme poverty and 2.1 for the overall poverty level. The sharp deceleration of growth in 2005 meant that the targeted level of overall poverty of 38.9 percent for the year could not be met. Despite progress in poverty reduction, improvement in living standards remains slow and the country is still one of the poorest in the CIS. The World Bank’s 2003 Poverty Assessment Report on the Kyrgyz Republic found a strong correlation between poverty and employment status, with widespread poverty reflecting a large pool of unemployed and underemployed workers, many of whom rely on subsistence agriculture and informal, petty street trade and are not included in the official unemployment rate. Growth has not translated into significant employment opportunities as a result of weaknesses in the labour market. Employment growth is well below GDP growth rates and the unemployment rate has continued to climb

7 The IMF (2006b) calculates the Kyrgyz Republic’s nominal stock of disbursed and outstanding external debt at $1.95 billion at end-2004, or $1.48 billion in net present value (NPV) terms, equivalent to 419 percent of fiscal revenues (defined as central government revenue excluding grants). Of the total nominal debt, just over two-thirds were owed to multilateral creditors. Nearly 90 percent of bilateral debt was owed to Paris Club creditors. 8 The Kyrgyz Government, however, decided in February 2007 not to enter the HIPC initiative.

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throughout the 2000-05 period even during years of strong growth in 2003 and 2004. The authorities believe that the actual unemployment rate is significantly higher than the officially reported rate of 8.7 percent in 2005. It is difficult to avoid the conclusion that while growth has been creditable, the Kyrgyz economy is operating below potential and lacks robustness. To date only one sector in the Kyrgyz economy, agriculture, has been able to attain its pre-independence output level. Trend GDP growth rates betray a declining tendency with an annual average of 5.7 percent in 1996-99 falling to 4 percent in 2000-05. The fragility of the economy is evident from sharp annual fluctuations in GDP growth rates ever since positive growth resumed in 1996. Rates fluctuated widely between a peak of 9.9 percent in 1997 and a trough of 2.1 percent in 1996-999. Sharp fluctuations have continued to characterise growth since 2000 with rates of between 7 percent (in 2003 and 2004) and lows of zero percent in 2002 and minus 0.6 percent in 2005. These fluctuations are smoothed somewhat when the gold sector is factored out, but non-gold GDP still fluctuated between 7.6 percent (2004) and 1.4 percent (2005). Nor is the high dependence of GDP growth on gold output (and variability of gold output and prices) the only source of sharp fluctuations. All other sectors of the economy, such as agriculture, non-gold industry, construction and services (and key sub-sectors in services), display sharp annual fluctuations in growth rates even in periods when exogenous shocks such as the Russian crisis and the Tulip Revolution were absent. Table 2: Indices of Output Recovery, 1990 -- 2004 1990 1995 1998 2000 2001 2002 2003 2004 GDP 100 50.6 60.9 66.6 70.2 70.2 75.1 80.4 Industry 100 26.9 41.1 41.7 43.9 39.2 45.8 47.9 Construction 100 32.2 26.5 33.7 35.1 35.6 34.8 36.7 Agriculture 100 61.3 81.4 90.4 97.0 100.0 103.2 107.4 Trade & catering 100 33.5 40.6 44.0 46.7 50.7 56.4 66.0 Fixed asset investment 100 50.2 37.2 62.0 53.0 48.0 44.8 45.7 Source: NSC. The fragility of the Kyrgyz economy is an important reason for the difficulties in recovering from negative growth in 2005. The authorities’ initially ambitious forecast at the end of 2005 for a GDP growth rate of 8 percent in 2006 was revised downwards to 6.2 percent in July 2006. Preliminary official figures in late January 2007 show that GDP grew by only 2.7 percent in 2006 (or by 5.1 percent excluding Kumtor gold output). Industrial output excluding gold increased by 4.2 percent but fell by 10.2 percent including gold. Inflation at year-end 2006 was 5.6 percent. Agricultural growth rate in the January-October 2006 period fell to 1.3 percent as a result of an 8 percent decline in crop production.

9 Fluctuations during this period can be explained by initial high growth, based on output recovery after a prolonged period of recession in 1991-1995, followed by adverse external shocks of the Russian financial crisis in 1998.

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Table 4: GDP and Sectoral Growth Rates, 1991 -- 2005 Trend growth rates (% annual average) 1991-1995 1996-1999 2000-2005 GDP -12.6 5.7 4.0 Non-gold GDP -12.5 4.3 4.5 Agriculture -5.9 9.6 2.7 Construction -12.4 11.7 6.7 Gold 0.0 10.6 1.1 Power -- -1.9 1.4 Manufacturing and non-gold mining -21.1* 0.2 2.0 Services -10.3 1.9 6.8 *Manufacturing and non-gold mining includes Power for 1991-95. Sources: IMF (2006b) and NSC. Annual growth rates (%) 2000 2001 2002 2003 2004 2005GDP 5.4 5.3 0.0 7.0 7.0 -0.6 Non-gold GDP 4.9 4.1 3.1 5.4 7.6 1.4 Industry 6.0 4.6 -10.7 15.6 2.7 -12.6 Mining -- 0.2 1.6 0.9 23.3 -13.9 Manufacturing -- 9.1 10.9 17.8 2.2 -15.6 Electricity, gas & water -- -7.8 -11.5 10.4 1.5 1.6 Construction 29.7 4.0 1.4 -2.2 5.4 2.1 Agriculture 2.7 7.3 3.1 3.2 4.1 -4.2 Services 9.0 3.9 4.2 7.3 11.9 8.1 Trade & repair 11.4 7.0 8.6 12.5 18.7 12.6 Hotel & restaurants -0.9 -8.3 17.5 25.0 15.2 12.2 Transport & communications 5.7 -3.0 1.1 9.0 16.3 9.5 Financial activities -1.1 -13.7 -1.5 10.7 3.7 -2.3 Source: NSC. The lack of robustness of the Kyrgyz economy is attributable to a number of factors, including: a low level of investment, lack of progress in diversifying a heavily concentrated economic structure, weak foreign trade and FDI performance, and low levels of productivity and international competitiveness. 1.2.1 Investment Growth has been led by consumption rather than by investment. The level of investment is relatively low at an average of about 21 percent of GDP in 2001-05 due to a low savings rate (17.6 percent of GDP) and low levels of financial intermediation from an underdeveloped and inefficient financial market. The level of gross domestic savings declined from 18.1 percent of GDP in 2001 to 17.2 percent in 2005 with the investment-savings balance met mainly through high levels of official foreign borrowing that has resulted in a massive debt overhang. FDI inflows averaged 4.4 percent of GDP in 1995-99 but were overwhelmingly used to finance the Kumtor gold joint-venture. With the completion of investments at Kumtor, FDI halved to 2.2 percent of GDP in 2000-05.

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There has been inadequate investment in the rehabilitation and expansion of domestic productive capacity, especially in infrastructure, and little progress in industrial restructuring. In 2001-05, agriculture accounted for only 2.98 percent of total investment. The largest share of investment went to transport and telecommunications at 19.7 percent, with the energy sector (electricity, gas and water) receiving 9.6 percent followed by manufacturing (9.5 percent) and mining (9.1 percent)10. The main sources of investment financing have been funds provided by donors or self-generated funds (profits) of local enterprises which together accounted for 63 percent of total investment financing in 2001-02. Households contributed 19 percent to investment financing and the Government 9 percent through the budget. FDI accounted for 9 percent of real sector investments, mainly in food processing, mining, trade and catering. The government’s investment capacity through the public investment programme (PIP) is severely limited by budgetary revenue constraints and the need to contain the level of official (domestic and external) debt. Investments in infrastructure under the PIP fell from 3.6 percent of GDP in 2003 to 3.2 percent in 2005. 1.2.2 Economic Structure and Diversification A major factor in the fragility and fluctuations in growth rates of the Kyrgyz economy is the country’s narrow economic base and insufficient progress with economic diversification. With the devastation of much of the Kyrgyz industrial system following the collapse of the FSU and weak industrial output recovery since then, the economy is heavily dependent on and narrowly concentrated in a handful of activities, principally agriculture, gold, construction and a few service sub-sectors such as telecommunications, repairs, trade and hotels and restaurants. The predominant role of agriculture in the national economy has been overtaken by the service sector since 2000 although agriculture still accounts for the largest share of employment (at about 50 percent). Agriculture’s share of GDP has declined from 34.2 percent in 2000 to 30.5 percent in 2005 while that of services has increased from 29.6 percent to 40.2 percent (see Table 5). Industry’s share of GDP declined from 23.3 percent to 16.3 percent during this period. Insufficient progress in economic diversification is most evident in industry which accounted for about 40 percent of GDP in the pre-independence period when manufacturing, comprising mainly machine building, metal processing, light industry and food processing, accounted for about one-third of GDP11. Following independence the share of industry in GDP declined to 12 percent in 1995. Although it increased to under 20 percent for much of the 2000-05 period, the lion share of industrial output is accounted for by a single good: gold. Gold alone accounted for about 8 percent of GDP during this period and in 2004 accounted for 45 percent of industrial output. Gold and energy together accounted for 11 percent of GDP and 55 percent of industrial output in 2002. However, gold output growth rates are now decelerating with a fall of 24 percent in Kumtor output leading the share of gold in GDP and in total industrial output in 2005 to decline to 6.2 percent and 38.5 percent respectively. Kumtor’s output is expected to decline significantly and cease completely by 2008 due to the depletion of its quarry reserves. Both the industrial growth rate and the share of industrial output in GDP will consequently decline sharply unless new gold reserves are found and/or other manufacturing industries grow strongly. But non-gold manufacturing has grown by only 2 percent since 2000. The share of mining (excluding gold) in GDP has

10 Calculated from data provided by NSC. 11 However, administratively determined prices in the FSU period usually inflated prices of industrial products relative to non-industrial products, resulting in the exaggeration of the size and share of industry in national output.

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stayed constant at 0.5 percent over the past five years, while that of electricity, gas and water has actually declined from 4.9 percent in 2001 to 3.1 percent in 200512. The annual growth rates of the mining sector and the electricity, gas and water sector in 2002-05 averaged 3.6 percent and zero percent respectively. Their development will require huge capital investments because mines are located mainly in remote, mountainous areas and energy requires development of a generation, transmission and distribution infrastructure. Table 5: Sectoral Composition of GDP and Structural Change, 1990 -- 2005 (% distribution) 1995-2005 1995 2000 2001 2002 2003 2004 2005GDP 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Agriculture 40.7 34.2 34.5 34.4 33.6 29.9 30.5 Industry 12.0 25.0 23.1 17.9 17.3 19.2 16.1 Mining -- 0.5 0.5 0.5 0.5 0.6 0.5 Manufacturing -- 18.1 17.6 13.0 13.3 15.3 12.6 Electricity, gas & water -- 6.4 4.9 4.4 3.6 3.3 3.1 Construction 6.2 4.2 3.8 3.4 2.9 2.5 2.5 Services 33.9 29.6 31.4 35.6 36.8 38.3 40.2 Trade & repairs 11.0 12.0 12.2 14.3 15.2 16.0 17.8 Hotels & restaurants 1.2 1.7 0.8 1.1 1.5 1.6 1.7 Transport & communications 4.5 3.8 4.2 5.1 5.4 6.4 6.8 Financial activities 3.6 0.4 1.1 0.7 0.6 0.6 0.6 Education 5.1 2.9 3.2 3.4 4.0 3.5 3.5 Health care 2.8 2.0 1.6 1.7 1.7 1.9 1.8 Others 5.7 8.8 8.3 9.3 8.4 8.3 8.0 Net taxes 7.3 7.0 7.3 8.7 9.3 10.1 10.5 Notes: (i) Percentages may not sum to 100 due to rounding. (ii) Change in format for service sector since 2002. Sources: NSC and calculated. Period averages 1990 1991-95 1996-2000 2000-05GDP 100.0 100.0 100.0 100.0 Agriculture 34.2 42.3 41.8 35.9 Manufacturing & non-gold mining 27.7 17.0 6.5 8.8 Gold 0.0 0.0 7.1 8.0 Power … … 3.7 4.5 Construction 8.1 5.4 4.6 3.4 Note: Power sector output included in 1991-95 included in manufacturing and mining. Sources: NSC and IMF (2006b). 1.2.3 External Sector The external sector is critical to the Kyrgyz economy not only on the demand side as a

12 There appear to be conflicting official statistics on sectoral shares of GDP. Some reports (e.g., NPRS-1) put the manufacturing sector’s share of GDP at 9 percent of GDP in 2001-05, up from 6.4 percent in 1996-2000, with industry’s (as a whole) share of GDP falling from 25 percent in 2000 to 16.4 percent in 2005, agriculture’s share falling from 34.2 percent to 30.5 percent and services’ share reaching 40.2 percent in 2005. Another official source (CDS Draft 2006) reports that mining, including gold, now accounts for 48 percent of industrial output, 10 percent of GDP, 41 percent of exports and 11 percent of tax revenues. Since some sources stated that gold accounts for 8 percent of GDP, then this means that non-gold mining must account for the remaining 2 percent, which is inconsistent with other sources which reports that non-gold mining accounts for just 0.5 percent of GDP.

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means for widening markets given the small size of its domestic economy. On the supply side, it is decisive as a source of FDI, technology transfer, management development and intermediate inputs13. EBRD’s Transition Report (2005) puts the Kyrgyz share of foreign trade in GDP at 74 percent in 2004, making it the second lowest in the CAR after Uzbekistan. The IMF (2006b) reports a higher figure of over 100 percent in 2004-05 and Kyrgyz official figures are even higher at 117.6 percent in 2005. Merchandise exports growth rates in 2001-05 fluctuated sharply between a high of 18.5 percent in 2004 and lows of minus 6 percent and minus 6.4 percent in 2001 and 2005 respectively, yielding an annual average rate of 10.8 percent. Merchandise imports have grown significantly faster than exports, resulting in a trade deficit that reached $419 million in 2005. The level of FDI in the Kyrgyz Republic is low, and the country’s cumulative FDI in the 1989-2004 period is the second lowest in the CAR after Tajikistan. Cumulative FDI in the 2001-05 period was only $243 million. The overwhelming share of FDI since 1996 has gone to the Kumtor gold mine with very little going to the non-gold economy. Net portfolio investment in the 2001-05 period amounted to a cumulative net outflow of $21.8 million. Table 6: External Sector Developments, 2001 - 2005 2001 `2002 2003 2004 2005($ million) Merchandise exports f.o.b 480 498 590 733 687 Merchandise imports f.o.b 450 571 723 904 1106 Trade balance -30 -73 -133 -171 -419 Current account balance -24 -49 -85 -76 -204 Gross FDI 90.1 115.7 123.8 144.0 136.0 Net FDI 1 5 46 131 60 Net portfolio investment 1.2 -12.0 6.0 -2.5 -14.5 (% growth) Merchandise exports -6.0 3.7 18.5 24.0 -6.4 [Exports of goods and services -2.1 14.2 16.4 26.6 -0.1] Merchandise imports -13.1 25.4 31.1 25.0 24.0 [Imports of goods and services -9.9 28.0 15.7 28.8 23.9] (% GDP) Exports 31.5 32.7 38.7 48.1 45.1 Imports 29.5 37.4 47.4 59.3 72.5 Total trade 61.0 70.1 86.1 107.3 117.6 Current account balance -1.6 -3.1 -4.4 -3.4 -8.4 Exports (% demand component GDP) 36.7 39.6 38.7 42.7 37.9 Net exports (% demand component GDP) -0.3 -3.8 -6.6 -8.7 -19.6 Sources: NSC; figures in italics from IMF (2007). Nevertheless, exports have been an important source of GDP growth in recent years, accounting for about 39 percent of the demand components of GDP in 2001-05. Much of the external demand has derived from strong growth in neighbouring countries such as Russia, Kazakhstan and China. But an average annual rate of exports growth at just around 6 percent above trend GDP in 2001-05 indicates that the Kyrgyz economy has been unable to more fully exploit opportunities arising from high growth in these markets and/or to access new markets elsewhere. The Kyrgyz economy’s inability to respond more vigorously to rapidly growing demand in its neighbours can be attributed its narrow economic structure 13 Even for a large and highly successful export-led growth economy such as China, imported inputs account for a significant share of the total value of exports.

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and insufficient progress in economic diversification. Agricultural exports used to constitute about 10 percent of total exports but their share has declined to about 5 percent in recent years. Remittances from Kyrgyz workers overseas, estimated to amount to about $50 million in 2006, are increasingly important. Anecdotal evidence also indicate strong growth of re-exports in recent years. Industrial exports now account for over 90 percent of total exports. They are, however, very narrowly concentrated with nonferrous metals (essentially gold) alone constituting nearly 60 percent of industrial exports and about half of total exports. The share of exports of electrical energy has fallen significantly from 15.8 percent in 2000 to 3.3 percent in 2003. The share of exports of processed foods and light industry has grown while that of machine building has tended to decline in the past few years. Exports to Russia, Kazakhstan and China account for 40 percent of exports. The large share of exports to non-CIS is accounted almost entirely by gold exports to Germany and Switzerland. Excluding gold, Kyrgyz exports are very narrowly concentrated in exports to just four countries: Russia, Kazakhstan, Uzbekistan and China. The authorities believe that there is significant potential in exports of hydropower given strong and growing demand in and outside the CAR while only about 10 percent of hydroelectric potential is estimated to be currently harnessed. Hydropower exports grew from 5 percent of total exports in 1998 to 14 percent in 2000 but fell to 3.3 percent in 2003. The variability of power exports was partly due to unstable demand for irrigation water in adjacent countries and growing domestic consumption. On the supply side, growth in exports of hydropower is constraint by serious structural and technical weaknesses such as limited capacity of the distribution network due to lack of investments and modernisation, as well as problems of poor governance and low tariffs. The electricity distribution infrastructure is estimated to require investments of $250 million over the next ten years. 1.2.4 Productivity and Competitiveness The World Bank’s Country Economic Memorandum (CEM; World Bank 2005a) contains an assessment of Kyrgyz economic productivity performance14. The assessment shows that the Kyrgyz Republic has relatively high labour costs compared with other CIS countries. Its large observed competitive gap is evident from the fact that the country has unit labour costs 66 percent higher than in comparators/competitors such as Armenia, Georgia and Russia, 2.5 times higher than Tajikistan and over three times that of Kazakhstan. The Kyrgyz economy’s high -- and hence uncompetitive -- unit labour cost remains unchanged even when agriculture is excluded. Its high unit labour costs are not due to exchange rates since the Kyrgyz real effective exchange rate (REER) has actually improved since 1995, indicating an increase in competitiveness on this variable alone. The REER deflated by the consumer price index (CPI) depreciated by over 30 percent in 1995-99 and has remained largely stable since. The key factor in the high Kyrgyz unit labour costs is a low wage-productivity ratio. The country has lower nominal wages than all its CIS comparators/competitors with the exception of Tajikistan. Russian and Kazakh workers have monthly wages over three times higher than the average Kyrgyz worker who is also paid about 9 percent less than an average Moldovan worker, 13 percent less than an Armenian worker and 15 percent less than a Georgian worker. Kyrgyz wages are also lower than trade competitors such as China and India where workers in garment factories in export processing zones earn more than 2.3

14 The discussion here summarizes the main findings from the World Bank’s CEM.

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times the average Kyrgyz wage. The high unit labour cost in the Kyrgyz Republic is explained by the country’s very low level of labour productivity. Kyrgyz firms have significantly lower output per worker than most other countries in the region. Only Tajikistan had a lower economy-wide labour productivity. Data on relative unit labour cost in industry, and on total factor productivity and labour productivity growth, reveal that rates of labour productivity growth in the Kyrgyz Republic grew at only about one-third the average rate for several other comparators in the region with the exception of Moldova. Since the productivity differentials are larger than the observed wage differentials, this means that the Kyrgyz Republic’s low wage advantage has been eroded by its larger low labour productivity disadvantage. The net result is an uncompetitive higher unit labour cost that creates difficulties in competing both domestically (against foreign products) and internationally. The World Bank’s (2005b) Investment Climate Assessment of the Kyrgyz Republic also confirms features of poor labour productivity performance and the country’s inability to exploit low wage levels to improve competitiveness. The Investment Climate Assessment provides evidence showing that the Kyrgyz Republic suffers from serious productivity gaps compared with a large number of countries in sectors such as garment and food which the Kyrgyz authorities expect to lead export growth in the future. An important reason for the country’s low levels of efficiency and international competitiveness, as will be discussed later in this report, is a weak private corporate or enterprise sector operating under an adverse business climate characterised by extensive and excessive state regulatory regime and distorted markets. Table 7: Productivity and Competitiveness Indicators Relative Unit Labour Cost, 2002 Kyrgyz Armenia Georgia Moldova Republic Kazakhstan Russia Tajikistan(Kyrgyz Republic = 1) Relative nominal US$ monthly wage 1.1 1.2 1.1 1.0 3.2 3.5 0.3 Relative labour productivity 2.0 2.0 1.2 1.0 10.5 5.7 0.7 Relative unit labour cost 0.6 0.6 0.9 1.0 0.3 0.6 0.4 Total Factor and Labour Productivity Growth, 1998 - 2002 Kyrgyz Armenia Tajikistan Georgia Moldova Uzbekistan Azerbaijan Republic CIS-7 avg.(% average) TFP 8.0 6.9 6.3 4.1 3.8 1.9 1.3 4.6 LP 8.1 6.3 7.8 0.2 3.5 1.6 1.4 4.1 Note: TFP is total factor productivity and LP is labour productivity. Source: World Bank 2005a. 1.3 Recent Development Objectives The address to the nation by President Bakiev given on 28 September 2006 outlined the broad medium and long term economic objectives of the Kyrgyz Republic. Annual GDP growth is planned to increase to 8 percent per year led by investments and growth in the

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four priority sectors of energy, communications (transport), agriculture and mining. Key measures for the development of these sectors would include: (i) more transparent and fairer means of tendering to the best qualified private investors in energy; (ii) increased participation and responsibilities of local authorities in transport projects; (iii) more effective resolution of conflicts over property and contractual rights in mining; (iv) greater participation by the local population in development efforts; and (v) innovation or technological progress to promote technology-intensive and higher value-added growth based on greater use of domestic skilled labour and locally produced inputs. Priorities for improving the business and investment climate and for economic diversification include: (i) improving governance through a clearer and more rational delineation of the powers and responsibilities of state bodies in economic administration and regulation; (ii) promoting the growth of the SME sector through more favourable tax policies; (iii) improving export competitiveness through specialisation; and (iv) agrarian policies to promote efficient large-scale farms, agri-business and rural market networks and supply chains. These highly generalized objectives and measures are fleshed out in greater detail in the Government’s draft Country Development Strategy for 2006-10 (CDS; November 2006 version). First, highly ambitious growth rates are set for 2006-10. Per capita GDP is planned to increase by about 60 percent over 2005 to reach $777 in 2010, making the Kyrgyz Republic a moderately developed country. The level of poverty is to fall by 2.5 to 3.0 percent annually with the overall poverty rate declining from 43.1 percent in 2005 (based on a new poverty line) to 30.2 percent in 2010. The annual rate of GDP growth will average 7.5 percent, accelerating from 5.0 to 5.5 percent in 2006-07 to 7.5 to 9.1 percent in 2008-10. Table 7: CDS Macroeconomic Development Targets, 2006 - 2010 Actual Projections 2000- 2006- 2005 2006 2007 2008 2009 2010 2010 GDP (%) 19.8 4.0 6.5 7.5 8.5 9.1 40.9 Per capita GDP (US$) 475* 505 557 619 692 777 Poverty level (% of population) 43.1* 41.5 38.3 35.6 32.9 30.2 Employment growth (%) 9.4 0.9 0.9 0.9 0.9 0.9 4.6 Labour productivity growth (%) 12.0 3.1 5.6 6.5 7.5 8.1 34.7 Consumption (% of GDP) 96.4* 102.6 100.4 96.4 91.6 87.2 Gross investments (% of GDP) 22.2* 23.2 26.9 30.2 35.1 38.4 Public (% of GDP) 4.6* 4.5 4.5 3.6 2.9 1.9 Private (% of GDP) 17.6* 18.7 22.5 26.5 32.2 36.5 Export growth (%) -11.3* 1.4 9.6 13.3 14.5 5.7 Import growth (%) 12.4* 23.7 12.4 9.2 11.4 4.3 Current account (% of GDP) -8.3* -11.1 -12.2 -10.7 -10.2 -8.5 Note: * figures for year 2005; other figures in the column are cumulative percentages. Source: Draft CDS (November 2006 version).

Second, growth is to be primarily export-led. Growth is to be sourced through improved competitiveness, with growth in labour productivity growing faster than output growth. Greater integration in the world economy is to be facilitated by a more diversified economy and accelerated export growth, based on the priority development of SMEs and industries where the country is stated by the authorities to have a considerable comparative advantage potential, such as in energy, mining, processing industries, agro-industry and key service sub-sectors (transport and communications, tourism). Technological innovation will be an

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important measure in improving productivity and competitiveness. Development of these priority sectors is expected to require an estimated $5.4 billion. Third, the high levels of investment envisaged will require a significant growth in private (domestic and foreign) investments. The cost of implementing the CDS is estimated at $7.0 to $7.5 billion and the annual investment rate is to increase to 38.4 percent of GDP. The PIP is planned to fall from 4.5 percent of GDP in 2006 to 1.9 percent in 2010. Constraints on official external borrowing and the need to reduce the large accumulated external debt will result in reductions of the share of public investments funded externally. Domestic investment resources available are estimated to amount to only $3.5 billion, leaving a shortfall of $4 billion of which $500 million is expected to be met through multilateral and bilateral donor contributions and $3.5 billion or about half of the total implementation cost met through private and foreign investments. Most of the increase in investment in 2006-10 will therefore have to underwritten by a significant increase in private investments, making the stimulation of private and foreign investments a policy priority. Fourth, private sector development, and increased private and foreign investments in particular, are to be facilitated by “radical” improvements in the investment climate and business environment and further structural reforms in a wide range of areas. These include deepening of reforms in the financial sector to mobilize domestic savings and increase intermediation, in the tax and custom administration system to lighten the tax burden and reduce the shadow or informal economy, in public expenditure policy to link Government spending with priority development programmes (with the PIP focused on investments in industrial, agricultural and social infrastructures); in countering corruption by reducing scope of state intervention in market mechanisms and achieving greater transparency; in improving the legal environment; and in public governance and decentralisation which would give greater powers to local authorities and strengthen local budgets. Measures to improve the investment climate would aim to address the key weaknesses of concern to businesses (in order of importance): (i) poor quality of tax administration; (ii) uncertainty and unpredictability of economic policy due to frequent changes; (iii) high levels of corruption; (iv) high cost of finance; (v) macroeconomic instability; (vi) cumbersome customs and foreign trade regulation; (vii) crime and lack of law and order; (viii) low quality of labour; (ix) difficulties in accessing finance; and (x) the judicial system and conflict resolution. These and other measures are expected to enable the Kyrgyz Republic to improve its rating of the World Bank-EBRD BEEPS integrated indicator of the quality of the investment climate from 25.2 points in 2005 to the average for ECA countries’ 2005 level of 18.27 points by 2010. The CDS development objectives are highly ambitious. The average real GDP growth rate of 7.5 to 8.0 percent targeted for the five-year period 2006-10 has never before been achieved. The highest annual growth rate previously recorded was 9.9 percent in 1997 due to a one-off surge in FDI to the Kumtor gold mine. Achieving the targeted average growth rate for 2006-10 will be difficult, but an acceleration of the growth rate in excess of the highest average annual rate of 5.7 percent recorded in 1996-99 would be feasible if sharp fluctuations in annual growth can be avoided and steady positive growth maintained throughout the period. Similarly, an acceleration of the investment rate to 38 percent of GDP by 2010 appears to be over-ambitious given that the rate averaged only about 21 percent in 2001-05. However, low rates of GDP growth relative to an investment rate of just over 20 percent in previous periods suggest a low marginal efficiency of investment. If the efficiency of investments can be raised, then the acceleration in growth rates could be realised without necessarily requiring the high and overly ambitious rates of investment envisaged in the CDS although investment rates will still have to increase significantly.

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The ambitious growth targets may be difficult to achieve, but the CDS presents a sound strategy in terms of its emphasis on productivity, competitiveness, economic diversification and exports as the main sources of growth. As stressed in the CDS, achieving these objectives will depend crucially on private and foreign investments and therefore on a dramatic improvement in the business environment and investment climate for private sector development. Raising the marginal efficiency of investments made by the private sector, however, would require inter alia that investment decisions are made on purely economic and commercial criteria. In this regard, it is important that the Government’s sectoral investment priorities identified in the CDS does not lead to implementation measures which will distort or undermine market processes for private sector investments. It is unclear at this stage whether the Kyrgyz economy in fact enjoys a comparative advantage in the sectors identified by the Government. As such, the Government’s role should be limited to mobilizing private and foreign investments in these sectors by creating an enabling policy and institutional environment, except in selective public goods (such as infrastructure) where direct public investments could also play a role in stimulating co-financing by the private sector. 2. THE ECONOMIC LANDSCAPE AND PRIVATE SECTOR 2.1 Size and Role of the Private Sector The private sector accounted for an estimated 5 percent of GDP in 1990. The sector has grown since independence initially through privatisation of state-owned enterprises (SOEs) and subsequently through the growth of de novo enterprises. Privatisation of SOEs was the main factor in private sector development in the period until the late 1990s. In agriculture, over 62,000 private farms – accounting for over half of the cultivated land in the country -- were created through the dismantling of most cooperative (kolhoz) and state (sovkhoz) farms and agricultural SOEs during 1995 to 2000. About 4,700 small SOEs, mainly in trade and services, were fully privatised by 1995 under a mass privatisation programme entailing distribution of free vouchers to the public and sales to workers and management. About 1,500 medium and large SOEs were corporatised and partially divested through sales to workers, management and the public. Nearly two-thirds of the total number of SOEs, accounting for about 45 percent of GDP, had been privatised by 2000. The Government’s draft privatisation programme for 2006-2007 (dated 12 February 2006) stated that over 70 percent of SOEs had been privatised since 1991. The number of joint-stock companies (JSCs) in the country is currently estimated to number around 1,200. Many SOEs privatised eventually came under control of management as workers were often either compelled to sell or transfer their shares to management, sometimes through dubious means. The management generally lacked skills in market-based methods of management and business operations in an increasingly marketised environment. Together with insider control and weak corporate governance, this impeded the recapitalisation and restructuring of enterprises. Most privatised enterprises consequently remain largely un-restructured to the present. The EBRD’s Transition Reports estimate that the share of the private sector in Kyrgyz GDP grew from 15 percent in 1991 to 40 percent in 1995. It grew to 60 percent in 1996 and stayed constant until 2002 when it increased to 65 percent. The private sector is now estimated to account for 75 percent of GDP. It is unclear, however, how the EBRD’s figure was calculated. The officially reported figure provided by the Kyrgyz authorities for the private sector share of GDP in 2005 is 86.4 percent. But the Kyrgyz authorities’ ownership statistics is based on a misleading two-sector classification where the state sector comprises 100 percent state-owned enterprises and a “private sector” that includes not only enterprises

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with full or majority private shareholding but also partially divested SOEs – even those with majority state (or minority private) ownership15. Official statistics therefore over-estimates the size of the private sector in national output. The private sector now accounts for the overwhelming share of production in agriculture, construction and services16. The private sector accounted for 80.9 percent of employment in 2004. Aside from non-productive services sub-sectors such as education, health and social services, private sector employment accounts for over 90 percent of total employment in most economic sectors. Employment in agriculture, mining and trade and repairs were almost entirely private. Table 9: State and Private Sector Shares of GDP (in %), 2004 State PrivateGDP 13.6 86.4 Agriculture 0.8 99.2 Industry 2.8 97.2 Mining 33.3 66.7 Manufacturing 2.2 97.8 Electricity, gas and water 0.0 100.0 Construction 31.3 68.7 Trade and repairs 0.1 99.9 Hotel and restaurants 1.7 98.3 Transport and communications 14.6 85.4 Source: Calculated from NSC figures. 2.1.1 Agriculture Privatisation of state and collective farms in the immediate post-independence period turned farm workers into private owners of farmland. Many farmers are, however, still operating collectively for various reasons, including a lack of credit for financing separate and individual production. In addition to private farmers, there are also many peasant farms (often groups of families operating jointly) and United Peasant Farms (UPFs) operated more or less as former cooperatives. The state still owns 25 percent of cultivated land, held mainly by local government bodies as a pool for re-distribution and by state-owned agricultural enterprises in seed growing and animal breeding in the northern part of the country. Of the total labour force in agriculture, 65 percent is employed in private farming (20 percent working in individual plots) and 35 percent in agricultural enterprises or collective farms. Over half of agricultural value-added is derived from private farms with peasant farms accounting for a major part of the remainder. Crop production accounts for 54.7 percent of agricultural output and livestock production for 43.7 percent. Peasant farms produce two-thirds of crops and slightly over half of livestock production is from private plots of households. The average size of holding is 1.5 ha for private farms, 11.8 ha for peasant farms and 671 ha for UPFs.

15 This is contrary to standard convention which uses a three-sector classification: “state” for fully majority state-owned enterprises, “non-state” for majority privately-owned enterprises with minority state shareholdings, and “private” for fully privately-owned enterprises. 16 Section 2.3 below describes the SME sector and provides an indirect estimate of the share of the private sector in different branches of the economy.

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2.1.2 Industry and Infrastructure Although the dominant share of the private sector in national output is not in doubt, the official figures under-estimates the size and role of the state sector in key industries because, as noted above, even majority state-owned enterprises are classified at belonging to the private sector. The share of the state sector in industrial output in reality remains significant in certain sub-sectors because of slow progress in the privatisation of key medium and most large SOEs. The Government’s privatisation programme for 2006-2007 lists 35 categories of economic activities that are excluded from privatisation. Although most of the categories refer to Government organs of economic administration and institutions for the provision of public services (e.g. health care and education), they also include those in non-vital activities such as public entertainment as well as enterprises in a very wide range of infrastructure and manufacturing industries. State ownership is still dominant in what the authorities define as “strategic industries”. This includes almost all of infrastructure (e.g. electricity, gas, water; road, rail and air transport; and communications) as well as the large and/or major enterprises in manufacturing. Official figures show that the state sector accounts for only 2.8 percent of industry. Even for the electricity, gas and water sector and transport sector where state ownership clearly predominates, the officially reported share of the state sector is curiously low at zero percent and 14.6 percent respectively. If the output of these two sectors is more accurately counted as state, then the corrected shares of the state sector in industry and GDP are 17 percent and 18 percent respectively. The fixed-line telecommunications monopoly Kyrgyz Telecom is 77.8 percent owned by the state. Plans to divest further to 49 percent or 51 percent of Kyrgyz Telecom have so far not succeeded because of a lack of strategic investors’ interest due to fixed low levels of tariffs and unfavourable terms and conditions, and because of objections from segments of the public. Two small fixed-line telephone companies, SaimatNet and WinLine, provide only domestic services and mainly in the Bishkek area. The largest mobile phone company, Bitel, is partially owned by the state. Almost all mines (with the exception of Kumtor gold mine), mainly in coal, uranium, molybdenum, mercury and antimony, are state-owned although foreign investments (e.g., from Kazakhstan and Russia) in uranium mines have been provisionally agreed. Plans to privatise SOEs in mining have not been fulfilled. Restructuring of the electricity industry began in the late 1990s in preparation for privatisation. The electricity monopoly was unbundled into four regional distribution companies to be privatised with the transmission grid and power generating companies to remain under state ownership. Privatisation of the industry has, however, not been achieved. There are recent (August 2006) reports that Chinese investors have expressed interest in investing in the energy and the telecom sectors. Kazkah investors are reported to have began construction of a toll highway between Almaty and Issyk-Kul. The four largest enterprises in the economy (Kyrgyz Telecom, Kyrgyz Energy, Kyrgyz Gas and Kyrgyz Airlines) are all fully or majority state-owned and together are reported to account for 80 percent of the country’s total capital stock. Privatisation of these “big four” has been planned since 1997, but to date none has been completed due in part to technical issues (such as valuation and pricing) and lack of investors’ interest, but mainly because of a lack of policy commitment on the part of the authorities. The largest manufacturing sub–sector is gold whose output is overwhelmingly accounted for a single enterprise, Kumtor, a state-foreign joint venture that was subsequently fully privatised to a Canadian mining consortium, Centerra. The state owns the bulk of gold reserves through Kyrgyzaltyn. There has, however, been some success in private manufacturing, in sub-sectors such as car radiators (Avtomash-Radiator), car batteries (Avtomash-Ecol), light bulbs (Maili-Suu Electric

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Lamp Factory), paper and packaging materials and plate glass making. Data provided by the Kyrgyz Government’s State Committee for State Property Management (CSPM) shows that as of 1st June 2006 there were 111 corporatised enterprises under full or partial state ownership. Of these, 79 enterprises were fully or majority state-owned with the remaining 32 having state shareholdings of 50 percent or less. The largest number (34) of fully or majority state-owned enterprises was in industry. The data on the number of enterprises with state shareholdings provided by the CSPM, however, refers only to corporatised entities and does not include uncorporatised SOEs. It may also exclude SOEs supervised not by the CSPM but by other agencies such as the industry and agriculture ministries. The total number of state enterprises therefore exceeds 111. The Government’s draft privatisation programme for 2006-2007, for example, contains appendices listing a total of 143 (fully, majority and minority) state-owned enterprises to be privatised. Moreover, this listing excludes SOEs not subject to privatisation in the 2006-2007 period. Regardless of the actual number of SOEs, it is believed that perhaps only 70 mainly large and medium SOEs are currently operational or viable. Although the author of this report has not been able to obtain data on the financial performance of the sector, it is generally acknowledged that SOEs in the Kyrgyz Republic are highly inefficient and that most SOEs are loss-makers. It has been reported that SOE credits in nominal values owed to the Government amount to 18.4 billion Soms (about $450 million), of which 17.4 billion Som or about 95 percent is owed by large SOEs including Kyrgyz Telecom, Manas International Airport and various energy providers (JCSS 2006a). SOEs in the energy sector, in particular, are highly inefficient and unprofitable. The energy sector has a huge quasi-fiscal deficit amounting to 8.2 billion Som (8.7 percent of GDP) in 2004 and 7.6 billion Som (7.6 percent of GDP) in 2005. 2.1.3 The Financial Sector The private sector now accounts for a significant share of the country’s small financial sector that is dominated by the banking sector whose assets amounted to about 22 percent of GDP in 2005. Access to the banking system is limited. While the ratio of bank branch to population (32,000) is not excessively low, only 1 in 40 Kyrgyz residents have a bank account and there is only one bank branch per 32,000 people. Similarly, despite recent growth, bank deposits and private sector credit are still at very low levels at only respectively 8 percent and 14.6 percent of GDP in 2005. The securities market plays a negligible role in financial intermediation, with stock market capitalisation at an estimated 1.5 percent of GDP and outstanding corporate bonds amounting to 0.3 percent of GDP17. The banking sector comprises 21 commercial banks of which one has had its license revoked and is currently non-operational. The 20 private banks accounted for 95 percent of banking sector assets at end-2005. The only state-owned bank is the Savings and Settlement Company (SSC, the former Sberbank or Savings Bank) who provides mainly payment, transfer and savings services. The SSC does not have a license for lending but was authorised to begin microlending in 2005. The authorities planned to privatise SSC in 2006 but have yet to do so. The level of foreign participation in the banking sector is very high with 15 banks having foreign shareholdings and with foreign investors holding majority shares in 10 banks. The seven largest banks, accounting for 77 percent of total banking sector assets, all have significant or majority foreign shareholdings. Although private banks

17 Stock market capitalization calculated as the total value of all listed companies, including state shareholding in these companies.

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dominate the banking sector, half of all bank accounts are held with the SSC. The planned privatisation of SSC by 2006 has yet to be met. The largest non-bank financial institution (NBFI) is the Kyrgyz Agricultural Finance Corporation (KAFC) established with the assistance of the World Bank. It is also state-owned and the largest provider of rural finance with one of the country’s largest networks and geographic spread of branches. KAFC was scheduled for privatisation in 2006 but the process is expected to be completed in 2007. The KAFC will be granted a full banking license upon privatisation but it was recently granted a limited banking license even before privatisation. Informal and micro finance play an important role in the economy, especially in the rural areas where two-thirds of the population live. Informal finance, including credits provided by purchasers of agricultural products (e.g. agro-processing enterprises), suppliers of inputs and marketing agents, are often a dominant and preferred source of financing for rural entities. In terms of formal credit channels, the total amount of microfinance credit extended in the country is equivalent to two-thirds of conventional bank credit outstanding at end 2004. The agricultural and rural sector in the Kyrgyz Republic is served by a larger and wider number network of financial services providers than is usual in other transition economies. This network includes 305 credit unions with over 27,000 members, 104 micro credit organisations (MCOs), the SSC and KAFC, microfinance provided through five banks (with 44 lending outlets) supported by the EBRD’s Micro and Small Enterprises Finance Facility, and rural branches of the commercial banks. Credits provided by the credit unions are largely sourced from an ADB credit line and in part from membership shares. Most MCOs are very small and the four largest (FINCA, Bai-Tushm, Kompanion and the Leasing-Mortgage Company) together account for 85 percent of total microcredit loan volume. The SSC has a branch in very district, a regional office in each oblast and a network of agencies in 1,000 post office branches. The KAFC is now the largest single provider of credit and at end-2004 its credits extended amounted to over one-quarter of the total credit extended by the banking system. 2.2 The SME Sector In terms of the number of enterprises, the corporate sector (excluding farms and individual entrepreneurs) in the Kyrgyz Republic comprises almost entirely of SMEs. Of a total number of 8,537 enterprises at end-2003, 448 were large, 791 were medium and 7,298 were small. The 8,089 SMEs accounted for 95 percent of the total number of enterprises in the national economy. However, large enterprises accounted for the largest share of employment, accounting for 60.7 percent of employment (135,808 persons) with medium and small enterprises accounting for 21 percent (47,100) and 18.3 percent (41,000) respectively18. A study of the SME sector by the Kyrgyz NSC (2005) shows that 97.4 percent of SMEs are privately-owned. Detailed data on the SME sector in the NSC report therefore reveals the pattern of private sector activities in the economy19. The number of SMEs, broadly defined to include individual entrepreneurs and farms, grew significantly by 160.5 percent between 2000 and 2005, from 181,125 to 471,752. The number of small enterprises grew by only a small margin while the number of medium enterprises fell. In aggregate, the number of small and medium enterprises (excluding

18 Individual entrepreneurs employed 134,386 persons. 19 The SME sector comprises commercial entities and covers small and medium-sized enterprises, peasant (farmers) farms and individual entrepreneurs. In agriculture (and hunting and forestry), mining, manufacturing, electricity, gas and water, and construction, enterprises with 50 or less workers are defined as small and those with 51 to 200 workers are classified as medium. In services, enterprises with 15 or less workers are defined as small and those with 15 to 50 workers as medium.

36

individual entrepreneurs and farms) declined. Excluding individual entrepreneurs and farms, the largest number of SMEs in 2005 was in trade and repairs (32.6 percent) followed by manufacturing (17.9 percent), construction (10.3 percent) and transport and communications (9 percent). Growth in the SME sector occurred primarily through a significant increase in the number of peasant farms and individual entrepreneurs, reflecting the limited employment opportunities elsewhere in the economy. Growth in the number of farms means that the average size of farm holdings and output per farm must have shrunk significantly given a more or less constant cultivated or arable land area in the country. Together with the decline in the number of small and medium enterprises, they show a trend towards smaller and informal undertakings. As Section 2.3 below shows, this trend is due to an unfavourable business environment in the formal sector with constraints on business (such as official corruption and excessive regulations) increasing in severity with the size of enterprises. The SME sector accounted for about 43.6 percent of GDP in 2005. It dominated production in all sectors in 2005 except industry and communication. It accounted for 22.7 percent of industrial output which means that large industrial enterprises, which are mainly state-owned or controlled, accounted for 77.3 percent of industrial output. SMEs accounted for about 85 percent of output in service sub-sectors such as trade and repairs and hotels and restaurants, indicating the overwhelming dominance of the private sector in these activities. SMEs accounted for 26.1 percent of exports and for 29.7 percent of imports in 2005. It is noteworthy that the greatest share of imports in the SME sector is accounted for not by medium enterprises but by small enterprises. Table 10: Share of SMEs in GDP and Sectoral Output, 2000-05 (%) Share of SMEs in GDP, 2000 – 2005 (%) 2000 2002 2004 2005GDP 100.0 100.0 100.0 100.0 SMEs 42.7 44.8 43.3 43.6 Small 9.2 5.6 6.7 7.4 Medium 6.7 4.4 4.3 4.1 Individual entrepreneurs 10.7 15.1 14.6 15.0 Peasant farms 16.1 19.7 17.7 17.1 Share of SMEs in Sectoral Output, 2005 (%) (including farms) Total Small Medium Individual FarmsIndustry 22.7 6.9 9.9 5.9 -- Agriculture 61.0 1.0 1.0 -- 59.0 Trade and repairs 85.8 35.0 4.6 46.2 -- Hotel and restaurants 84.5 51.9 12.5 20.1 -- Transportation 50.9 7.5 7.3 36.1 -- Communication 6.2 1.7 4.5 -- -- Exports 26.1 15.2 6.7 3.0 1.2 Imports 29.7 19.7 4.5 5.5 -- Source: NSC. Although the SME sector accounted for 43.6 percent of GDP, its share (excluding farms but including individual entrepreneurs) of non-farm or non-agricultural national employment was low at only 12.8 percent in 2005. Small and medium enterprises accounted for only 34 percent of total SME non-farm employment with individual entrepreneurs accounting for 66

37

percent. Excluding individual entrepreneurs and farms, the largest share of SME employment was in manufacturing (33.2 percent). The average number of employees or individuals per SME in 2004 was only 10, reflecting the small size of SMEs and perhaps under-reporting to avoid social fund payments. The average for small enterprises was 5 and for medium enterprises 60. For industrial SMEs, the average was 60, with an average of 10 and 100 for small and medium industrial enterprises respectively. Table 11: SME Sector Employment, 2001-2005 Number of Employed Persons in SMEs, 2001 – 2005 (excluding farms) (Thousand persons) 2001 2002 2003 2004 2005 SMEs total 225.2 214.0 223.1 236.3 247.3 Small 47.6 41.7 41.6 41.7 39.4 Medium 66.3 49.8 47.1 45.3 44.8 Individual entrepreneurs 111.3 122.5 134.4 149.3 163.1 (%) SMEs total 100.0 100.0 100.0 100.0 100.0 Small 21.1 19.5 18.6 17.6 15.9 Medium 29.4 23.3 21.1 19.2 18.1 Individual entrepreneurs 49.4 57.2 60.2 63.2 66.0 SME Share of National Employment, 2002 – 2005 (excluding farms) (%) 2002 2003 2004 2005 SMEs 11.8 12.2 12.6 12.8 Small 2.3 2.3 2.2 2.0 Medium 2.7 2.6 2.4 2.3 Individual entrepreneurs 6.8 7.4 7.9 8.4 SME Employment by Sectors, 2004 and 2005 (excluding farms and individual entrepreneurs) (Absolute number and %) 2004 (%) 2005 (%) Total SMEs 91,949 100.0 88,495 100.0 Agriculture 8,462 9.2 8,372 9.5 Industry 35,048 38.1 32,689 36.9 Mining 1,814 2.0 1,846 2.1 Manufacturing 31,555 34.3 29,412 33.2 Electricity, gas & water 1,679 1.8 1,431 1.6 Construction 17,824 19.9 16,981 19.2 Trade and repairs 13,353 14.5 12,812 14.5 Real estate and rentals 7,611 8.3 7,830 8.8 Others 9,651 10.5 9,811 11.1 Source: NSC. The SME sector excluding farms and individual entrepreneurs recorded net losses in three years out of five during the 2000 to 2004 period20. Agricultural SMEs reported losses every year during the period but the largest amount of losses was in SMEs in the transportation (and communications) and construction sectors which recorded net losses over the entire period. On average, about 68 percent of all SMEs were loss-makers and only about 32 20 The reported financial results of SMEs should be treated with caution because enterprises are likely to under-report profits or over-report losses to minimize tax obligations.

38

percent were profitable. Medium enterprises had the highest proportion (at around 53 percent) of profitable enterprises, mainly in construction and trade and communications. However, evidence showing extensive concealment of the real amount of profits and turnover among SMEs mean that these figures must be treated with caution. The number of SMEs is heavily concentrated in Bishkek which account for 63.8 percent of SMEs in the country. The next largest concentrations are in Chui Oblast (10.5 percent), Osh City (7.6 percent) and Jalalabat (4.6 percent). SMEs account for a significant share of oblasts’ industrial output in a number of regions. They account for half or over half of industrial output in Naryn, Osh and Talas in 2005. These are economically less developed oblasts and their high SME shares of industrial output reflect their low level of industrialisation and the paucity of large industrial enterprises. SMEs account for over 50 percent of industrial output in Bishkek which is the most economically and industrially developed part of the country. Table 12: Regional Distribution of SMEs, 2004 amd 2005(%) Share of Share of SMEs in Number of SMEs Oblast Industrial Output 2004 2005 2004 2005 National 100.0 100.0 Batkan 2.3 2.5 40.2 33.1 Jalalabat 5.2 4.6 20.2 21.4 Issyk-kul 3.9 3.6 3.7 5.0 Naryn 1.7 1.8 50.2 47.2 Osh 4.5 3.8 88.3 58.8 Talas 1.7 1.7 45.9 51.3 Chui 11.9 10.5 8.8 9.5 Bishkek City 60.8 63.8 51.5 52.3 Osh City 8.0 7.6 17.4 18.5 Source: NSC. 2.3 The Informal Economy Official estimates of the shadow or non-observed economy (NOE), comprising hidden, informal and household production for own final use, are included in officially reported GDP figures21. The NOE on the production side is estimated to have increased almost two-fold between 1995 and 2004, from 8.4 percent to 15.6 percent of GDP, due mainly to the increasing role of households in production. The share of household agricultural production is estimated at 13.4 percent in 2003 and 15.1 percent in 2004. The size of the NOE in GDP including household agricultural production is officially reported at over 30 percent in 2004. A recent UNDP (2006) study that takes into account the changes in the sectoral structure of GDP following the NSC’s adoption of the International System of National Accounts shows that the highest shares of the NOE outside agriculture are in trade and repairs, accounting for 75.5 percent of sectoral gross value added or 12.1 percent of GDP, followed by transport (34.2 percent of sectoral output and 1.1 percent of GDP) and hotels and restaurants (20.9 percent and 0.3 percent respectively).

21 The NSC has undertaken various studies of the shadow or non-observed economy in the Kyrgyz Republic, with the NOE defined as covering hidden or concealed production, illegal production, informal sector production and household production for own final use.

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Informal activities comprising hidden or unreported and un-taxed activities also occur in the formal sector. The inclusion of these activities would give a fuller account of the actual scale of informal activities in the economy, making the informal sector larger than the NOE based only on activities outside the formal sector. The UNDP study shows that when these activities are taken into account, the informal sector in the Kyrgyz Republic amounted to 45 percent of GDP in 2004, a figure higher than the NSC’s figure of 30 percent. Other studies cited in the UNDP study have estimated the share of the informal sector in the Kyrgyz Republic at 41.2 percent of GDP in 2002-03, compared with 61.3 percent for Azerbaijan, 45.2 percent for Kazakhstan and 37.2 percent for Uzbekistan. In developed economies by comparison, the size of the informal sector ranges from 23.4 percent in Belgium and Spain to 27.8 percent in Italy and 29 percent in Greece. In developing economies, they amount to as much as 76 percent in Nigeria, 71 percent in Thailand and 68 percent in Egypt. The UNDP study’s main findings are summarised in Box 1. An important finding in the UNDP report concerns the role of official corruption in compelling businesses to operate in the informal sector. The report found extensive official corruption throughout every sphere of the Government. Its surveys found that the average bribe paid by businessmen to government officials is over 5,000 Som. The bribe paid and their impact on costs of doing business varied widely depending on the type of business and licenses involved. Average bribe amounts of 10,000 Som are typical for companies in the production and distribution of electricity, gas and water and in financial activities. Bribes averaged 6,000 Som for businesses in manufacturing, construction and telecommunications, and are lowest for those engaged in trade and repairs and in the provision of social services. For companies in certain industries, the level of bribery is so large that it makes the business unviable to operate in the formal sector. The average bribe paid by unregistered enterprises was about two times less than those registered. The largest reported amount of bribes was for JSCs in health and social services (22,500 Som) and construction companies (17,100 Som). Maximum bribes for limited liability companies (LLCs) in finance and in the distribution of electricity, gas and water ranged between 15,000 and 17,500 Som. Box 1: Summary of Selected Findings in the UNDP Informal Economy Study 1. Informal activities among enterprises account for about 40 percent of their total sales profit and wage bill, with about 43 percent of enterprises failing to report their actual incomes. 2. The share of informal activities is 39.6 percent of the current structure of GDP. Trade and repairs is the sector with the largest informal activities, accounting for 39.5 percent of the total informal economy, followed by industry at 24.9 percent and other productive services (hotels and restaurants, real estate and rental, etc.) at 21 percent. 3. A large number of individual entrepreneurs and small businesses, 31 percent and 28.4 percent respectively, operate as un-registered entities. 4. The share of informal activities is highest in the northern and more developed regions of the country, especially in Issyk-kul and Bishkek where the informal sector account for about 50 percent and 40 percent of their respective local economies. Their high shares of informal activities may be attributed to their more economically developed situation, particularly in services, and to higher competition from importers. 5. The economic sectors with the highest share of informal activities nationally are mining, car repairs, trade, and real estate and rentals – sectors where cash transactions predominate except in mining where international bank transactions enables concealment. 6. Informal activities are lowest among the more formal and stringently legally regulated corporate forms such as JSCs and LLCs and highest among unregistered enterprises and patent and private or individual enterprises. 7. Informal activities are inversely related to the size of the enterprises, with the share lowest among

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large enterprises, followed progressively by medium and small enterprises and by individual entrepreneurs. This reflects the greater difficulties of concealment, or the increasingly tighter inspections and supervisions, the larger the size of economic entities. 8. A significant number (43.4 percent) of enterprises throughout the country under-report their incomes and wage bill. The highest level of concealment of actual labour employed and the wage bill is in Bishkek and Issyk-kul although Osh has the highest proportion of illegal workers. The largest proportion of illegal employees and under-reporting of wages are in mining, construction, repairs and hotels and restaurants. 9. A significant share of the economy is un-taxed because of sizable informal and hence unreported activities. It is estimated that the non-taxed economy amount to 32 percent of total production value (excluding agriculture) in 2004. The share of untaxed turnover is highest in light industry, presumably because of the large numbers of underground sewing enterprises in the country. But all industrial branches have sizeable untaxed turnovers which represent significant potential for increasing tax collection. Source: UNDP (2006). According to respondents in the UNDP survey, the worst corruption was associated with tax and audit inspections, followed by inspections relating to the social fund, sanitation, epidemiology, fire standards and then those relating to customs and building standards. A survey of tax inspectors reveal that at least 85 percent of those interviewed have been offered bribes ranging from 500 to 20,000 Som depending on company size and amount of concealment involved. Many companies pay bribes at least twice a year when tax inspections are held although tax inspections are legally allowed once a year. Companies reported that the main obstacles to business were: high taxes, competition from the informal sector (who operate with lower costs and thus enjoy a price advantage), excessive government regulations, political instability and the lack of an effective judiciary and legal system. Overcoming these weaknesses was believed by enterprises to be essential to

ducing levels of corruption and informal activities.

. LEADING ISSUES IN PRIVATE SECTOR DEVELOPMENT

s in living standards then xacerbates problems in governance and policy implementation.

re 3 Economic theory and empirical evidence from international experience both show that the twin processes of market reforms and economic growth are intimately and functionally related and are mutually reinforcing. The experiences of the more successful transition and emerging market economies such as China, Vietnam and India suggest that there is a virtuous circle in the transition process whereby initial market reforms results in higher output growth as a result of gains in factor productivity accruing from a more efficient allocation of resources across sectors and from improved performance of firms subjected to market discipline. High output growth creates more resources and political capital which facilitate and encourage further and deeper market reforms that in turn perpetuates strong growth. The converse of this is a vicious circle of ineffectual market reforms and mediocre or sluggish economic performance, due to poor reform policy implementation arising from a lack of policy commitment and/or weaknesses in public governance and administration. The economy then becomes trapped in a low-level equilibrium characterised by low levels of investment, productivity, international competitiveness, exports, FDI and growth. Social discontent and political instability arising from insufficient progrese Why has the Kyrgyz Republic not been able to generate a virtuous circle of reform and growth despite important initial progress in market reforms? The answer in analytical or conceptual terms lies in large part in the dysfunctioning of its market mechanism. This stylized facts of Kyrgyz economic performance discussed in the preceding sections of this

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demand among its fast growing eighbours is also evidence of its dysfunctional market.

ironment and investment climate is in turn the prerequisite higher levels of investment.

1 Agriculture and Industry

.1.1 Agriculture

tors, such as water availability, input supply and markets determine farm economic tatus.

report provides numerous empirical evidence of the macroeconomic symptoms and consequences of a dysfunctional market mechanism, such as low rates of output growth, levels of investment, productivity, international competitiveness and exports as well as insufficient progress in economic diversification. The inability of the supply side of the Kyrgyz economy to respond vigorously to growing external n This section examines the leading issues in private sector development in the Kyrgyz Republic from the sectoral perspective. The key constraints to private sector activities in these economic sectors, as well as to their overall development, are mainly generic to all sectors and include factors such as under-investment, technological backwardness and weak market-oriented management skills. Among these, clearly the most decisive are under-investment and a poor physical infrastructure. As such, they relate to general features of under-development typical of all developing countries. However, these may also be seen to stem from a dysfunctioning of the market mechanism as manifested in a poor business environment and weak investment climate. The sub-sections below provide numerous examples of these in various sectors. The basic causes of the unfavourable business environment and investment climate are excessive state intervention, weak implementation of structural and policy reform policies and official corruption. Extensive state interference means that the state gives with one hand in creating a basic market system but then takes back with the other hand through extensive and debilitating regulation and controls. The poor business environment and investment climate result in weak corporate and household sectors that are unable to generate savings to underwrite a growth in financial intermediation and investment. If higher level of investment is decisive to the country’s growth prospects, then improving the business envto 3. 3 Agriculture remains the structural backbone of the real sector in the Kyrgyz economy. Over the past ten years the sector contributed around 35 percent of GDP and accounted for over 50 percent of the working population. The share of the agro-food sector accounts for over 40 percent of GDP when associated processing, service and trade industries are included. Around 1.4 million ha (7 percent) of the 200,000 square kilometres surface area of the country is arable land. Irrigated agriculture covers about 1.1 million ha (80 percent of arable land). Although its share of GDP (30.5 percent) is now smaller than services (40.2 percent), agriculture is still the most important activity in the national economy due to its key role in alleviating poverty and in providing employment, food security and consumer price stability. Agricultural employment (now at over 925,000 persons) has increased by 61.6 percent since 1991. The sector absorbed not only much of the growth in the labour force but also the surplus labour displaced during the deindustrialisation and SOE privatisation process. The absorption of labour combined with a decrease in the cultivated acreage from 1,300 thousand hectares to 1,118 thousand hectares has meant a significant fall in farm labour productivity and increasing fragmentation of farm holdings into smaller sizes, with individual households and small farms dominating the sector. According to a recent social assessment of the agricultural sector undertaken by the World Bank, however, there does not appear to be a positive relationship between holding size and the economic status of farms. Many other facs

42

. In general, income from cropping is the ost significant farm household income source.

development; (vi) trade and tax policy; (vii) rural finance; and (viii) rural evelopment.

Agricultural growth rates display a decelerating trend. High growth rates of 10 percent in 1996-97 fell to about 5 percent in 1998 to 2001, and to 4.1 percent and negative 4.2 percent in 2004 and 2005 respectively. The annual average growth rate fell significantly from 9.6 percent in 1996-99 to 2.7 percent in 2000-05. Growth in agriculture has been driven more by the desire of rural households to increase food security rather than as a response to market incentives. Growth to date has relied on expansion of subsistence agriculture and inflow of labour to agriculture. But decelerating growth rates reveal the exhaustion of this pattern of development. Current crop yields are at a low to moderate level as expected from low-input irrigation systems where crop management is poor and water delivery (time and volume) and water management are below optimum levels in many cases22. The lack of availability and currently critically poor state of agricultural machinery is also a constraint. There is thus considerable scope for increasing the productivity of major crops through basic improvements to crop management and input usem Given the limited scope for expansion of the agricultural area, the principal source of sectoral growth will have to be come from increased agricultural factor productivity. This will require greater economic diversification and a shift away from current patterns of resource use and input-based growth towards higher productivity based on increased application of agricultural and science-based technologies. Continuous flow of knowledge and innovative best practices to production entities and administrative agencies in the sector is decisive to raising productivity, as is the critical need to raise the overall level of investment. Both the CDS and the Presidential address to the nation on 28 September 2006 give priority to policies for developing agro-processing and promoting investment in the sector. An ADB-supported study (ADB 2006) on a development strategy for the agricultural sector in the Kyrgyz Republic identifies 120 problem areas restricting agricultural development in eight priority areas that are to be addressed by the draft strategy following consultations with the Government. The priority areas are in: (i) public sector services; (ii) agro-processing and marketing; (iii) land market development; (iv) water resources management; (v) training, research and d Higher crop yields can be achieved in response to irrigation, higher input use, improved crop varieties and more efficient management systems, but farmers are unlikely to significantly expand output beyond subsistence levels unless their surplus production can be sold profitably. There is presently very little value added downstream of the farm gate and supply chain linkages are weak. It is estimated that less than 15 percent of agricultural produce by value goes to manufacturing sub-sectors. There is therefore considerable but largely unexploited potential for the development of agri-businesses in food, cash crop and horticultural processing and in inputs for light industry (cotton, wool, leather, etc.). Agricultural processing has recently grown at over 6 percent per year and currently accounts for 14 percent of manufacturing and employs 50,000 persons. The value chain between agriculture and industry (and exports) is underdeveloped, with agri-businesses processing only 10 to 12 percent of agricultural output in 2003-05. Under the CDS 2006-10, the Government is seeking to raise this to 20 percent by 2010. Although agricultural exports to Russia and Kazakhstan have grown in recent years, their overall share in total exports has not grown. Development of agri-businesses and agricultural exports will require

22 An interesting comparison is the yield of winter wheat which averages out in the Kyrgyz Republic at about 2.4 ton/ha as compared to 4.7 ton/ha in Xinjiang Province of China, an area where the agro-ecology is quite similar (WB 2006b).

43

high value-added production and a wider range of better quality rocessed products.

ld Bank 2006b) and on gri-business marketing development (World Bank 2004a, 2005c).

es and commercial organizations to improve the ompetitiveness of Kyrgyz products.

diversification towardsp Measures to sustain sector growth will need to emphasize not only technology transfer to increase production and productivity, but also measures that improve the incentives to increase marketed volumes and to engage more actively in agricultural markets. The commercialization of agriculture will be a major challenge due to the small size of the domestic market, the difficulties of exporting, the weakness of physical and market infrastructure, poor understanding by farmers of how markets work, and limited agro-processing facilities. The domestic urban market comprises no more than 2 million people, many of whom still produce part of their own food. It is thus easily saturated, especially given the ease of importing agricultural products into the Kyrgyz Republic. A number of major initiatives aimed at raising productivity, diversification, water management and rural market infrastructure development are being supported by the donor community, including an Agricultural Area Development Project (Chui Oblast) supported by the ADB and the World Bank-supported projects on water management improvement (Wora Collaboration and creation of strong linkages is needed with organizations involved in support to irrigated agriculture, agro-business, marketing, and rural development, especially those providing training and human resource development at the Water Users Association (WUA, in which users or farmers assume responsibilities for management and maintenance of local irrigation networks) and farmer level. At the moment many farmers do not benefit from advisory services. There are various organizations that provide assistance to farmers through training and workshops, but the advice tends to be too general and not focused enough to satisfy the diverse farmer needs. The most important advisory service is the Rural Advisory Services (RAS) under the Agricultural Support Services Project (ASSP) supported by the International Development Association (IDA), International Fund for Agricultural Development (IFAD) and the Swiss Government. RAS is providing important assistance to farmers in most areas of the country by such measures as general farmer and staff training and the provision of extension materials, but is not reaching a sufficient number of farmers. A recently approved World Bank/IDA-financed Agribusiness and Marketing Project will assist the Government in expanding the level of activity in processing, marketing, and trade enterprises downstream the farm-gate, in order to increase the number, and economic importance of producer organizations. It will also help build trade linkages between producers and primary and secondary level trade organizations. The project will work directly with private enterprisc Various policies for promoting agricultural development are detailed in the CDS 2006-10. The more efficient use of land to increase productivity is to be facilitated through making the market for land function more efficiently. This will involve measures to strengthen private property rights in land ownership, including (i) the privatisation of state-owned land and farms, (ii) completion of the land ownership registry, (iii) clarifying individual household registration of land and asset ownership in collective farms, (iv) simplifying laws and procedures for land purchase, (v) adoption of a law on land leasing, and (vi) creation of an electronic registry database on land ownership, leases and contracts. Access to finance in agriculture and agri-businesses is to be facilitated by eliminating legal barriers on the use of land as collaterals and encouraging financial leasing, with a law on financial leasing expected to be adopted in 2007. Irrigation services and water resource management will be improved by further structural and institutional reforms. This would involve a clearer division of the respective rights and responsibilities of the WUA and the Water Resources

44

or condition, essential for developing the rural arket infrastructure and the value chain.

of acceptable ollateral in rural areas24 and the perceived high risks of agricultural lending.

for e attraction and programming of domestic private sector and foreign direct investment.

.1.2 Mining

nd gold production ere is steadily declining with output likely to cease in a few years’ time.

Department (WRD) in the Ministry of Agriculture. Ownership of the state-owned irrigation system will be gradually divested to the WUA with state ownership retained only for irrigation structures of national and regional importance. Tax incentives are to be improved with the new Tax Code exempting medium and large farms and agri-businesses from VAT and the imposition of a higher rate of land tax which will accrue to local governments for use in developing the rural infrastructure. The WUA’s capacity to rehabilitate and expand local irrigation and drainage systems transferred to it, however, will require external funding (borrowings, equity sales and donor contributions) as well as increase in tariffs and collection rates. A further constraint is the lack of funds to rehabilitate and develop the rural road network, which is currently in very pom Investment in the sector has mainly been in the form of public sector investments funds provided through the PIP. There has been extremely little FDI to the sector and domestic private investment is almost insignificant relative to the sector’s requirements. FDI in agriculture amounted to only $763,400 in 2005, a decrease of 8 percent compared with 2004. Despite the importance of the agro-food sector in the economy, only about 5 percent of total lending by commercial banks goes for agriculture, agro-processing and storage activities. The main reasons for very limited lending to agriculture stem from systemic weaknesses in the banking sector. Constraints to agricultural lending include lack of skills among commercial banks in appraising long-term agricultural loans23, the lackc The ADB-supported draft development strategy for agriculture proposes the development of public-private partnerships (PPPs), including management by concession, as an innovative means for promoting investment in the sector. This will require a clearer delineation between areas of agricultural activities reserved for the private sector and those retained by the public sector. The draft strategy recommends that agriculture public administration specialize on a limited range of essential public services provision while services best provided by the private sector, including stock-breeding, seed farming and fish farming, be privatised. Another recommendation is the establishment in the Ministry of Agriculture of a capacity th 3 Mining became the main sub-sector in industry in the late 1990s with the collapse of manufacturing post-independence and the onset of gold production at Kumtor. Official statistics show that mining in 2004 accounted for 48 percent of industrial production, 10.2 percent of GDP, 41.1 percent of exports and 11 percent of tax revenues. The industry employed over 15,000 workers whose average monthly wage (about 10,600 Som) is four times the national average. The creation of one job in the industry leads to the creation of 1.6 jobs in related upstream and downstream industries. However, as noted elsewhere in this report, quarry reserves at Kumtor has been exhausted since 2004 ath The CDS as well as the Presidential address to the nation on 28 September 2006 identify the mining industry as one in which the Kyrgyz Republic has a comparative advantage. The industry has been singled out as priority sector and is planned to become a major contributor

23 As of end-2003, there were no commercial bank loans for agriculture in either production or processing with maturity of over one year. 24 KAFC is an exception in working with a wide range of assets in rural areas.

45

five years, the number of operational mines in the yrgyz Republic has declined two-fold.

itial ublic offering (IPO) overseas, possibly on the London Alternative Investment Market.

mbines regulatory and owner-operator functions and is not commercially or arket oriented.

to accelerated GDP growth and. It is unclear, however, whether the industry does indeed enjoy a comparative advantage and whether its growth prospects are as strong as believed by the authorities. FDI in the industry outside gold mining, for example, has been negligible25. Development of the industry has been hampered by the remote, inaccessible and scattered locations of mainly small ore deposits in mountainous areas. Moreover, raw or smelted ores never constituted a major product or a major export during the FSU period although this may have been due to backward Soviet mining technology and/or more abundant and easily exploited resources elsewhere in the FSU. Despite increasing global demand for mineral resources and higher prices, and despite an increase in the number of registered mining companies in the pastK Whatever the actual potential of the industry is, its potential has remained largely unexploited due to chronic under-investment. The investment climate in mining is poor due to two key factors: weak state governance or excessive state interference and shortcomings in the legal framework in the industry. State interference has been justified on grounds that mining is a strategic industry and the thesis that since most mines had been developed during the FSU period by the state with public investments, the state today therefore has the right to control developments in the industry. State mining companies dominate the industry and enjoy subsidies and preferential treatment from the state. The Government’s involvement in gold mining is through the state-owned gold mining company OJSC Kyrgyzaltyn which has received huge and preferential privileges in its refining activities. Kyrgyzaltyn’s 66 percent equity holding in Kumtor was reduced to 33.3 percent in 2005 and subsequently to 15.7 percent. The company has broadened its role by forming voluntary joint-ventures with private and especially foreign investors. These (mainly foreign) joint ventures have proved unprofitable for the state (although corrupt elites involved may have reaped significant financial benefits) and unattractive to foreign investors because of over-valuation of state capital contributions and under-valuation of the investors’ capital contributions. According to the draft CDS, the Government now intends to fully privatise sub-surface resources through competitive sales to encourage foreign investment. OJSC Kyrgyzaltyn, which also owns significant gold deposits, is to be privatised through an inp The legal framework governing the industry based on this paradigm is restrictive and unfavourable to private and foreign investors. Excessive state regulations have also led to extensive corruption. The development of mining in the Kyrgyz Republic depends critically on an abandonment of this paradigm and significant improvements to the legal framework and tax regime to create a more favourable investment climate. The existing Soviet-era based legal framework contains provisions on subsurface use of resources that hinder operations of mining companies. Its operative specialised laws on subsoil, on segregation of exploitation of different types of mineral resources (such as oil and gas, coal) and on production sharing agreements contradict one another. By-laws in the forms of regulations, orders, instructions, etc., are often based on wide and arbitrary interpretations of the law and result in complicated licensing procedures and industrial safety norms as well as corruption. The investment climate is also undermined by a discriminatory and distortionary tax regime and by the retention of a Soviet-era system of management and administration in the industry which com

25 Lack of FDI may be due to an unfavourable investment climate in the sector due to shortcomings such as a highly restrictive legal framework and excessive state interference, but these factors have not constrained FDI where there are clear commercial prospects such as in gold.

46

ould allow the dustry to grow significantly more than if the reforms were not implemented.

A recent World Bank-supported study (PIU 2005) of the mining industry undertaken by the Government and consultants proposed a roadmap for development of the mining industry based on international best practices in the legal, taxation and governance system relating to mining. The legal framework in mining would be improved by replacing existing disparate and contradictory laws with a single unified Mining Code which would address current weaknesses. On taxes, the study found that the current fiscal regime is the Kyrgyz Republic in terms of the tax burden is slightly worse than in Kazakhstan and Mongolia but better than in Uzbekistan, China and Russia. A disadvantage in the Kyrgyz’s tax system is that excessively high royalty rates (12 percent of sales) for a number of minerals makes it difficult for mining companies to amortize its funds or assets for a variety of projects. If amendments to mining taxation are incorporated in the new national Tax Code, then the Kyrgyz Republic will have one of the world’s most favourable tax regime in mining. However, the new Tax Code also contains provisions for taxation methods based on negotiations rather than on law which would create conditions for corruption. According to the study’s projections, adoption of legal, tax and governance reforms together with improved collection and analysis of geological information in the mining industry detailed in the roadmap win Table 13: Mining Industry Development Impact Scenarios Passive Scenario (roadmap reforms not implemented): assuming current gold production in Kumtor, Makmal and Solton-Sary gold mines last until 2010, plus existing production of mercury and non-ore materials. (In US$ unless otherwise noted) 2005-10 2010-20Tax revenues p.a. $37 million $8 million Investments in mining $124 million 0 Net mining exports p.a $234 million $6 million . Local purchases p.a. $27 million $12 million Retained value p.a. $87 million $31 million Employment (persons) 14,398 11,613 Reformed Scenario: assuming reforms in regulatory environment, continued underground reserves development in Kumtor and Makmal gold mines; commencement of gold mines at Jeroy, Taldybulak-Levoberejny plus mines under project design at Kuru-Tegerek, Ishtamberdi and Tereksay; introduction of 2 gold mines with 50 tons reserves each with annual production of 4.5 tons each; increase in non-ore minerals production by 50 percent; and opening of one new tin mine. (In US$ unless otherwise noted) 2005-20 Tax revenues p.a. $90 million Investments in mining $683 million Net mining exports p.a. $391 million Local purchases p.a. $45 million Retained value p.a. $170 million Employment (persons) 19,939 Speculative Scenario: assuming reformed scenario plus introduction of operations of “Lucky” gold mine equal to Kumtor gold mine; gold price of $470/ounce; 50 percent increase in non-ore materials, coal, oil and gas; increase in local purchases due to import substitution. (In US$ unless otherwise noted) 2005-20 Tax revenues p.a. $120 million Investments in mining $1,168 million

47

Net mining exports $576 million Local purchases p.a. $76 million Retained value p.a. $237 million Employment (persons) 26,694 Source: PIU (2005). 3.1.3 Textiles and Clothing

tile and lothing industry may have considerable growth prospects that could be developed.

tive, sometimes exacerbating difficulties faced by producers, due to eak implementation.

duce modern technology, market-oriented management and access to export arkets.

.2 Infrastructure and Services

The textile and clothing industry in the Kyrgyz Republic was a priority sector that enjoyed significant investments during the FSU period. The industry still accounted for nearly 40 percent of budgetary revenues and employed nearly 300,000 persons in the mid-1990s. Since then the industry has declined significantly due to its inability to adapt to a market-based economy and to a lack of investment. However, the industry still constitutes the lion share of light industry. Light industry now accounts for about 3 percent of GDP with textiles and clothing contributing 77 percent to total light industrial output and 2.3 percent of GDP. The availability of abundant raw materials, relatively low technological requirements and its potential both in creation of significant employment and exports means that the texc Of a total of 559 industrial enterprises privatised between 1991 and 2003, 55 were in light industry. The major textiles SOEs converted into JSCs were the KKSK, Bishkek Kenaf Manufacutring, Tekstilschik, Osh-Zhibek, Mata and Osh Non-woven Fabric Manufacturing. Most of these entities were unable to compete against imports and to survive. The entire (and largely privatised) textile industry declined in almost all categories, including falls of 350 percent in cotton fabric production, 400 percent in wool fabric and 650 percent in silk in 1998-2002. The industry today no longer produces silk fabrics and children clothing due to competition from low-cost imports. The industry’s decline can be attributed to a variety of factors, including weak market-oriented management skills, uncertainties in supply of raw materials, increased competition from low-cost imports and lack of investments in newer technology needed to achieve increases in product quality, variety and competitiveness. The competitiveness of the Kyrgyz Republic’s textile and clothing industry is below those of comparator countries such as China because of low productivity despite lower nominal wages. The industry’s decline also resulted in the severance of traditional supply and value chains among rural producers of raw materials (animal fibres, cotton and silk), the spinning, cloth weaving, knitting, dyeing and printing industries and clothing and household textile manufacturers. Government policies to reverse the decline in the textile and clothing industry have largely been ineffecw Abundant domestic raw materials provide prospects for a revitalisation of the industry. The raw material base comprises raw cotton, wool and other animal fibres, silk cocoons and chemical fibres. Cotton is a major industrial crop in the Kyrgyz Republic and farming conditions in the southern region of the country are favourable for intensive production, higher yields and improved quality through the application of more advanced agro-technology and management. About 95 percent of current cotton production is exported without processing or value-added. Increasing production quantity and quality, as well as value-added in exports, will require significant private investment and specially FDI that could introm 3

48

.2.1 Energy

ut the weighted verage rate is still below cost recovery rate of 0.94 Som or $0.02 per kWh.

ort and storage and also participates in joint-entures and production-sharing agreements.

ry funding to maintain construction of the Kambarta yrdroelectric Power Station 2.

3 The development of the energy sector is singled out as a priority in both the Presidential address to the nation on 28 September 2006 and the draft CDS. The authorities believe there is considerable development potential in the energy sector. Although accounting for only 2 percent of energy resources in the CAR, it is officially reported that the country has sizeable coal reserves and about 30 percent of the region’s hydro resources, of which only 10 percent is currently exploited. The coal industry is highly inefficient and its development is constrained by backward technology and the high cost of transportation to markets and final users. The industry runs at a loss and is subsidized through the state budget. The power sector currently accounts for nearly 5 percent of GDP, 16 percent of industrial output and 10 percent of state budgetary revenues. Energy losses, due to thefts and inefficiencies in transmission, amount to over 40 percent of output of which 25 percent was commercial losses (tariffs below cost recovery) and theft. In 2005 the state collected only 73.7 percent of payments for actual energy consumed. The huge accumulated debt of energy companies (quasi-fiscal deficit amounting to 7.6 percent of GDP in 2005) has undermined tax and loan payments to the state budget, creating knock-on effects of a triangular chain of mutual debts and defaults among suppliers and consumers. A unified rate of 0.62 Som or $0.01.5 per kWh for energy was introduced for household consumers on 1st May 2006, ba The state dominates the energy sector. An important measure in the restructuring of the energy sector was made in 2001 when the vertically integrated energy generation and distribution monopoly, Kyrgyz Energy, was unbundled along functional lines into four distribution companies that were to be privatised. However, hardly any progress has been made in privatisation due in part to political objections. For example, the privatisation of one of the unbundled distribution companies, Severelectro, was stopped by parliament. The State Energy Agency (SEA) created in 1997 to regulate the industry was abolished in 2006 and its functions transferred to the Anti-Monopoly Committee. Small (mini) hydropower plants and private energy distribution companies were created but this measure did not improve the efficiency and financial performance of the industry because of incomplete restructuring and privatisation, the failure to adapt to a market or commercial orientation in management and operations and weaknesses in the legislative and regulatory framework. In the gas sub-sector, the state-owned monopoly Kyrgyz Gas owns and operates the transmission and distribution network. Kyrgyz Gas is planned to be restructured into a separate transmission joint-stock company with several distribution companies created and privatised. The state-owned national oil and gas monopoly, Kyrgyzneftegaz, is responsible for exploration, production, processing, transpv The authorities’ stated long-term objective for the energy sector is to eradicate losses and achieve energy security by 2025. To achieve this objective, specific institutional, tariff and investment policy reforms and measures are proposed in the draft CDS. Achieving this objective, however, will require privatisation most likely to a foreign strategic investor who can recapitalise and restructure the industry and introduce modern market and commercially-based management methods. No significant investments have been made in the energy sector for the past several years except for minor investments under the state’s PIP and insignificant budgetaH The Central Asian region is well endowed with significant energy-related resources but the

49

clined with each republic focused on chieving a higher level of self-sufficiency in energy.

d and gradual rocess of partial divestiture, an option which is discussed later in this report.

ntial for the Central Asian countries. Its key findings on the yrgyz Republic are as follows.

al basis with greements between various pair of countries based on consistent principles.

distribution of these resources is highly skewed. The Kyrgyz Republic (and Tajikistan) has abundant hydropower potential but negligible amounts of fossil fuels in contrast to Kazakhstan which has significant reserves of oil, gas and coal, Uzbekistan which has substantial gas reserves and Turkmenistan which also has substantial gas reserves and some oil. During the FSU period these resources were managed on an integrated and regional basis. Hydropower resources in the Kyrgyz Republic (and Tajikistan) were operated primarily as an irrigation system for agriculture with power generation being secondary. After the break-up of the FSU, the scope of regional exchanges or transfers, which began to be undertaken in the form of trade in energy, has dea No regional energy cooperation arrangement is in place, with each CAR country seeking to use its own energy and water resources domestically although a joint use and trade of these resourced would yield greater mutual economic benefits. The apparatus for energy policymaking and regulation also needs to completely overhauled. The Kyrgyz Republic currently lacks a single authority for the development of the fuel and energy complex, leading to uncoordinated, fragmented and incoherent policies and management26. It is difficult to see how the energy sector can be developed without progress in privatisation. Reform and restructuring of both the hard and soft infrastructure of the energy should be tailored to facilitating privatisation. Given the political controversies surrounding privatisation of energy, the authorities should make a greater policy commitment to a phasep The authorities are also seeking to increase the share of energy (hydropower) exports both within and outside the Central Asian region as part of its overall export-led development strategy. Sustained growth in neighbouring countries such as China, Iran, Pakistan and Russia, as well potentially increased political stability in Afghanistan, has raised the authorities’ expectations that opportunities may materialise to export significant amounts of hydropower outside the region. However, the Kyrgyz Republic faces energy shortages in the winter and attempts to secure major export markets for its summer hydropower surpluses have to date not been successful. The World Bank (2004b) has undertaken an assessment of regional electricity export poteK In terms of meeting regional demand, the most attractive new generation option for the Kyrgyz Republic is the Bishkek II Thermal Power Project which is partially constructed. This project represents a more cost effective and quicker option to meet the country’s future requirements than the Kambarata hydropower projects. However, both the Bishkek II Thermal Power Project and the Kambarata project are dependent on availability of gas supply from Uzbekistan. In addition, some upgrading of the transmission facilities will be required to facilitate intra-regional trade, including the construction of the North-South Line in Kazakhstan and the reduction of transmission bottlenecks in the southern part of the Central Asian grid. If intra-regional trade in energy can be developed, then it could provide significant benefits. However, appropriate agreements among the countries in the region will be required. These most likely will have to be negotiated on a bilatera In terms of exports outside the region, countries such as Afghanistan, Pakistan, Iran, China and Russia are all potential markets for electricity. Pakistan and Iran, in particular,

26 The creation of the Ministry of Industry and Energy Resources in February 2007 might serve as a single authority for the fuel and energy complex.

50

gion would require agreements on power ansit with a number of Central Asian countries.

rters vary. Western vestors currently view new generation projects as high-risk ventures.

the usiness environment that could facilitate future large-scale investments in generation.

jects, beginning with smaller ones that do not need riparian greement such as Bishkek II.

.2.2 Transport and Communications

percent annually. Transport and communications currently account for 17

experience their peak demand when the largest potential electricity surpluses exist in the Kyrgyz Republic and other Central Asian countries. Access to these markets will particularly benefit the Kyrgyz Republic (and Tajikistan) which has the potential to export significant quantities of electricity. Accessing these markets, however, face a number of constraints such as the ability of Afghanistan to pay for electricity imports, transit and associated construction of new transmission facilities through Afghanistan to access markets in Pakistan, the considerable distance to population centres in Eastern China where electricity demand growth lies and access to the Russian market via the North-South transmission line across Kazakhstan that is under construction. Potential supplies from the Kyrgyz Republic to Iran will also likely have to compete with supplies from Turkmenistan and Tajikistan and will have to transit through Afghanistan or Turkmenistan and possibly through Uzbekistan as well. Thus, access to export markets outside the retr Major new generation projects in the Kyrgyz Republic to export markets outside the region will only be commercially feasible if there is assured transit access. Electricity from the Republic Kyrgyz and other Central Asian countries has the potential to compete in cost terms with marginal generation costs in each of the potential export markets, but the cost advantage is not overwhelming and may not be sufficient to overcome concerns over security of supply. The development of export markets will be very much demand-driven. Moreover, perceptions of risk among potential investors and impoin A possible scenario for the development of Central Asia’s electricity generation and trading – within which prospects for the Kyrgyz Republic have to be situated – envisaged in the World Bank study involves a phased introduction of measures to make capacity available, beginning with the introduction of loss-reducing programmes, followed by construction of new capacity (i.e., Bishkek II Thermal Power Project) needed to meet local winter demand and the completion of the transmission link to Russia through Kazakhstan. These activities should be completed within a medium time frame of up to 10 years. However, the outlook for implementation of new projects, focused on export markets outside the region, in a subsequent phase is currently too uncertain to justify the commitment of significant resources to larger generation projects. As such, the World Bank study suggests that efforts should instead be focused on developing intra-regional trade in electricity and improvingb The study shows that investment needs being considered by the Kyrgyz Republic, for the rehabilitation of existing plants and networks as well as for new projects (covering transmission and distribution, rehabilitation or new construction of generation facilities at Bishkek CHP 2, Kambarata 1 HPP and Kambarata 2 HPP) are huge, amounting to $2.67 billion between 2004 and 2025. The prioritisation of investments should be on, in decreasing order: (i) loss reduction first, followed by generation rehabilitation; (ii) using existing surpluses to develop trade in electricity; with Russia a serious export market for the Kyrgyz Republic upon the completion of the North-South line in Kazakhstan; and (iii) then consider implementing new proa 3 The transport and communications sector is officially reported to have grown by 10.5 percent annually in recent years, with especially rapid development of modern communications which grew by 20

51

ercent of GDP.

wned and only limited restructuring has taken place. A new national airline is to be created.

refully focused interventions, even more serious degradation is evitable (ADB 2006).

r (or 1,000 ilometres over the past five years) due to inadequate funding for maintenance.

and gro-processing in particular, thwarting national programmes for poverty alleviation.

p Transport. Transport services other than road are heavily regulated by the state. Inter-city road transport services are largely privatised. The national air carrier and railways are state-o A deteriorating physical transport infrastructure is a major constraint to economic development in the Kyrgyz Republic. Freight and passenger road transport accounts for about 95 percent of internal transport. However, the country’s roads system is facing a crisis. Recent studies by the World Bank (2006) and the ADB (2005c, 2006) of 4,300 km of the country’s principal roads found that two-thirds were in distressed condition. These very poor roads carry two-thirds of the country’s traffic volumes. Structurally, one fifth of the roads studied were found to be degraded beyond the point where any asphalt surfacing could be repaired. Past neglect in maintenance means that little can now be done to prevent a large part of the present asphalt surfacing from degrading to un-surfaced conditions. Without massive, rapid and cain The main transport corridors comprise 2,231 kilometres and 6 routes, of which the main arteries include routes from Bishkek to Osh, to Georgievka, to Chladovar and to Naryn and onwards to Torugat. The condition of these corridors is generally poor and results in high freight transport costs that constitute a high percentage of production and marketing costs which undermine the competitiveness of Kyrgyz enterprises. Public funding of road maintenance has been very limited and averaged only 200 to 250 million Som per year. This amount is reported to be about 15 to 20 percent of the amount necessary to maintain roads in good condition. About 200 kilometres of hard surface roads are lost each yeak The failure to improve the roads network will seriously undermine the country’s development prospects. Centres of industry and commerce will be isolated and lose trade competitiveness against countries in the region. Dispersed population groups within the country, especially in the rural areas, will become further disconnected from urban markets and social services. It will also undermine the development of rural marketing networks and supply chains essential to rural development and the development of agri-businessesa The main objective in transport development, as laid out in the draft CDS and the Presidential address to the nation on 28 September 2006, is to improve access to both regional and local markets27. The overriding policy objectives of the Kyrgyz Ministry of Transport and Communications (MOTC) are: (i) assured connection between regional markets and the Kyrgyz national hubs of industry and commerce, as well as access to sites of prime interest to international tourists; and (ii) assured access to local markets for goods and services, as well as to social amenities, for all main national population centres. Given the shortage of investment resources available, the priority in the Kyrgyz Republic road sector has to be on stabilisation and maintenance of the existing road networks before undertaking further extremely expensive rehabilitation and reconstruction (ADB 2006). The considerable investments needed, relative to the country’s level of GDP and budgetary position, even for maintenance will have to come from public investments supported by

27 As detailed in the draft CDS, achieving these objectives will include measures for the full rehabilitation of the Bishkek-Osh, Taraz-Talas-Suusamyr, Osh-Isfana and Bishkek-Georgievka routes.

52

mbitions and national budgetary resources that are likely to be allocated to e road sector.

level make it unlikely that donor financing of e road sector can be significantly increased.

uld be made conducive to private and foreign vestments that could come in the future.

grants and loans from donors. Preliminary calculations show that there is wide gap between MOTC’s budget ath A preliminary assessment of the investment resources available for the transport sector in the Kyrgyz Republic, based on national and MOTC budgetary projections, show that budgetary allocations to the transport and communications sector will increase from $42 million to only $53 million in nominal terms between 2006 and 200928 (ADB 2006). These amounts represent a constant share of 6 percent of total budgetary spending, or effectively only 1.4 percent of GDP. A significant part of the increase will be absorbed by inflation so the increase in investment in the sector through the budget will be marginal. The main domestic means for increasing investment financing in the road system is through either higher taxation and/or reallocation of budgetary resources from other sector, both of which would be politically controversial. External financing from donors will account for an important component of budgetary investments in the road sector. The country’s high debt burden and the need to reduce its external debtth The draft CDS states that private financing in the long run will not be a key source because of the public goods nature of roads, and funding will therefore have to rely to a considerable extent on donors. But unless this policy is changed to allow greater private sector participation, the road sector will be unable to develop in line with national economic requirements as a result of significant shortfalls in investment funding. The role of private and foreign investment in the country’s road sector is unlikely to be significant in the short to medium term. Such investment in the longer-term is likely to be in toll roads in high traffic corridors which could yield a commercial return. Other FDI is likely only when investors seek to exploit resource opportunities (such as minerals) and require transport access. However, there are opportunities for private investors in the near to medium-term in private contracting or outsourcing in road maintenance. Regardless of the extent and pace of private sector participation, the entire road management system should move towards greater commercialisation and operations based on market principles. The policy and institutional environment in the road sector also shoin Innovative private and external financing mechanisms, involving equity financing in the form of public-private partnerships and/or from concessions and performance maintenance contracting, could substantially increase investments in the road sector. The Kyrgyz Republic’s roads sector has hitherto been closed to the public (i.e. private sector) and has suffered as a result. It lacks a body of stakeholders such as private contractors who can lobby the Government to ensure regular and effective funding of the sector. The Road Fund that was enacted in 1998 has never truly functioned to support the sector’s development (ADB 2006). Taxes collected under the Road Fund are not paid into a separate account as decreed by legislation and the Fund has never received any money. Road Fund taxes are absorbed into the general fund of the Ministry of Finance and Economy and are not earmarked for road sector development. A clear and predictable financing mechanism for roads is needed and the functioning of the Road Fund as originally intended when it was enacted would serve this need. Nonetheless, innovative solutions for financing road investment as used successfully in other countries need to be adopted. One such solution is an autonomous, non-discriminatory (i.e. applicable to all vehicles irrespective of national

28 These figures are from an appendix to the ADB-supported road sector strategy for the Kyrgyz Republic currently being drafted by M. Sims.

53

sing solution for raising investment funds needed to aintain the country’s road system.

f small works contractors, thus reinforcing market reforms and rivate sector development.

al phone services using wireless fixed telephone terminals with its own power upplies.

registration) road user payment system based on toll charges on heavy commercial vehicles, who cause the greatest wear-and-tear and damages to roads, using the international corridors. Road tolls are allowed under Kyrgyz legislation but only where there are alternative routes29. But such alternatives are rare given the topography of the country. In the long-term, tolls are the most promim Greater private sector participation will require a separation of roles in the road sector between the Government and the private sector. Most countries are actively separating planning from management of roads for two main reasons. First, state road agencies have too many conflicting responsibilities: they are typically responsible for planning, managing and executing road works, and as such they are both supplier and consumer of work they finance. This conflict of interest weakens financial discipline and compromises efforts to control costs and maintain quality. Second, state road agencies are usually public monopolies and thus not subject to market discipline. Although the MOTC has divested its road transport operations (the “avtobases”) into the private sector, road maintenance operations have been retained by the state as a strategic activity. This has not had desirable results as both the quality of roads and the MOTC’s technical capacity to intervene have declined. The draft road sector development strategy therefore recommends that maintenance works be opened to private contractors. Another recommendation is greater community participation in decisions concerning their (local) road networks and opportunities for them to earn income from works carried out. Community-based organisations in both developed and developing economies successfully manage small road networks. They make assessments of their communal needs, select the most appropriate labour based on labour and/or mechanised technology to mobilise, estimate costs and possible resources and consult with their local communities and potential donors30. Community based initiatives also promote the emergence op Communications. Telecommunication, and mobile (cellular) telecommunication in particular, has been one of the more dynamic sector in the Kyrgyz economy in recent years with considerable foreign investor interest. Following the Kyrgyz Republic’s accession to the WTO, the telecommunications market has been liberalised with the state-owned Kyrgyz Telecom monopoly (created in 1993) on international and long-distance calls ended. Progress in the privatisation of Kyrgyz Telecom has been very slow and parliament blocked proposals to divest 51 percent in 2003. As the biggest telecommunication company in the country, Kyrgyz Telecom remains the major national operator of inter-city and international electric communication. Local land-line telecommunication is currently unprofitable for Kyrgyz Telecom due apparently to tariffs for domestic calls which are below cost. Inter-city and international communication services are also provided by 15 other service providers with the first competitor, Saima Telecom, entering the market in 1997. Saima, comprising its own cable network, operates mainly in the Bishkek area although it has began operations in Tokmak’s industrial zone and the suburbs of Bishkek. Saima is also an internet service provider. Another major competitor in fixed telephone communications is SapatCom (formerly Win Line which began operations in 2000) who also provides local, trunk-line and internations

29 An example is a new Issyk-kul-Almaty toll road that is reported to have begun construction in 2006 with Kazakh investments. Moreover, tolls are already levied on the Bishkek-Osh road for tunnel maintenance. 30 A previous ADB TA project (TA3757) developed detailed pilot plans for community-based initiatives in three rayons (Akzy, Kemin and Jumgal).

54

Europe. owever, It is believed that counterfeit production occurs in the informal economy.

ormation systems in state bodies. The rivatisation of Kyrgyz Telecom is to be accelerated.

significant mobile phone operators are Sky Mobile and egacom (also Russian owned).

.2.3 Tourism

and services with the aim of increasing the share of tourism in GDP to 6 percent by 010.

The regulatory regime to safeguard competition has been strengthened with the creation of the National Telecommunications Agency (NTA) although it appears that some regulatory functions were transferred to the Anti Monopoly Committee (AMC) in 2006. The respective responsibilities and functions of the NTA and AMC in regulating the telecommunications sector are unclear. There are currently 310 licenses issued with 247 communications agents operating. Preliminary figures from MOTC show that income from telecommunication sector amounted to 5 billion Soms in 2005. The formal economy in the Kyrgyz Republic currently does not manufacture telephone and associated equipment, with domestic demand met by imports of equipment mainly from China, the United Arab Emirates, Russia andH According to both the Presidential address to the nation on 28 September 2006 and the draft CDS, the priority for the development of communications will be on high-tech telecommunication and internet services that would accelerate the integration of the country into global information systems, growth of cellular or mobile telecommunication and electronic-based automated accounting and public infp Mobile (cellular) telecommunication that began in 2004 in the Kyrgyz Republic is the fastest growing sub-sector in the industry. The number of mobile phone subscribers has grown from 10,000 in 2000 to over 500,000 in 2005, making the Kyrgyz Republic the second largest mobile phone market in Central Asia after Kazakhstan. There are currently 4 mobile phone operators (including Kyrgyz Telecom) with national licenses. The market is dominated by Bitel which has national coverage and over 600,000 subscribers as of June 2006 or over 70 percent of total mobile phone subscribers in the country. Ownership of the company is currently being legally contested by three companies: the Russian-owned AFC System, Altimo (formerly Alfa Telecom), both of which are among the largest shareholders in the East European mobile phone markets, and the Kazakh-owned Seymar. The Kazakh owners took over management (through its representative, Alliance Capital) of Bitel in April 2005. In December 2005 the Kyrgyz Supreme Court ruled that ownership over Bitel should be transferred to Russian-owned CJSC Reservespetsmet. This was disputed and although legal ownership of Bitel remains unresolved, the company is presently controlled by the Alfa Group (an associated company of Vympelcom, the second largest operator of mobile phone services in Russia). The two other M 3 The Kyrgyz authorities have targeted tourism as a major service sub-sector to be promoted. Tourism remains largely underdeveloped in the Kyrgyz Republic. Although it has grown by an annual average of 30 percent in recent years, the growth is from a small base and the sector earned only $70 million and accounted for 4 percent of GDP in 2005. The authorities are seeking to promote higher value tourism and plan to privatise remaining SOEs in tourist resorts 2 Domestic tourism is almost entirely leisure tourism at resorts and guest-houses around the Issyk-Kul Lake. International tourism is dominated by tourists from the CIS, mainly Kazakhstan, Uzbekistan and Russia (Siberia), visiting the Issyk-Kul Lake. Non-CIS tourists (from Europe, North America, Japan and South Korea) are usually adventure travellers visiting the country as part of the Silk Road. Non-CIS tourism in the Kyrgyz Republic today is

55

rates of 15 to 20 percent. This limit makes it nattractive for banks to lend to tourist firms.

.3 External Sector

of trade and creation of border trade centres, such as in the southern part of e country.

luation provisions. It also grants at least most-favoured-nation status to all WTO embers.

basically a small niche market attractive to foreign visitors seeking nature, ecological and what is termed “adventure” tourism31. The lack of knowledge in the rest of the world about Central Asia and the Kyrgyz Republic has inhibited the growth of tourism. The key impediments to growth of tourism, especially higher value tourism, are: a poor tourism infrastructure (low quality of tourist accommodation, telecommunications, internal and international transport); perceived high security risks; a highly bureaucratic and unfriendly visa, border control and customs system and procedures; and poor international marketing of the country as a tourist destination by both Government authorities and private entrepreneurs. Private tourist firms numbering 172 now account for almost all tourism in the country, with perhaps 20 entities operating in the informal sector and accounting for perhaps about 12 percent of the market. Access to finance is a key constraint for tourist firms due to legislation imposing a maximum interest rate of 8 percent in commercial bank lending to such firms, compared with normal commercialu 3 The draft CDS is targeting a cumulative growth of 150 percent of the service sector in the Kyrgyz Republic between 2006 and 2010, with the sector envisaged to account for 45 to 47 percent of GDP and employ 2.1 million persons by 2010. Within services, the share of trade is targeted to increase from 43 percent of total sectoral output to 53 percent. Measures for trade promotion detailed in the draft CDS include the improvement of the regulatory framework and business environment and introduction of modern trading methods. Simplification of taxes, together with more effective regulation and electronic trading, will aim to reduce informal trade activities by two times. Border trade will be developed through regularisationth A recent trade policy review of the Kyrgyz Republic by the WTO (2006) found the legal framework for foreign trade and investment to be largely favourable. Legislation to improve the policy and institutional environment for foreign trade and investment has been on-going since the adoption of a package of legal and institutional reforms upon WTO accession in December 1998. As a result, the Kyrgyz Republic has one of the region’s most open trade and investment regimes. The country’s multilateral trade policy has been focused on meeting WTO accession commitments in trade in goods and services and protection of intellectual property rights (WTO 2006). It is negotiating to join the plulilateral Agreements on Government Procurement and on Trade in Civil Aircraft. Following WTO accession, it bounded all its tariffs generally at a 10 ceiling percent rate and other import charges and agricultural export subsidies at zero, eliminated discriminatory excise taxes and applied the customs vam The authorities have actively pursued regional trade agreements, mainly with FSU states, in the form of bilateral and regional preferential free trade agreements (FTAs) and customs union. However, the country’s membership of multiple preferential trade agreements, which have different scopes, rules and implementation periods, may add uncertainty to the country’s trade regime, weaken transparency and detract from multilateral trade liberalisation goals (WTO 2006). These regional agreements have sometimes been

31 The international tourism market in the Kyrgyz Republic comprises tour packages travel along the Silk Road (70 percent), mountain trekking packages (15 percent), mountain climbing packages (10 percent) and other activities (5 percent) such as horse-riding, cycling and scientific study tours.

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em of Preferences hich allow all imports from least developed countries to enter duty free.

incentives for omestic companies in supplying goods and services to public organisations.

nced corruption; prevalence of muggling; and the existence of a large informal economy.

implemented poorly, especially in customs, tariffs, other charges and fees and transit arrangements. The country has a series of on-going disputes with parties (such as Uzbekistan) to such agreements and dispute settlement procedures have yet to resolve these issues conclusively. The Kyrgyz Republic is also a beneficiary of the European Union (EU), Japanese and US preferential schemes under the Generalised Systw The country’s 2003 Investment Law based on national treatment has improved the investment regime. Foreign investors may operate either wholly foreign-owned or joint ventures and almost all activities are generally open to FDI. No formal limits on foreign equity ownership except on selective industries regarded as strategic, such as production of alcoholic beverages, air transport and selective infrastructure activities. In practice, however, foreign investors may not be treated equally with domestic investors because the Investment Law also states that foreign investors have the same rights as domestic investors except for cases stipulated by law. An example is the Law on Sustainable Development of the Ecological and Economic System of Issyk-Kul which states that transfers of recreational facilities and tourism infrastructure to foreign ownership is forbidden. The Land Code also imposes restrictions on purchase of land if foreign shareholding of the acquiring company’s capital exceeds 20 percent. The State Procurement Law provides special d While tariffs are low32, with one-third of imports subject to a rate of 10 percent, the authorities have moved away from the pre-accession uniform 10 percent rate in response to domestic protectionist pressures. This has unfavourable implications for economic efficiency. The country’s relatively uniform tariff structure simplifies customs procedure, reduces market distortions and enhances transparency. However, an average bound rate of 7.7 percent exceeds the applied MFN rate and tariffs can be raised within existing bindings that would detract from predictability (WTO 2006). The tariff structure and its economic effects are also complicated by substantial preferential imports and associated rules of origin. Exports are largely unregulated. Except for non-ferrous metal fragments and waste, licensing is mainly for public health and safety and environmental protection. Exports are zero-rated for VAT (except for gold which is VAT-exempt) and free of excise duties. The four free economic zones that have been established have had very limited success in attracting investment and promoting exports. They are also characterised by tax evasion and corruption, and are being scaled down with only the Bishkek zone to be retained. Government procurement has been liberalised and is now used less frequently as a means of supporting domestic industry. The Soviet-era standards system, numbering 20,000 standards, is being reformed to a market-based regime. Although many of these standards are inoperative, their extensive scope provides grounds for corruption. Despite the largely favourable legal framework in the Kyrgyz Republic, the WTO trade policy report highlights a number of areas in which the trade and investment regime in the country should be improved. These include: administrative barriers to doing business due to excessive Government intervention; insufficient transparency in licensing procedures; problems with extensive Government inspections; unclear public procurement policies; pronous The challenges in the development of the external sector in the Kyrgyz Republic are two-fold: first, more effective and fuller exploitation of existing opportunities, and second, development of new opportunities and markets through greater economic diversification.

32 The simple average applied MFN rate is 4.9 percent, down from 5.2 percent in 2005 and 8.7 percent in 1999.

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ated by problems in border crossing and ustoms clearance which usually involve bribes.

egime and weak regulatory capacity services administration, also need to be addressed.

the onstraints relate to a poor business environment which is discussed later in this report.

Crucial to meeting both these challenges are raising enterprise efficiency and international competitiveness, underwritten by significant improvements in the soft infrastructure relating to policy, regulations, standards, etc., and the hard or physical infrastructure for trade such as transport and warehousing. Transport and trade margins are high across sectors in the country and reportedly as high as 5 percent of GDP in agriculture and 14 percent in manufacturing (World Bank 2005a: 4). Costs of road transport, which accounts for about 97 percent of freight traffic and 99 percent of passenger traffic, are high due to their poor physical condition because of serious under-investment and weak management and administration. High transport costs are exacerbc One of the World Bank (2005a) CEM’s main findings is that external barriers to Kyrgyz integration into regional and global markets are formidable. These derive not so much from tariffs, safeguard arrangements or technical barriers, but mainly from prohibitive transit and transport costs, both formal and informal. Safeguard measures and technical barriers, which are pervasive in CIS countries and elsewhere, remain potentially problematic but they have hitherto have had negligible adverse impacts on Kyrgyz exports. Kyrgyz exports face low (if any) duties partly because of preferential CIS-related trade arrangements, and partly because of the low level of processing embodied in exports to non-CIS or non-preferential markets. These issues will need to be addressed before they become binding constraints as Kyrgyz exports begin to – as they need to do – diversify into non-preferential markets and/or embody a higher level of processing. In addition, domestic policies that have impeded exports, such as a tariff schedule creating distortions for certain sectors, customs administration, excessive and cumbersome standards rin The country’s liberal foreign trade and investment regime and WTO membership need to exploit more fully the potential and advantages afforded. Ways of using the WTO as a vehicle for further structural reforms need to be explored. The Kyrgyz Republic has also not benefited much from participation in regional trade arrangements, notably the Eurasian Economic Community (EURASEC). The country should explore ways of tapping this potential more fully. The World Bank proposed a two-pronged strategy for addressing both the domestic and external aspects of foreign trade constraints, comprise three core components. One component would be organisational changes to enhance the Government’s institutional capacity in foreign trade policy analysis, policymaking and management33. The other two components concern the leveraging of the Kyrgyz Republic’s WTO membership to accelerate reforms in policy and institutional environment for trade, and a trade promotion strategy aimed at maximising future benefits from the country’s membership of EURASEC. These two components comprise an excellent and well-focused agenda for overcoming key constraints to trade development. The main issues and measures for addressing them are summarised in Box 2. It may be noted that many ofc Box 2: Summary of Issues and Options in Trade Promotion . Addressing Domestic Trade-Related Constraints (i). Inefficiencies in customs administration, characterised by excessive bureaucratic requirements, delays in clearing imports and exports, absence of licensed customs brokers, mandatory inspection of 33 This would also involve greater collaboration and dialogues between the Government and the business sector.

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all shipments and lack of data interchange between traders and customs administration and between customs bureau of neighbouring countries. These weaknesses raise transaction costs for traders, distorts competition and pose barriers to exports. Although a new revised customs code is largely consistent with international best practice (including WTO rules and the revised Kyoto convention) and facilitates emergence of licensed customs brokers, it is essential that bottlenecks in neighbouring countries be simultaneously addressed through intensive cross-border cooperation. (ii). An unnecessarily complex and confusing standards regime, characterised by mandatory inspections and certifications, unique national standards, overlapping agency responsibilities for regulation setting and enforcement and extensive Government involvement in all aspects of the standards system (standardisation, accreditation and conformity assessment). The existing system imposes significant additional production costs for businesses and high administrative burden (financial, personnel and other costs) for the Government as well as creating extensive opportunities for official corruption. Important recent institutional reforms include the vesting of conformity assessment responsibilities of Kyrgyzstandart in a new body separate from accreditation and standardisation and a new Law on the fundamentals of Technical Regulations which, amongst other provisions, excludes the national standards body from issuing regulations. Further measures to improve the standards system should include recognition and acceptance of foreign countries’ international standards based technical regulations, promotion of international standards and accreditation conformity assessment procedures, and transferring the tasks of standards development and conformity assessment from state agencies to private sector bodies. (iii). The existing regulatory environment for trade-related backbone services, such as telecommunications, transport, financial services, distribution and marketing, and business services (legal, accounting, consulting), is inadequate for fostering competition and development of domestic and foreign service providers. Addressing this issue will require further liberalisation in a wide range of regulatory and sectoral policies, especially in competition policy, to facilitate market entry and a level playing field for both domestic and foreign firms. A priority in this domain is liberalisation, and privatisation in certain instances, of the infrastructure industries. The country’s schedule of GATS commitments binds its telecommunication market to be open and the Law on Electric and Postal Communications is in principle pro-competitive and up to date. But the country has yet to comply fully with non-binding GATS provisions on regulatory principles set out in the GATS Telecommunications “Reference Paper”, and delays in privatisation of Kyrgyz Telecom has impeded foreign investments and management development. Serious weaknesses in transport services, such as weak enforcement and discipline among contracting parties (which result in effective violations of obligations under free trade arrangements), also need to be addressed. These issues could be addressed through inter-related sets of reforms aimed at exploiting more fully and maximising the benefits of Kyrgyz’s WTO membership. Trade Promotion Strategy A trade promotion strategy should be aimed at maximising future benefits from the country’s membership of Eurasian Economic Community (EURASEC). Various bilateral and multilateral trade agreements under the CIS framework to which the Kyrgyz Republic is a party do not provide a sufficiently robust regional trading environment because of discretions given to contracting parties – and hence non-compliance – on issues such as customs. An underdeveloped market-based foreign trade regime and protectionist measures in particular in some countries also hinder effective free trade. The best regional trade strategy for the Kyrgyz Republic would be to focus on EURASEC by using WTO rules to reform the EURASEC framework for regional trade. The major issues that could be addressed in such an approach would include: border and customs procedures; conditions of transit, technical standards, antidumping, trade in services and air transport. Source: World Bank (2005a). In addition to improvements to the policy and institutional environment for foreign trade and

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re able to do so epending on detailed production cost structures and productivity levels.

ansport access to export markets is similarly ssential to the success of this strategy.

.4 Financial Markets

the issue is one of its ractical non-existence and a weak legal and regulatory framework.

outstanding corporate bonds at near negligible 2.7 percent and 0.2 percent of GDP

investment as stressed in the World Bank (2005a), WTO (2006) and other reports, a significant and sustainable growth in Kyrgyz exports will also require the country to develop and exploit its comparative advantage in selected industries. It is unclear at this stage which these industries might be in the Kyrgyz Republic because of the absence of detailed studies on the subject. Such studies will need to examine the country’s revealed comparative advantage (RCA) in view of its trade patterns, resource endowments, technological capacity and productivity levels. A recent study (Lucke and Rothert: 2006) on Central Asia’s comparative advantage in international trade argues that while it is difficult to predict the viability of specific non-traditional exports, broad guidelines for identifying potentially competitive exports sectors are available and can be used. Current factor prices, especially wage costs, are useful indicators of a country’s comparative advantage. The largest international factor price differentials are for low-to-medium-skilled labour rather than for financial capital or machinery. While resource-rich countries in the CAR, such as Kazakhstan and Azerbaijan, have high relative nominal wages and are unable to compete (e.g. in direct competition with China) on price in labour-intensive manufactured products, a country such as Kyrgyzstan with lower nominal wages might be mod The study suggests that at least two strategies for expanding non-traditional exports are worth exploring, although both are hampered by high transport costs and periods. First, a country such as the Kyrgyz Republic could aim to integrate into global or European production chains, allowing the country to concentrate on specific components of the value-added chain in which it enjoys a comparative advantage due to its low labour costs. Lower transport costs (and times) would be critical to the success of this strategy not only in supplying products to export markets at competitive prices but also because of the substantial imports of intermediate products needed in which transport costs will increase the ratio of transport costs to local value-added. Second, the Kyrgyz Republic could aim to expand its non-traditional exports by vertically integrated industries. This strategy would be most promising for the processing of raw materials that may already be competitive traditional exports, such as processed agricultural and food products and textile and clothing. Availability of efficient and low cost tre 3 Underdeveloped and inefficient financial markets in the Kyrgyz Republic are both a cause and consequence of a weak corporate sector in the country. In the banking sector, the impediments are largely those of insufficient progress in enforcement of a basically sound legal and regulatory framework and of market inefficiency. Despite a large number of banks with extensive foreign investment, the banking system is characterised by limited capacity in financial intermediation, high interest rates, expensive collateral-based credit and shortage of long-term financing. In the capital, securities and equity market, p The financial sector in the Kyrgyz Republic comprises 21 commercial banks (of which one is non-operational) and a large number of non-bank financial institutions (NBFIs), including 12 insurance companies, 5 investment funds, 2 pension funds (1 state and 1 privately owned), 21 brokerages and 15 registrars. There is a relatively large network of credit unions (numbering 306) and microfinance organisations (136). The sector, however, has a low level of financial intermediation as evident from a broad money (M2) nominal GDP ratio of 20.9 percent, banking sector assets at 21.7 percent of GDP, stock market capitalisation and

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respectively in 200534. Although there have been significant progress in financial sector reforms, the sector remains small and weak35. Banking Sector. The banking sector accounts for the overwhelming proportion of financial intermediation in the national economy. All but one bank are privately owned, with extensive foreign participation (predominantly Kazkah, but also Russian, Turkish, Korean, Italian and Pakistani as well as IFC and EBRD investments) in fifteen banks of which ten are majority foreign owned. Foreign ownership accounted for 57 percent of capital and 60 percent of assets in the sector in 2004. The five largest banks, all with foreign shareholdings, accounted for about 50 percent of capital, 60 percent of deposits and 66 percent of loans. The rate of growth in credits to the private sector has accelerated from 12 percent in 2002 to 66 percent in 2004 but declined to 21 percent in 2005. In aggregate terms, financial intermediation through the banking system is far from sufficient to support private sector or national economic development. Growth of aggregate credit in the Kyrgyz Republic is one of the lowest among transition, CIS and CAR economies. Credit to the private sector average below 5 percent of GDP each year in the 1999-2003 period although it grew to 7.1 percent in 2004 and 8 percent in 2005. The disbursement rates of various existing donor-financed credit lines are low, suggesting that private sector credit might be constrained by lack of bankable projects. Kyrgyz banks are both reluctant and unable to extend credits. The low level of intermediation is largely explained by supply side constraints. The Kyrgyz ratio of bank deposits to GDP (at 14 percent in 2005) is among the lowest for transition economies and in the CAR. The funding base is low because of low deposit levels due to the lack of confidence in the banking system and reluctance of businesses to operate in the formal sector which would make them liable to a high tax burden and an excessive regulatory regime. Banks are also constrained by low levels of banking skills and technology in credit and risk management. Credit card service is rudimentary and only a few banks provide housing finance products. Until very recently, no bank in the country had a credit scoring system due to a lack of reliable financial information. The only private credit information bureau is weak with only a few banks participating. The credit-deposits ratio is low at around 60 percent with a high differential between deposit rates and lending rates at over 20 percent in 2004-05. The entry of foreign banks has widened slightly banks’ product base, but the range of products is still very narrowly limited to short-term working capital and trade financing loans and investment financing. Banks have made progress in diversifying away from collateral-based loans to those geared to the borrower’s capacity to generate cash flow. But the majority of loans are still collateral-based with a flawed, bureaucratic and costly pledge system undermining the lending process. The cost of creating collateral in the Kyrgyz Republic is one of the highest in the world, at 12.4 percent of per capita income compared with 9.2 percent for Azerbaijan (with one of the least developed banking sectors among transition and CAR economies), 7.7 percent for Europe and Central Asia and an average of 5.2 percent for OECD countries. Foreclosure procedures are unpredictable because of weaknesses in the judiciary and official corruption. All these shortcomings raise risk for lenders and transaction costs for borrowers. The new Pledge Law approved in 2005 will streamline collateral requirements and introduce out-of-court procedures for foreclosure of assets but its enforcement remains to be tested. On the demand side, in addition to disincentives for operating in the formal sector, potential

34 For a detailed statistical profile and assessment of the Kyrgyz financial sector, see JCSS (2006a). 35 See (IMF 2006a) for an assessment of recent and on-going financial sector reforms.

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borrowers and users of banking services are deterred by high lending rates, onerous borrowing requirements which often demand large collaterals, the poor range and quality of services, high service charges and shortage of long-term financing. The financial health of many Kyrgyz businesses, especially SMEs which dominate the economy, are weak and most lack the financial and business track record, accounts, business plan and other information to render them eligible for low cost finance. This means that the problem of adverse selection is pervasive and applies throughout the entire economy. Weaknesses and corruption in the judiciary, especially in contract enforcement and property rights protection, together with those in the legal, regulatory and supervisory framework for banking, also exacerbate distrust of formal financial institutions. Most businesses and households still hold dollars as a safe haven and rely on relatives and friends as the principal source of external financing. Box 3: INEXIMBANK: Issues in Growth of Lending Main Constraints 1. Limited financial resources 2. Lack of reliable and full information (especially income sources) on clients 3. Clients’ concealment of actual incomes due to avoidance of high tax burden 4. Difficulties in foreclosure under pledge/collateral system in cases of defaults by clients 5. Absence of nationwide database on credit history of clients 6. Difficulties faced by clients in obtaining passports for identification and verification. 7. Difficulties in valuation of agricultural lands used for pledges/collaterals and in selling agricultural land (restrictions under Law on Management of Agricultural Land) Options 1. Lending to physical persons without validation of incomes based on a more rigorous valuation of pledges/collaterals and use of urban real estate as pledges/collaterals 2. Lending based on deposits (maximum of 20 percent) as partial ledge/collateral 3. Lending to physical persons without pledges/collaterals in cases of positive credit history 4. Improved terms and periods of loans 5. Offer wider range of products and services (e.g. leasing and mortgage) Source: Author’s interviews at INEXIMBANK. The soundness of the banking sector is improving due to on-going improvements in banking regulation and supervision which, for example, has raised capital requirements and reduced NPL levels (6.4 percent of gross loans in 2004) because of the exit of weaker banks and progress in bank restructuring. Further improvements to the soundness of the banking system will require a degree of sector consolidation through further entry of stronger banks and increases in minimum capital requirements (currently 60 million Som for existing banks and 300 million Som for new banks). An electronic payments system needs to be introduced to replace the current system which is based on paper documentation and inefficient, slow and expensive. Improvements to the legal and regulatory framework have been and are being made, but enforcement capacity needs to be considerably strengthened. Perhaps the most urgent improvements needed are those which can have the greatest positive impact on raising confidence in the banking system and on its ability to intermediate at higher levels. These include inter-related measures to: (i) increase the availability and quality of financial information, particularly by properly regulated private providers and analysts of financial information; (ii) improve banking technology and skills of commercial banks in credit and risk management and in developing and managing a wider range of financial products and services; (iii) introduce a formal deposit insurance system once

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banking sector legislation, regulations and enforcement are strengthened; and (iv) enhance competition which could lower borrowing costs as well as improve services and product ranges. Microfinance. Microfinance is the principal source of finance for the rural and SME sectors, with microfinance credit extended at end 2004 equivalent to two-thirds of conventional bank credit outstanding in the economy. The overwhelming majority of microcredit organisations (MCOs) and credit unions are very small. Their long-term prospects are uncertain and contingent upon continuation of financial incentives and donor-supported technical assistance and funding. The market is segmented with credit unions and MCOs providing an average loan size less than half that of KAFC’s. Credit unions and MCOs serve primarily smaller agricultural and non-agricultural enterprises while KAFC support goes mainly to larger farmers. The sector will need to go through a process of extensive consolidation and to develop its capacity in mobilizing savings to ensure a sustainable basis for credit provisions. Loans currently exceed deposits, reflecting the heavy reliance on donor funds and wholesale financing. This process might have to involve collaboration with or even integration into existing commercial banks or financial institutions with existing or potential businesses in rural and SME lending. Capital and Securities Market. Capital markets have hardly developed in the Kyrgyz Republic and play a negligible role in financing. Nearly 1,600 Kyrgyz firms have issued shares or bonds amounting to 31.9 billion Som ($4.6 billion), but the overwhelming proportion of share issues were in the form of free voucher allocations to the public during the mass privatisation process and did not raise capital for enterprises. Of around 1,200 JSCs in the country, about 300 have 500 or more shareholders. Shares of about 400 JSCs are traded at the trading platforms of three organisations: the Kyrgyz Stock Exchange (KSE), the Trading System (SETS) and the Central Asian Stock Exchange (CASE).. The number of JSCs listed at the KSE peaked at 69 in 2000 but only six JSCs are currently listed. About 85 percent of turnover at the KSE is in securities of unlisted companies. SETS and CASE have no listing with all turnover there in unlisted companies. Turnover at the KSE averaged $22 million in 2000-2003 but increased to $59 million in 2004 as a result of the privatisation of three SOEs. Most corporate securities were issued in the form of equities, with the total volume of 14 corporate bond issues in 1999-2004 amounting to only 263 million Som ($6 million). Trading of corporate securities is required by law to be conducted through the exchanges but most transactions are negotiated and closed outside the exchanges and simply registered at the exchanges. The market for government securities is its infancy with only a small number of primary issues with commercial banks holding about 95 percent of total government securities outstanding. The development of the securities market in the Kyrgyz Republic is constrained by a weak regulatory and supervisory framework, the lack of firms suitable for listing, poor corporate governance and tax disincentives. The country at present does not comply with any of the 30 principles set by the International Organisation of Securities Commissions (IOSCO) on investors’ protection and mitigation of systemic risks. The current Law on Securities Market (1999) fails to provide sufficient supervisory and enforcement powers to the regulatory body, to set adequate accounting, audit and corporate governance standards, to distinguish between public and private placements, to require adequate due diligence by issuers and underwriters and to clearly regulate clearance and settlement of securities traded in the secondary market. Current market regulations do not provide adequate entry standards for market intermediaries. The institutional capacity and effectiveness of the State Commission on Securities Market (SCSM) in regulation and supervision has been undermined by a weak mandate, limited operational autonomy, and the lack of financial resources and technical

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skills. Measures to address some of these weaknesses have been introduced by the Government following the merger in 2005 of the SCSM into a newly established State Agency for Financial Supervision and Reporting (SAFSR), a sector-wide regulator for non-bank financial institutions and markets with competence over insurance, pension and investment funds. But the institutional capacity of the SAFSR needs to be considerably strengthened before it can function effectively. Tax policies appear to be deliberately designed to enable government securities to crowd out corporate securities. The current taxation of income from investment in corporate securities (in the form of interest, dividends and capital gains) discriminates against particular types of investments and creates market distortions. Individuals are exempted from taxes on interest earnings but legal entities such as JSCs and LLCs are subject to a withholding tax. Banks, however, enjoy exemption from withholding tax on interest earnings from government securities. This creates a bias in favour of holding government debt and against private sector debt such as interest-bearing corporate bonds. At the same time, dividend earnings for legal entities (and individuals) are tax free which create a bias for holding equities and against corporate bonds where interest earnings are subject to the withholding tax. Moroever, capital gains realised from sale of corporate securities are taxed as ordinary income. With dividend earnings tax-free, JSCs have an incentive to distribute profit as dividends rather than re-invest36. Development of the securities market will require considerable strengthening of the legal and regulatory framework, improvements in corporate governance and rectifying discriminatory and distortionary taxes. The privatisation of the large SOEs, such as those in infrastructure, through the securities market could help promote market development. Development of insurance companies and privately-operated pension funds, which are currently practically non-existent, could also be an important stimulus to securities market development37. But development of NBFIs and of the capital market poses a chicken-and-egg or vicious circle problem. Pension funds and insurance companies can only develop if there is a developed and well-regulated capital market (especially in fixed incomes securities necessary for pension funds and insurance companies to minimise risks). Overall, however, the greatest constraint to securities market development is on the supply side: a weak corporate sector with very few efficient, profitable and well-governed firms with strong growth prospects. Privatisation of the large SOEs through listing may not adequately address this constraint as the eligible large SOEs are only a handful while securities market development require a critical mass of listed firms to ensure market depth and breadth in portfolio choice. In the short to medium term, external financing of firms is likely to continue to rely on the debt market, through growth of long-term lending from banks and possible development of the corporate bond market. Nevertheless, it is essential that measures to promote securities market must be initiated now to provide non-bank channels of financial intermediation. The securities market needs to develop to alleviate risks stemming from an over-reliance of bank lending and to make available a wider, more diversified and competitive range of financing instruments and products. 3.5 Business Environment and Investment Climate The fundamental problem in private sector development in the Kyrgyz Republic is that

36 A more detailed assessment of these incentives and disincentives effects is contained in an unpublished financial sector assessment prepared for the JCSS (2006a). 37 Insurance premiums collected in 2004 amounted to only 0.2 percent of GDP. The only life insurer went bankrupt in 2003. The State Social Insurance Fund is the sole government operated pension fund. The only other pension fund is a private fund with only 600 subscribers.

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private firms, which already dominate the country’s economic landscape, operate within an inefficient and dysfunctional market system. This is manifested in a business environment and investment climate that are not just poor but which are in fact hostile and adverse to entrepreneurship. Although market-based economic and legal institutions have been established -- albeit often in a formal rather than in a substantive manner -- a Soviet-era system of administrative micromanagement and economic controls has been retained. This has resulted in excessive regulations which, together with weaknesses in public administration, create distortions of and impediments to the efficient functioning of markets. Despite earnest intentions by the authorities to create a pro-market and pro-private sector economic environment, the actual outcome has been one which disables rather than enables private sector development. Enterprises have to succeed not because of such an environment, but in spite of it. They are often held hostage to system of state administration and regulation that is often over-bearing and corrupt. Transparency International ranks Kyrgyz Republic as one of the most corrupt countries in the world, at 118th and 126th place in 2003 (out of 133 countries) and 2004 (146 countries) respectively. No improvement in this area has been made since the Tulip Revolution in March 2005. The Transparency International recent ranking for the Kyrgyz Republic shows a decline, with the country falling from 134th position (out of 158 countries) in 2005 to 145th position (out of 163 countries) in 2006. The Kyrgyz authorities have introduced a wide-ranging programme aimed at improving the investment climate and business environment. Dialogues and consultations with the business sector and civil society have resulted in a number of collaborative policies, such as a comprehensive investment climate matrix of reforming the business climate. These efforts, however, tend to have unrealistic objectives and deadlines and are not well prioritised, sequenced or related. The effectiveness of reforms has been significantly undermined by legal ambiguities and uncertainty, poor implementation and lack of appropriate enforcement mechanisms. Weak institutional capacity in public administration, characterised by very low levels of civil service salaries, insufficient training of personnel, weak leadership, political patronage and extensive corruption, is a major cause of poor implementation. The regulatory burden is also made heavier by numerous and frequent revisions, inspections and audits. The World Bank’s (2006a) Doing Business Report for 2005 found that the Kyrgyz Republic ranked 84th out of nearly 150 countries in ease of doing business. It ranked well in terms of starting a business (at 27th place), getting credit (35th), investors’ protection (49th) and registering property (54th); moderately in terms of hiring and firing of employees (63rd), dealing with licenses (65th) and closing a business (93rd). But it ranked poorly in terms of trading across borders (150th), enforcing contracts (147th) and paying taxes (135th). The country’s overall ranking is creditable. But the real issue is whether they are sufficient to enable to Kyrgyz enterprises to attain levels of productivity and international competitiveness necessary to attracting FDI and to achieve vigorous export growth. The answer is clearly no and the pattern of economic performance provides empirical evidence for this answer. As argued in earlier sections of this report, the Kyrgyz economy needs to compensate for its disadvantages in small domestic market, inaccessible geographic location and poor natural resource endowment by developing advantages in productivity and competitiveness. The World Bank’s (2005b) Investment Climate Assessment identified tax administration, macroeconomic stability and regulatory certainty as the most important concerns for Kyrgyz businesses, together with cost of and access to financing38. Tax administrators and

38 The main data sources for the World Bank Investment Climate Assessment were: the World Bank-EBRD Business Environment and Enterprise Performance Survey (BEEPS) for 2002 and 2003; focus

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inspectors are generally reported to enjoy unjustifiably large powers in interpretation of tax laws and regulations, and to apply them unevenly, arbitrarily and corruptly. The regulatory burden is also heavy for Kyrgyz businesses. Despite some progress in streamlining the enterprise registration process, a host of administrative barriers continue to consume a large amount of entrepreneurs’ effort and time. The proliferation of inspections has meant that the total number of inspections and the average number of days spent by businesses in dealing with inspections are considerably above those reported for several other countries in the region. These problems stem in part from inherent institutional weaknesses in public agencies which often have unclear and duplicative functions as well as poor transparency and accountability, with off-budget funding creating moral hazards for corruption. These problems appear to be most serious in key agencies such as tax administration, labour and social security (social fund) and sanitation. The issuance of licenses and permits is similarly a major constraint for businesses. Ambiguities, inconsistencies and contradictions in laws and regulations on licenses and permits engender arbitrariness and corruption in their issuance. These constraints can also be attributed to weaknesses in the country’s legal and regulatory framework. Among these, the most important are: (i) the lack of legal consistency and certainty due to the lack of a clear hierarchy of legal and normative acts in the legal system; (ii) inadequacies in the quality, depth and reach of legal reforms, with new laws and regulations being over-ambitious and unrealistic; (iii) an insufficient institutional setting for implementation, with too many institutions responsible for overseeing implementation and most bodies lacking skills, capacity and resources to carry out their functions; and (iv) an overall lack of capacity across implementing agencies to adopt relevant legal and regulatory changes, and a distinct lack of easily available information on legal, regulatory and judicial issues as well as lack of an appropriate monitoring and evaluation system for the overall reform process. Weaknesses and abuses in the judiciary have undermined confidence in the legal system, with 65 percent of enterprises surveyed indicating that they do not believe the judicial system would uphold contracts and property rights in business disputes. Kyrgyz businesses complain about the lack of access to low cost and/or long term finance. Low depositors’ confidence in the banking system, together with low deposit rates and low level of banking skills and transparency have constrained growth in the funding base and increased the overall cost of capital for banks. Flaws in the pledge system and a predominant focus on collateral-based lending have exacerbated funding difficulties for businesses, with most relying on internally generated funds and loans from relatives and friends. The new pledge law recently enacted would streamline collateral requirements and introduce out-of-court procedures for foreclosures of assets but cannot be effective without strengthening their enforcement mechanisms. 3.5.1 Voice of the Business Community A number of surveys and studies by Kyrgyz business associations reveal the main concerns of businesses. They all identify the same key impediments to market entry and exit and business operations posed by extensive and cumbersome requirements and procedures in the system of business registration, licensing and permits, technical, building and environmental standards. Excessive inspections and often arbitrary interpretation of laws and standards lead to extensive official corruption. An annual National Business Opinion Surveys (May 2004) conducted by the Project Management Agency (PROMA) and the

group discussions, the PROMA National Business Opinion Survey for 2002; the World Bank Doing Business in 2005 report; and World Development Indicators.

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International Business Council (IBC, a leading and influential non-governmental business association) found that the three greatest difficulties faced by businesses were: access to finance (67 percent of respondents); the limited size of the market in the country (36 percent); and intervention by state agencies in businesses (36 percent). The other main difficulties were: weak technical capacity of businesses, lack of knowledge and information, shortcomings in legislation, lack of social protection for businesses and tax and customs barriers. The priorities for Government action according to the respondents were (in decreasing order of importance): reform of tax system and reduction in tax rates (80 percent of respondents); eradication of official corruption and bribery (75 percent); reduction in number of business permits required (71 percent); greater availability of cheaper finance (71 percent); and reduction in number of inspections (66 percent). Other measures sought by businesses included improvements to the legislative framework and the judiciary, greater availability of information and advisory services in the regions, and provision of professional and technical training and of equipment leasing. Among businesses engaged in exports, the priorities were: simplifying customs and transit controls; easier access to foreign markets (especially Russia, Kazakhstan, Uzbekistan and China); and timely and reliable reimbursement of VAT for exports. Recent IBC surveys identified the main concerns of business in making investment decisions and on how they viewed competitiveness of the Kyrgyz economy against other countries in the region. Among the top ten issues in investment decisions, the (lack of) safety and security was the highest concern followed by shortage of skilled personnel, (high) tax rates, (un)predictability of laws and regulations and official corruption. In terms of the country’s competitiveness, businesses regarded the country as least competitive in terms of official corruption, safety and security, tax administration, predictability of laws and regulations and consistency of court judgements (IBC 2006b). The IBC’s Business Agenda, outlining the key issues and options for improving the business environment, identifies the key concerns of its members as excessive regulation, corruption, an unfair and complicated tax regime and a weak judiciary. Businesses also reported a deterioration in the legal environment, public administration and customs administration. They expressed concerned about the “criminalisation of politics and business”, “unlawful seizure of private property” and “no security of investment”. The same set of issues of concerns to Kyrgyz business and generally similar proposals for addressing them were discussed at the “Economic Forum on Removing Barriers to Business” held on 31 May 2006 in Bishkek. The forum highlighted the increasing incidences in infringements of private property rights (Economic Forum on Removing Barriers to Business. Policy paper briefs and proposed detailed measures to address these issues tabled at the forum, representing the consensus view of Kyrgyz business, were submitted to the Government with the understanding that the Higher Economic Council of the Government would monitor implementation of measures to improve the business environment and investment climate. Box 4: IBC Business Agenda: Priorities for Improving the Economy (Summary) Regulation Objectives: A smaller, tighter set of genuinely essential and beneficial set of regulations that could be equally and effectively enforced without corruption. Proposed measures include: (i) rigorous, transparent and consultative process of reviewing and revising regulations; (ii) guillotine dates for adoption of proposed new regulations; (iii) automatic acceptance of international certificates for product safety and quality; (iv) self-regulation by business; and (v) significant reduction in number of inspections and elimination of corruption among regulatory agencies.

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Elimination of Corruption Proposed measures include: (i) greater accountability of elected officials and transparency of their actions; (ii) adoption of law preventing corruption and legislation to protect informers; (iii) improved incentives and disciplinary measures for public administration officials; (iv) creation of new Revenue Agency, Corrupt Practises Investigation Agency and reforms of security services, police, judiciary and government. Taxation Objectives: a simpler, more competitive and stable tax regime and uncorrupted revenue administration for tax, customs and social fund collections. Proposed measures include: (i) creation of new semi-autonomous and politically independent Revenue Agency (for tax, customs and social fund); (ii) significantly reduce requirements on tax accounting/audit and reporting and tax inspections; (iii) reduce number of taxes to 4 or 5 (e.g. VAT, profit, personal income, excise and real estate); (iv) apply flat rate taxes with minimal exemptions except for VAT exemptions up to 2.5 million Soms turnover; (v) improve patent system for self-employed and simplify tax regime for small business with clear incentives for graduating from patents to simplified (small business) taxation to full tax reporting; (vi) reduction of personal income tax and social fund contributions); (vii) 10% corporation tax; (viii) incentives for capital investment); (ix) more effective VAT refund system for exporters; (x) overall tax burden lower than competitor countries; and (xi) stability of tax rates. Judiciary Objectives: a clean, political independent and professional judiciary. Proposed measures include: (i) independent oversight by parliament and civil society; improved incentives and professional standards for judges and staff; (ii) restructuring of judicial system and reduction of staff numbers; (iii) external advisors for judicial reform process; (iv) enhance transparency and accountability of judiciary; and (v) investment in restructuring, professional training and IT. Source: IBC (2006a). Tax Issues. A high tax burden is one of the most common complaints of Kyrgyz business, as is the case in almost all economies. A Council of Tax Consultants (CTC) study on “Rationale of Need for Tax Policy Reform” cite a finding in the UNDP Human Development Report’s (2006) which ranked the Kyrgyz Republic poorly (135th out of 155 countries) in terms of the tax burden in impeding job creation. The total tax burden on Kyrgyz business was 18 percent and 31 percent higher than the averages in the region and worldwide respectively. The avoidance of what businesses regard as punitive levels of social fund contribution has led many enterprise employees to be paid 30 to 90 percent of their earnings outside the reported payroll. Without this evasion, tax burden for enterprises would exceed 2.5 to 4 times gross revenues, leading many businesses to go bankrupt. The CTC study also argues that the effective tax burden is unfair and uneven due to extensive tax evasion, with 150 to 200 Kyrgyz enterprises pay between 60 to 80 percent of taxes in an economy with over 300,000 registered economic entities. The tax burden varies across industries and businesses from between 5 to 50 percent of turnover rather than revenues.

The (draft) new Tax Code has been objected to by a group of 32 Kyrgyz business associations including the IBC, the (CTC) and the Congress of Business Associations (CBA). Amongst other objections, the new Tax Code has been criticised for failing to eliminate the most discriminatory policies, to simplify tax accounting and for legalising mechanisms and practices that have led to extensive corruption over the past decade. An alternative new Tax Code drafted by the group has been proposed for Government and parliamentary consideration. It contains nine sets of “concepts” or principles for improving

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the tax system and administration39. By late August 2006, only 6 out of 50 detailed “conceptual points” had been agreed with the Government. Other proposals made by the group include the establishment of an autonomous revenue collection agency responsible for tax, customs and the social fund. 3.5.2 Government Initiatives The Government has made improvement of the business environment and investment climate a priority as part of its strategy to increase the country’s levels of productivity, exports and private and foreign investment. The inaugural speech of the Prime Minister in May 2005 announced a number of measures to improve the investment climate, including improvement of the systems of registration and licensing to remove barriers to market entry and exit, the creation of an investment promotion agency that would also promote public-private partnerships, and facilitating access to domestic and foreign sources of investment capital, especially in export-oriented industries. However, as noted by the Prime Minister, most of these actions mainly entailed a more effective implementation and enforcement of measures that had previously been announced. The Government’s economic programme for 2006 included policies for improving the legal environment for business and private investment. Improvement of the business environment was also a focal point in the Presidential address to the nation on 28 September 2006. The draft CDS devoted considerable attention to this issue and outlined a number of measures which would enable the Kyrgyz Republic to improve its rating of the World Bank-EBRD BEEPS integrated indicator of the quality of the investment climate from 25.2 points in 2005 to the average for ECA countries’ 2005 level of 18.27 points by 2010. The range of measures outlined in the CDS and in other Government pronouncements addresses the keys constraints to business. The key challenge, however, is the ability of the Government to implement the measures due to weaknesses in the system of public administration and public governance. Box 5: Recent Legal Reforms in Business Environment Key measures that have been introduced since the Tulip Revolution to improve the business environment include: a Presidential Decree “On Measures Aimed at Limiting Interference of Regulatory, Law Enforcement and Other Government Institutions in the Operation of Legal Entities and Entrepreneurs” (23 July 2005); proposal for the creation of Special Commission on Elimination of Barriers to Entrepreneurs (CEBE) with stakeholder representation; proposed decree to strengthen the General Prosecutor’s Office capacity to control inspections of businesses and to enforce the Law on Protection of Entrepreneurs, modelled on a supposedly successful experience in Kazakhstan; the Law on Labour Migration (13 January 2006) aimed at streamlining exit procedures and tax obligations for Kyrgyz citizens working abroad and for foreigners working in the Kyrgyz Republic (which appears to impose greater restrictions on foreign workers, aimed apparently at citizens from neighbouring countries); the Law on Changes and Amendments to the Law on State Registration of Rights on 39 The five concepts on tax administration were: (i) maximum inclusion of anti-corruption safeguards; (ii) achieving a balance of interests, rights and obligations between taxpayers and the state; (iii) presumption of honesty as the legal basis for formation of all norms in tax legislation; (iv) simplicity and transparency in tax enforcement and administration; and (v) liberalisation of tax enforcement with regards to honest tax payers and ensuring punishments for tax violations and crime. The five concepts proposed for the tax system were: (i) competitiveness of the tax system and a decrease in the tax burden that could be underwritten by an increase in the tax take and legalisation of shadow economic activities; (ii) equitable tax burden across sectors and categories of taxpayers; (iii) stimulation of priority sectors; and (iv) tax legislation oriented towards social development.

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Immovable Property and Related Transactions” (16 February 2006) aimed at increasing transparency in procedures for obtaining rights of ownership, use and disposal of land and real estate by eliminating contradictions and ambiguities in existing legislation; the Law on Changes and Amendments to the Law on City Planning and Architecture (16 February 2006) aimed at simplifying planning approval procedures; the Law on Changes and Amendments to the Land Code (29 January 2006) aimed at clarifying the legal basis for the introduction of land use zoning in settlements and competitive tenders for obtaining land parcels; the Law on Changes and Amendments to the Law on Insurance Fee Tariffs in State Social Insurance (12 May 2006) aimed at a broader coverage to include individual entrepreneurs operating on a patent basis and employees in industries such as textile and clothing and footwear. The Government has created a number of platforms for public-private dialogues for improving the business environment. The most prominent of these include the Special Commission on Elimination of Barriers to Entrepreneurship (CEBE), the Public Chamber (PC) and the High Economic Council (HEC). The CEBE is headed by the First Deputy Prime Minister, the PC by the President of the Republic and the HEC by the Prime Minister. All three comprise representatives from relevant Government economic departments, parliament, business associations (and donors in the case of CEBE)40. The CEBE was established on 3 February 2006 (based on a Government resolution) for the purpose of developing proposals to eliminate legal, administrative, economic, organisational and other barriers to business. It has reportedly met only once to date, and its work has focused mainly on reviewing duplication of functions among state controlling bodies, revision of normative and legal acts governing the functions and operations of 18 state controlling bodies and on reducing and streamlining procedures for inspection of business. The PC was created as a consultative body in accordance with a Presidential Decree for the purpose of promoting economic and entrepreneurial development through promoting and monitoring the coordination of various Government economic departments and their implementation of policy. It is also mandated with developing proposals for improvements to the regulatory framework for business and management development, with reviewing and approval of draft normative acts related to entrepreneurial and business development and with public dissemination of policy. The PC has reportedly met only once to date without any apparent decision or result. The HEC was established in accordance with a Government resolution as a consultative and advisory body to encourage and facilitate open discussion of issues and priorities in national economic development, including the national development strategy and specific sectoral policies. It is also tasked with preparing policy proposals to the President and Government. Unlike the CEBE and the PC, the HEC meets regularly on a quarterly basis. Outcomes of the HEC’s activities include approval of a draft programme on concepts in tax policy reform and of draft concept for development of technology parks. It has also taken decisions on developing draft normative acts on legal drafting procedures, inspections of business and obligatory business payments (the latter in collaboration with an export group supported by the UNDP). The effectiveness of most mechanisms for public-private dialogue and collaboration in economic policy formation and implementation appears to be limited although the leading bodies (as described above) were only created recently and will need time to develop their potential. Both the Government and businesses are still unclear as to which type and modality of partnership will be the most effective. Some members of the business community

40 In late 2006, the HEC comprised 7 members from Government, 3 from parliament and 9 from the public and the PC comprised 3 representatives from the Government, 1 from parliament and 42 from the business community.

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believe, rightly or wrongly, that the Government is inherently inclined to restrict substantive private sector participation in policy making and Government transparency and accountability to the public, making such partnerships a public relations exercise with the Government unwilling or unable to make clear responses to private sector proposals. Moreover, these mechanisms so far do not allow the private sector to participate in policy implementation. Current legislation does not provide an adequate basis for formal and substantive public participation in policy-making and implementation. The Law on Civil Service adopted in August 2005 provides for transparency and public access to information on the work of the civil service but the law lack details and is often difficult to enforce. Recent amendments to the Law on Normative Legal Acts require civil organisations to participate in the drafting of legislation but it is unclear as to how effective the provision is in practice. 3.6 Privatisation Policy Although the private sector now accounts for over 75 percent of GDP in the Kyrgyz economy, its share and importance is exaggerated due to two factors. First, as discussed earlier in this report, official figures are based on classifying all enterprises with mixed ownership – including those that are majority state-owned – as private. Second, the strategic industries, especially infrastructure industries such as power, water and transport, are either fully or majority state-owned (but are classified as “private” because of small non-state shareholdings). Weaknesses in infrastructure due to under-investment, weak corporate governance and poor business management are a major cause of the unfavourable business environment and investment climate. The full or partial privatisation of these industries is important to their investment, restructuring and efficiency. However, no substantive progress in their privatisation has been made since independence despite numerous and repeated policy announcements to do so. The Government’s current privatisation programme for 2006-07 (Government of the Kyrgyz Republic 2006b) lists a wide range of economic activities, in addition to those in culture, social services and defence, that are precluded from privatisation. However, the key industries and large-sized enterprises, such as those in infrastructure, are eligible for privatisation. The privatisation programme also allows for flexible and a wide variety of privatisation methods and modalities including auctions, competitive tenders, direct sale, management (and performance) contracting leading to subsequent sale and/or leasing. Also allowed is what is described as “making a contribution to the statutory capital of business partnerships and companies” subject to parliamentary approval. This refers to privatisation in the form of private investments in state-owned entities of strategic or social importance to prevent their insolvency or bankruptcy. Privatisation of infrastructure industries and large-sized enterprises which should and could be privatised has been held back by a variety of related obstacles. First, there appears to be a lack of policy commitment on the part of the authorities. Second, and related to the first, their privatisation is politically controversial and opposed by members of the public who argue that these strategic industries serving public interest should not be owned by private interests seeking to pursue only profits. Third, there is lack of interest among potential private and foreign investors due to the poor financial state and low commercial prospects of many SOEs. Fourth, in many industries the minority state shares remaining from previous partial divestiture available for sale are unattractive to investors who interested mainly in gaining majority control. Fifth, previous privatisation attempts, such as those of the big four (airline, energy, telecom and gas), are said to have foundered because of technical issues relating to asset valuation and pricing. And sixth, privatisation is often conditional upon agreements by investors to a number of obligations or restrictions on minimal investment,

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employment levels and production scale and variety. The Government’s policy commitment to privatisation exists on paper and could be strengthened if it can be shown that these and other obstacles can and should be overcome. The Government already acknowledge the fact that the revitalisation and development of these industries, especially infrastructure, can only be met through private and foreign investment. Political controversy over and popular objections to privatisation of infrastructure could be alleviated if parliament and the public can be assured that the provision of public goods and the public interest can best be met under either full or partial market-oriented private ownership with effective regulatory safeguards against monopolistic or unfair practices, as is the case in many other countries. Private and foreign investors interest can be stimulated by more commercially realistic and attractive terms of sale in which projected future earnings and increased asset value accruing to the state, in addition to increased tax revenues and benefits to the overall economy (resulting from higher private investment and improved management), take precedence over the amount of immediate and one-off privatisation proceeds. Except for the infrastructure industries, there is no need for the state to impose financial, operational and performance targets on privatised enterprises: doing so only leave them unsold and under the control of the state who in any case is itself unable to fulfil those targets (otherwise why sell them?). Moreover, the scope of economic activities precluded from privatisation should be significantly narrowed. State enterprises currently precluded from privatisation include those in waste disposal, gold mining (Kyrgyzaltyn), theatres, film-making and cinemas, road maintenance and operations and a wide range of other activities. Privatisation of infrastructure on a partial basis, rather than full divestiture, would probably be more politically and popularly acceptable. Public-private partnerships (PPPs), or public-private joint ownership and co-financing, is a tried, tested and successful modality for benefiting from private sector investment and management while retaining a degree of public ownership. It is increasingly common in both developed and developing countries41. This modality should be actively pursued in the Kyrgyz Republic in its privatisation and structural reform programmes. Aside from the benefit of additional (private) investment, PPPs also usually result in greater efficiency and productivity due to their commercial orientation. The legal framework in the Kyrgyz Republic appears to permit PPPs. Privatisation in the form of “making a contribution to the statutory capital of business partnerships and companies” subject to parliamentary approval, as permitted in the Government’s privatisation programme (described earlier), could provide a legal basis for PPPs. The Laws on Concessions and on Procurement might similarly provide a legal basis. But the legal basis for PPP is untested and therefore ambiguous since no PPP has yet been employed. A specific legal basis for PPPs will need to be developed. 4. OPTIONS IN PROMOTING PRIVATE SECTOR DEVELOPMENT The ADB and other donors are providing a wide range of support to the Kyrgyz Republic for the development of the national economy. Their support for structural reforms and for the development of key sectors such as agriculture, infrastructure, financial market, trade as well as important areas in public administration (including tax and customs administration and the regulatory regime) all impact directly and indirectly on private sector development. The sectoral assessments and development strategies underlying ADB and other donor support

41 It is increasingly used in the United Kingdom even in social service sectors such as the state education and health systems. It is also increasingly used in India and China (in China in the form of state-private/foreign joint ventures and listed state companies, which are both a form of PPP).

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identify the main sector-specific issues in private sector development. Sector-specific measures for addressing private sector issues are usually contained in donor assistance for particular sectors. The draft ADB-supported agricultural and financial sectors development strategy, for example, discusses sectoral private sector development issues in considerable details. The preparation of this report has drawn from the private sector issues discussed in these sectoral strategies and assessments. . It is outside the scope of this report, focusing on the leading national issues in private sector development in the Kyrgyz Republic, to provide a comprehensive list of options for private sector development relevant to each and every sector. The options presented in this report are therefore limited to those which the report regard as fundamental and generic to the national economy. They are designed to address the core issues as summarised in the analysis of the problematic in private sector development in the Kyrgyz Republic that follows below. The options presented should also be seen within the context of previous, on-going and planned initiatives by the Government and donors in private sector development. The options proposed here are intended to form a single, coherent package which could serve as key components of a discrete ADB programme of assistance focused on private sector development. The proposed initiatives are inter-related and mutually-reinforcing, with potential synergistic and multiplier effects. They are presented here as concepts which will need to be developed into operational projects should the ADB and the Government decides to pursue them further. 4.1 The Problematic in Private Sector Development The stylized facts of economic performance in the Kyrgyz Republic strongly suggest that the economy is performing below potential. Trend GDP growth rates since 2000 show a declining tendency with sharp annual fluctuations in both GDP and the output of various sectors. Structural change has occurred with the service sector now making the largest contribution to national output, but the significance of this change must be qualified by the fact that it has occurred in large part through the negative phenomenon of a massive deindustrialisation. Associated with deindustrialisation has been the deterioration of infrastructure, especially in road transport critical to the development of trade and rural value chains. Aside from the emergence of gold production in 1997, there has been little economic diversification. The economy today is possibly becoming even more concentrated as a result of the deceleration of agricultural growth rates and slowing gold production. In the absence of the development of new gold resources, GDP growth rates are likely to continue to decelerate and the share of industry in GDP will decline further despite initial signs of more vigorous growth in agro-processing and selective light industrial sub-sectors. It is difficult to see how the Kyrgyz economy can escape from its low-level equilibrium trap and attain the objectives for 2006-10 set in the CDS unless key constraints to robust and sustainable growth are overcome. Among the most serious of these constraints is the low level of investment that has impeded economic diversification and improvements in productivity and international competitiveness necessary for export-led growth. The low level of investment and insufficient improvements in economic efficiency, and the under-performance of the national economy more generally, reflect the weak performance of the private sector that now accounts for 75 percent of more of GDP. As preceding sections of this report have tried to argue, the weak performance of the private sector is due to what in analytical terms can be conceptualised as a dysfunctional market mechanism. It is dysfunctional in the sense that market entry and exist by firms is difficult and that firms that succeed in entering markets operate in markets where prices (costs), competition and the

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normal functioning of market forces are distorted42. The low level of investment and productivity, and the lack of economic diversification, in a private sector dominated economy are therefore ultimately attributable to the unfavourable business environment and investment climate. The significant potential of the private sector in the Kyrgyz Republic remains largely unexploited. As acknowledged in the Presidential address to the nation on 28 September 2006 and in the draft CDS, attaining national development objectives depends critically on harnessing the potential of the private sector. The development of a sizeable private sector as has occurred in the Kyrgyz Republic is not necessarily equivalent – nor does it automatically lead -- to the development of a well-functioning market mechanism. The market mechanism in the Kyrgyz Republic is dysfunctional and highly imperfect for five principal reasons. The first and foremost reason is extensive and excessive state interference in economic activities, as evident in a huge range of highly detailed regulations and standards governing all spheres of the economy. Most of these regulations and standards are not only unnecessary but they are also inconsistent, contradictory and meaningless. They essentially constitute a mechanism for micro-management of the economy through administrative methods and are an analogue of the Soviet-era system of direct economic controls. Their effects are to act as a brake on private entrepreneurship. Second, there are serious institutional weaknesses in country governance and the public administration that perpetuate the retention of excessive interference in economic activities. Extensive regulation of the economy creates serious moral hazards for rent-seeking and corruption by officials. Corruption is endemic and pervasive throughout the public administration system. Corruption raises transactions costs, undermines and distorts markets signals and processes and creates an uneven playing field, thus exacerbating the dysfunctioning and imperfections of the market mechanism. It is often argued that increasing civil service pay could be one of the most important actions to fight corruption. This is not borne out by international experience43. Extensive regulation is the major cause of corruption because of the rent-seeking opportunities it provides. It also provides officials with extensive and unwarranted political power, enabling them to exercise cronyism and patronage at both national and local levels of government and to use and abuse official positions to achieve their political and financial ambitions. This in the Kyrgyz Republic has also led to the fragmentation of political power and public administration, with some powerful state bodies operating more or less as independent kingdoms over which the national executive, parliament and the judiciary have weak effective control. For these reasons, the system of excessive regulation has proved difficult to reform, with implementation of policy particularly weak. The excessive system of regulation represents a “stealth” state economic sector used for illegal rent extraction by corrupt officials; it is effectively an “informal state economy” used for illegal commercial pursuits and its effect is to crowd out private sector activities. Third, although the private sector is dominant in the national economy in terms of its share of GDP, the state sector remains dominant in terms of its ownership and control of infrastructure and key industrial branches which are strategic and vital to the efficient functioning of markets and national economic development. These industries, such as those in energy, transport and communications, are highly inefficient and underdeveloped due to

42 Prices and costs of doing business generally are, for example, distorted or inflated by the resources (time and money) needed to deal with extensive administrative procedures, inspections and official corruption. They are also distorted by ambiguities in the legal framework such as in property and creditors rights. 43 Some high-income economies with high civil service pay, such as Hong Kong, Italy and Saudi Arabia, also face serious problems of official corruption.

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poor management and under-investment, leading to shortages and bottlenecks that impede the efficient functioning of markets and development of services supporting market-based production and distribution. Fourth, the consequence of a weak business environment for private entrepreneurs occasioned by excessive regulations, weak public administration and inadequate infrastructure, is a thin layer of a weak and fragile private corporate sector. The national economy is dominated by a very large number of small economic entities comprising mainly farms, individual entrepreneurs and small enterprises, most of which operate in the informal sector. The morphology of the Kyrgyz economy brings to mind Napoleon’s dismissive description of England in the early 19th century as “a nation of small shopkeepers”44. As discussed earlier in this report, even medium and large enterprises conceal a proportion of their activities in the informal (or unreported) economy to minimise tax and social fund obligations. It may be argued that a modern corporate sector that is the foundation of developed market economies is still rudimentary and underdeveloped in the Kyrgyz Republic. Kyrgyz enterprises are inefficient and have been unable to exert the supply responses to growing domestic and external demand. This leads to a vicious circle in which a dysfunctional market mechanism impedes the development of a robust corporate sector that in turn provides insufficient stimulus for development of market forces and market-based economic institutions. Fifth and lastly, the small size and shallowness of the financial sector is a reflection of inefficiencies in the financial market as evident in a low level of intermediation and the high costs of finance. These inefficiencies, however, are due only in part to weaknesses in the banking system such as poor quality and range of products and services, and an inadequate regulatory and supervisory framework. They derive ultimately from a small and weak corporate sector and a large informal sector. Measures to develop financial markets are therefore contingent upon parallel measures to develop the corporate sector and their business environment. The entry point for breaking the vicious circle of low levels of investment, productivity, international competitiveness and exports in the Kyrgyz economy has to be the business environment. The weak business environment is the fundamental first-order constraint generic to all sectors and spheres of the national economy. Some other constraints, such as the lack of finance, infrastructure weaknesses and poor management and marketing skills are essentially second and third order problems whose resolution cannot be substantively achieved without an improvement in the business climate. The improvement of the business environment will also be the most effective – and only practicable – measure for graduating informal economic activities into the formal sector. Addressing these issues faces three major questions. One is that to date there has been a poor record of reform policy implementation in the Kyrgyz Republic, so what realistically can be done to ensure better implementation? The second question is the uncertainty about where the best entry point for reforms lies in practical terms, given the varying levels of institutional capacity in policy implementation and reform policy commitment among the various state economic bodies. And third, improving the business environment inevitably involves reforms in country governance and public administration which in a number of key areas are outside the scope for support and funding by IFIs. To what extent can measures specifically aimed at improving the business environment succeed without a major overhaul

44 Napoleon’s description was of course wrong; the industrial revolution began in England and the country became the “factory of the world” in the nineteenth century.

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of the system of public administration, and indeed of the system of political governance? It is doubtful that policy implementation can become more effective, and substantial improvement to the business environment made, unless and until public administration and governance are considerably improved. This needs to be stated to stress the fact that there is no real long-term solution or magic bullet that can work in the absence of substantial reform of the culture and processes of public governance and administration. In the interim, initiatives to improve the business environment can only be tactical, short to medium term interventions aimed at selectively targeted priority areas where innovative modalities of policy implementation might provide a way out of the current impasse. They might also provide a path for deeper, longer lasting reforms. The initiatives proposed by this report are as follows, in descending order of priority.

(i) The formulation of an integrated and holistic strategy for private sector development, with a single Government agency or a non-governmental body tasked for this purpose.

(ii) The creation and mandating of a semi-autonomous Governmental professional

body, enjoying an arms length relationship with the Government and insulated from political interference, to formulate and effectively implement selected and specific policies aimed at improving the business environment and investment climate.

(iii) The strengthening of an independent mechanism for the oversight of the

performance of public administrative bodies, empowered to assess the performance (performance audits) and effectiveness of the main agencies with responsibilities in areas of greatest impact on the business environment.

(iv) The creation of a state-owned holding or asset management company tasked

with maximising shareholder value of state investments, operating without political interference on a commercial basis, to improve the Government’s capacity to exercise its ownership and corporate governance rights and functions in fully and partially state-owned firms.

(v) An accelerated programme for the privatisation of key infrastructure industries,

based on a more market-oriented paradigm and methods of divestiture and possibly including a public-private partnership pilot which would also help develop the explicit legal basis for such partnerships.

(vi) Strengthening the regulatory framework for competition, focused on the

infrastructure industries to facilitate their privatisation, and involving the clarification of the respective responsibilities and functions of a national competition body and industry regulators and building up their institutional capacity in policy making, investigations and enforcement.

(vii) An expanded and accelerated programme of privatisation of other industries.

(viii) Support for the development of value-chains and rural market infrastructure to

promote economic diversification and exports, comprising assistance to strengthen interindustrial and interregional economic policy analyses and a facility for long-term financing for SMEs engaged in these activities.

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(ix) A pilot at the local level to improve the business environment and investment through integrated and cross-cutting reforms which could also assist the Government in developing the governance and public administration reforms necessary for the decentralisation of economic decision making to local levels of government.

4.2 Private Sector Development Strategy Most Kyrgyz policy makers are fully aware – perhaps more so than the IFIs and outside experts – of the issues and constraints in the country’s private sector development and the policies and measures needed to address them. But policies and measures have hitherto tended to be piecemeal, lacking priorities and sequencing because of the lack of a specific and integrated strategy for private sector development. Such a strategy would identify priorities and the packaging of diverse policies and measures into more coherent and holistic sets to achieve greater impact, synergy and sustainability. Strategy Objectives, Focus and Priorities. Targets set in the draft CDS for improving indicators of the business environment and investment climate are essentially measures of means rather than strategic objectives in private sector development. With the private sector dominant in the economy, the general or strategic objectives in private sector development are not functionally different from the national economic objectives set out in the CDS. However, more specific private sector development objectives or targets should relate to how the private sector contributes to the achievement of the national objectives. They would relate, for example, to performance indicators such as levels of private and foreign investment, productivity, international competitiveness and exports. A key advantage in having a distinct private sector development strategy is that it would facilitate identification of prioritisation and sequencing of measures. It would also enhance coordination of cross-cutting measures across sectors and issues. By delineating the boundary of the appropriate role of the state in the economy, it would furthermore enable analysis to be made of the potential positive or negative impacts of specific proposed state intervention (such as the Development Fund concept). In terms of priority, the main policy measure has to be on improving the business environment and investment climate. If improving enterprise efficiency is the target variable, then improving the business environment and investment climate should therefore be the main policy or instrumental variable in enhancing enterprise efficiency. However, a very wide range of factors impact on the business environment and there is a need to prioritise and sequence the specific measures needed. Surveys show that key that the key concerns of Kyrgyz businesses relate mainly to excessive state regulation or interference and official corruption. Addressing these shortcomings should therefore assume priority, especially in streamlining the scope of standards and reducing the number of inspections. A high tax burden is another major complaint of Kyrgyz businesses. The scope and rate of taxation is always highly contentious, with businesses throughout the world complaining about high taxes and governments seeking to ensure adequate budgetary revenues and macroeconomic stability. It is outside the scope and competence of this report to comment on the merits and demerits of the new Tax Code. But regardless of this, it would be important to improve tax administration by reducing corruption and the number of (illegal or extra-legal) tax inspections. Reducing excessive state regulation and interference as well as improving public administration to counter official corruption and abuses could be a prolonged process entailing reform of the legal and regulatory framework. The state’s institutional capacity in

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such reforms across a broad front is clearly insufficient. In the short term, priority in these reforms should be selectively focused on key areas with the greatest direct impact on key sectors or enterprises vital for export promotion and economic diversification. Successful reforms in selected pilot sectors or localities could then provide lessons and prototypes for reforms nationally. Another priority in enhancing the efficiency of enterprises and markets should be in improving infrastructure. This will require significant restructuring, recapitalisation and adoption of commercially-oriented principles and methods of management which the state is not best suited to undertake. Full privatisation may neither be technically feasible nor politically acceptable at present, but partial divestiture of energy, communications and air transport should be accelerated. In natural monopoly or public goods industries such as road transport, improvements in capacity and efficiency could be achieved in part through adoption of commercial corporate forms and their contracting out of management and service delivery to private operators. All other SOEs engaged in commercial operations should be fully privatised. Retention of partial state ownership of infrastructure industries in the short to medium term means that the state will need to improve its capacity and methods in exercising its ownership and corporate governance functions both to protect the public interest and to enhance confidence of potential private investors in these industries. This can be achieved through the creation of a politically independent, commercially-based and corporatised state asset management company. Sectoral development priorities, particularly in investments, should largely be market-led rather than determined by governmental administrative decisions. Public and donor-funded investment in the real and financial sectors should be determined by, related to and synchronised with the priorities in improving efficiency of enterprises and markets to achieve synergy, rather than formulated as basically stand-alone policies for sectoral development. The efficiency of investments in mining or energy, for example, would be poor unless accompanied by clear measures to improve the functioning of their markets. In operational terms, this means that industrial policy and public investments should aim mainly to create an enabling policy and institutional environment or optimal investment climate for private investment. Organisational Issues. Various Government agencies currently have responsibilities (sometimes overlapping) over various aspects of private sector development but no single agency has overall responsibility. The MOEF and the Ministry of Industry, Trade and Tourism (MITT) are the principal agencies engaged in private sector development policy making with the latter coming closest to having overall responsibility in private sector development in part because of its mandate in entrepreneurship development. Various line ministries are also concerned with private sector issues in their respective sectoral areas. Given the importance of private sector development in the Kyrgyz Republic, consideration should be given to assigning one agency, such as the MOEF, with the overall and over-arching responsibility for formulating a private sector development strategy, and for coordinating and monitoring policy implementation among relevant agencies. The MOEF’s responsibilities for formulating national development policies would provide it with the holistic, inter-sectoral and cross-cutting perspective needed for private sector development throughout the national economy. However, the MOEF would need start-up financial and technical assistance from donors to establish a core group of qualified specialists in private sector development. Another option is to delegate these tasks to consultative bodies such as the HEC and the CEBE, but their institutional capacity (e.g. lack of permanent staff and infrequent meetings) would not suffice to execute the tasks effectively. Yet another option is to assign these tasks to a newly created body such as the Tripartite Commission proposed

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below. 4.3 Establishment of a Tripartite Commission for Business Development The issues that need to be addressed in improving the business environment in the Kyrgyz Republic are well known to policymakers, businesses and donors. The major problem is weak policy implementation by the responsible Government departments as acknowledged by the authorities themselves45. Different and more innovative modalities of policy implementation tailored to – or more precisely, side-stepping -- existing weaknesses in public administration and governance constraints could be considered. Consideration could be given to a different modality for policy implementation which involves a form of contracting out of selective responsibilities and functions to a more independent and professional semi-autonomous governmental body. A modality that has proved successful in the United Kingdom and other countries is the delegating of certain policy making and executive functions to what (in the United Kingdom) is loosely called either a quasi-autonomous non-governmental organisation (QUANGO) or a non-departmental public body (NDPB) -- non-departmental in that, although a public body, it is not formally a part of government. It is akin to a non-governmental organisation (NGO) because it is formally not a part of the government or the civil service. But it is also not exactly an NGO because it is established by government and sometimes by parliament. It is publicly funded and accountable to varying degrees to government and/or parliament (hence semi rather than fully autonomous). Its senior executives and staff are professionals recruited from the members of the public on an open and competitive basis. Its distinguishing features are that: (i) although not a formal part of the executive branch of the government, it is mandated with implementing public policy; (ii) because it is not formally a part of the government, it enjoys considerable operational autonomy and in particular, political neutrality and independence with powerful statutory safeguards built-in to ensure that it operates at arms-length from the government without political interference; and (iii) its decisions and operations are fully transparent and are subjected to a much higher degree of public accountability than government departments. These three characteristics, especially its political neutrality and insulation from political interference, have made it a successful mechanism for implementation of public policy in areas where political neutrality and public trust are essential. In the United Kingdom, a number of regulatory agencies, policymaking bodies in economic affairs, social services (health, education and culture) are QUANGOs. The United Kingdom’s Competition Commission and various industry regulators (including those for electricity, gas, water, transport and financial services), as well as the independent Monetary Policy Committee under the Bank of England, are variants of a NDPB. The exact configuration of QUANGOs and NDPBs in the United Kingdom and elsewhere varies, depending on the areas they work in. If this model is to be employed in the Kyrgyz Republic, the specific arrangements will have to be tailored to the country’s governance and legal framework. Bodies in the Kyrgyz Republic that perhaps comes close to a QUANGO or an NDPF are the National Statistics Committee and the Anti-Monopoly Committee. It is proposed that consideration be given to the creation of a Tripartite Commission for Business Development (TCBD) in the form of a QUANGO or NDPB. The TCBD could in the first instance be established to operate for four to five years, with a mission to achieve by 2010 the target for improving the business environment in terms of the indicators set in the

45 Where policy commitment is strong, the reasons for weak implementation (as recounted earlier) include inadequate institutional capacity, vested interests and corruption both among officials and business.

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draft CDS, i.e., increasing the Kyrgyz Republic’s rating of the World Bank-EBRD BEEPS integrated indicator of the quality of the investment climate from 25.2 points in 2005 to the average for ECA countries’ 2005 level of 18.27 points by 2010. The TCBD would be mandated by the Government (and if appropriate, with parliamentary concurrence) with responsibilities for executing and monitoring implementation of policy and measures aimed specifically at improving the business environment in particular and private sector development more generally. Within the context of an objective to raise the Kyrgyz Republic’s World Bank-EBRD BEEPS investment climate rating to 18.27 points by 2010, its responsibilities and functions could be to: (i) formulate policies and for promoting business development and private (and foreign) investment, and specific measures for their implementation46; (ii) implement policies and measures in selective areas where these policies and measures have been decided by the Government and/or enacted by parliament execute and assigned to the TCBD for implementation; (iii) monitor and assess on a periodic basis the effectiveness of implementation and impacts of policies, related to the business environment, that are implemented by other Government agencies; (iv) ensure transparency and accountability through regular disclosures and reporting to parliament and the public; (v) act as a centralised source for public information on laws and regulations relevant to businesses; and (vi) receive complaints from businesses and the public on instances of official abuses and other irregularities affecting the business environment and which could then be referred to the authorities for investigation and resolution. The task of formulating a private sector development strategy, as proposed earlier in this report, could also be delegated to the TCBD by say the MOEF. It could also assume responsibility for implementing the possible local pilot in business environment policy implementation discussed below. The TCBD would function to monitor implementation of recent anti-corruption strategy and measures47. No single Government agency is at present tasked with, or has the institutional capacity to, monitor and assess the effectiveness of the implementation of the diverse corpus of policies and measures for improving the business environment in particular and for private sector development generally. This function is needed and could be assigned to the TCBD. The TCBD’s potential role in providing direct firm or micro-level support needs to explored further, as this role might best be performed by line ministries with specialist sectoral expertise albeit in coordination with the TCBD. This proposed initiative is at this stage a concept for improving policy implementation by assigning certain policy-making and implementation responsibilities to a politically independent and highly qualified professional non-governmental body that is accountable to the Government but not part of it. A number of issues will need to be resolved if and when this concept is to be translated into a concrete and operational project. Key among them is the determination of which specific policies and measures that the TCBD should be mandated with formulating and implementing because most of these policies and measures are currently the responsibilities of other (existing) Government agencies. This is both a technical and a political issue. In principle, the TCBD should be delegated with responsibility of policy making and implementation in selective key aspects of reforms in the systems of

46 This would include recommendations for streamlining the legal framework for private and foreign investment. 47 The new national anticorruption strategy includes measures such as the conversion of the National Council on Good Governance into the more powerful Consultative Council on Good Governance under the President, and the ratification by parliament of the UN Convention Against Corruption. The. declaration of income and property by Government officials is now mandatory but it remains to be effectively enforced.

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tax administration, customs administration, technical standards and inspections as well as anti-corruption measure – areas which have the greatest and most direct impact on the business environment and investment climate. The TCBD would be headed and staffed by professionals recruited on an open and competitive basis from the public and enjoying private sector (market-based) levels of remuneration. Its board, however, would include non-executive directors representing three groups as its title implies: the Government, the business community, and either parliament with possibly observers from the donor community and/or the judiciary. Representatives from Government should include members of the key economic bodies (such as the MOEF, the MITT and NBKR). Representatives from the business community could be from existing business associations (such as the International Business Council). Representatives from the business community should include those from the localities. The TCBD could be linked to, say, the MOEF. A number of entities, such as the Higher Economic Council (HEC), the Public Chamber (for Development of Economy and Enterprises, or PC) and the Special Commission on Elimination of Barriers to Entrepreneurship (CEBE) have already been created in the Kyrgyz Republic to improve formulation and implementation of policies to improve the business environment. But all these bodies are headed by government officials, are mainly forums for public consultation and lack substantive executive powers in policy implementation as well as a permanent professional staff. Unlike a QUANGO or NDPB, they do not enjoy clear and discrete powers in policy implementation. The underlying rationale for the proposal to create a TCBD in the form of a QUANGO or NDPF is to “contract out” specific policy making and implementation to an outside body that is insulated from political interference and strongly committed to reforms, in light of well-recognised limitations of public administrative bodies in policy implementation. This concept need not necessarily involve the creation of the TCBD as an entirely new body. An alternative might be to transform an existing body or bodies (such as the PC and/or CEBE) into the TCBD, with the PC and/or the CEBE closed and merged into a new TCBD. This alternative, however, would essentially be equivalent to creating the TCBD from scratch since there is no permanent professional staff in the PC and CEBE and the proposed structure and functions for the TCBD differs significantly and substantively from those in these two bodies. If this proposed concept is to considered, the next step would be to scope out in detail the TCBD’s mandate, organisational arrangements, terms of reference and resource requirements. Technical and financial support for this effort, as well as for meeting the start-up costs, might be considered by the ADB or other IFIs. It should also be noted that the application of the proposed concept of implementing public policy through a QUANGO or NDPF type mechanism need not be restricted to the TCBD. It is essentially a potentially more effective modality of public policy implementation in the Kyrgyz Republic and as such could be considered in other areas of public administration reform. 4.3 Strengthening Oversight in Public Administration and Policy Implementation There are potential risks to the TCBD’s effective functioning. The main risk is that its successful execution of selective responsibilities in policy-making and implementation transferred to it from other Government agencies might not enjoy the necessary coordination with and support from these agencies. This risk can be mitigated by a clear and powerful mandate from the highest level of Government, with the TCBD reporting to the leadership,

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parliament, judiciary and the public on obstacles posed by other agencies. These risks would also be mitigated if there is an effective mechanism for the independent oversight of the functioning and performance of Government agencies. Because of potential conflict of interest, this oversight function cannot be undertaken by the TCBD and should be assigned to an independent body accountable to parliament. The existence of such an independent mechanism would support the TCBD’s monitoring and reporting of obstacles and violations by Government agencies in policy implementation. Currently, the Chamber of Accounts only audits government and other entities enjoying public (budgetary) funding in addition to audit of republican and local budgets. It does not undertake performance audit or assessments of effectiveness of Government agencies in implementing policy and in the delivery of public goods and services. The Chamber of Accounts should not be a Government body but be independent of it, and made accountable to parliament with its powers and institutional capacity significantly strengthened. It should operate as a NDPB. The ADB and other IFIs could consider providing support to strengthen the Chamber of Accounts as an independent oversight body. A priority in the focus of ADB support in this effort could be to develop the Chamber of Account’s capacity to perform oversight in Government agencies responsible for key areas impacting on the business environment, especially tax administration, customs administration and standards. This support could be supplementary to on-going and planned assistance by the ADB, the World Bank and other donors in tax and customs administration, the standards regime and other areas. 4.4 State-Owned Holding Company to Strengthen Corporate Governance and

Performance of State-Linked Companies The current political climate does not appear conducive to the full divestiture of some large enterprises. The process of gradual and partial privatisation means that significant assets will remain under state ownership in the near to medium term. Even if the privatisation of key infrastructure industries succeeds or is accelerated, divestiture is expected to be partial and varying but significant degrees of state shareholding is likely to be retained. Some sub-sectors, such as road transport, will remain dominated by the state. For infrastructure industries as well as others of strategic importance, the state needs to improve their performance because of their impacts on the national economy in general and on improving the investment climate in particular. Their performance is also vital to improving the state’s budgetary balances and overall fiscal position. These industries need to be commercialised and subjected to market discipline, with public interest safeguarded through effective regulation in cases of monopolies. To achieve these objectives, it is essential that the Government improve its ability to exercise its ownership, control and governance rights over state assets in companies with both majority and minority state shareholdings. The Government currently lacks either the mechanism or capacity for effective corporate governance of Government-linked firms. Assets of uncorporatised SOEs and shareholdings in fully or partially owned corporatised enterprises (JSCs and LLCs) are held mainly by the Committee for State Property Management (CSPM), but also by other governmental bodies such as the Ministries of Industry, Trade and Tourism and of Agriculture48. These agencies are state administrative bodies lacking the mandate and skills to manage state assets on a commercial basis to maximise their value. In particular, the current arrangements are

48 Outstanding credits owed by SOEs to the Government, amounting to 18.4 billion Som ($450 million), are managed by the State Fund for Economic Development under the MOEF.

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incompatible with those required for attracting private and foreign investors in the partial divestiture of large or infrastructure enterprises. The Government acknowledges the need to improve the management of state shareholding and adopted, for example, a resolution (Number 628, October 2001) in this regard. It is proposed that the state establishes a state-owned state asset management (SAMC) or holding company (SHC). The SHC should be a corporatised commercial entity (i.e. JSC), with its shares held by the Ministry of Economy and Finance (MOEF). The SHC should enjoy full operational and management autonomy free from any political interference and adopt international best practice in corporate governance. While reporting to the MOEF, it should also be accountable to oversight by parliament and other stakeholders such as the public and the business community. Its board of directors, management and staff should be professionals (including foreign specialists where necessary) in asset management and investment financing, recruited on an open and competitive basis and remunerated according to market rates. The mandate of the SHC, which is essentially a mechanism for ownership and control of assets belonging ultimately to the Kyrgyz public (with the Government acting only as an agent of the public), should be to safeguard the public interest by maximising (the state’s) shareholder value. Maximising shareholder value should be its only mandate and it must be operated on a purely commercial basis subject to full market discipline. Investments undertaken and shareholdings held by the SHC should not be a direct instrument of the state’s industrial policy or public investment programme (which includes a wide range of non-commercial investments, such as in health and education). State investments and shareholdings through the SHC are inevitably indirect instruments of industrial policy, but they should be held on commercial grounds and subjected to market discipline without preferential or distortionary features. In other words, investments undertaken through the SHC may support the state’s industrial policy, but they are restricted to those that are commercially viable and similar to those undertaken by private investors after rigorous due diligence and analysis and expected to yield maximum returns. As a commercial operation aimed at maximising shareholder value, the SHC should not takeover assets of all existing state shareholdings as poor performing assets in many state enterprises would compromise the balance sheet, portfolio quality and financial performance of the newly created SHC. The capitalisation of the proposed SHC in the Kyrgyz Republic can come from two sources. One is through transferring state shareholding in fully and partially state-owned enterprises that are commercially viable and/or intended for private and foreign investment, such as through PPPs. The other source possibly is investment capital that is earmarked for a new Development Fund being proposed by the Government. Instead of creating a separate Development Fund, the Government might consider channelling investments proposed under the proposed Development Fund through a newly created SHC. This would help ensure the commercial viability of investments. While the exact scope of its mission and mandate will need to be developed in consultation with the Government, the SHC should include powers to appoint members of the board of directors and senior management (in line with best practice in corporate governance) of enterprises and to guide and approve the formulation of their financial targets and strategic and operational business plans. Consideration could be given in the future to the possibility for divesting some shares of the SHC itself to the public through a domestic listing. This would not only enable the Kyrgyz public to participate in the country’s economic progress but also facilitate corporate governance. Both the SHC itself and the companies in which it invests must adopt international best practice in corporate governance. This would require

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not only a code of best practice for the SHC itself, but also a code tailored for the companies it invests in. The company charter (or articles of association) of the SHC and invested companies should be drafted to ensure compliance with the codes. A number of countries have successfully managed their state assets in the form of SHCs. State asset management companies at the national and local government levels exist in the People’s Republic of China. Huijin, a state-owned commercially-oriented holding company owned and controlled by the People’s Bank of China (the central bank), successfully owns and manages all state shareholding in state-owned banks and other state-owned financial institutions (some of which are partially divested, with foreign shareholding and listed domestically and overseas). Sri Lanka recently established, with ADB and World Bank support, a SHC to improve the performance and corporate governance of state companies. Singapore has one of the most successful experiences with SHCs. The Singaporean Government has two SHCs. Temasek is responsible for investments within the country and the Government Investment Company of Singapore (GICS) undertakes investment overseas49. The organisational structure, mandate and terms of operations proposed for a Kyrgyz SHC is largely based on the Temasek model. The SHC created by the Government in Kazakhstan in 2006 is explicitly modelled after Temasek. The Temasek model, however, will need to be tailored to Kyrgyz conditions and requirements and comply more with international best practice in corporate governance50. The ADB (and other donors) could consider support to the Kyrgyz Government to create the proposed SHC if the proposal is of interest to the Government and ADB. Such an initiative is already under consideration by the ADB in its proposed TA for SOE Reforms and State-Owned Asset Management. ADB support to the Kyrgyz Government for the creation of a SHC, however, should be conditional upon the Government’s agreement to accelerate and deepen its privatisation programme, particularly in infrastructure. This condition is needed to mitigate the potential risk of a moral hazard in a weakening of the Government’s privatisation policy commitment if and when the performance of state firms improve following the creation of the proposed SHC. Initiatives to support these actions are proposed below. Moreover, support should be geared to the Government’s commitment to accelerate progress in improving the business environment and investment climate. Even with the creation of a SHC, state and other enterprises would be unable to improve performance unless the business environment within which they operate improves considerably. 4.5 Accelerated Privatisation of Infrastructure The deteriorated state of infrastructure is one of the most serious constraints to both private sector and national economic development in the Kyrgyz Republic. Infrastructure weaknesses are due to the lack of investment which in turn is a result of a lack of progress with privatisation. Plans for the privatisation of the big four, i.e. Kyrgyz Energy, Kyrgyz Telecom, Kyrgyz Airline and Kyrgyz Gaz, have been made since 1996. Ten years on, they still remain to be privatised. The lack of progress in their privatisation has resulted in very high costs for the Kyrgyz economy and public, not only in terms of the adverse fiscal impact (e.g. huge quasi-deficit in energy) but also in terms of the debilitating effects of an inefficient, backward and inadequate infrastructure sector on the national economy and on businesses and the investment climate in particular.

49 This distinction between the two SHCs is however being blurred because Temasek has began to invest overseas, more recently in Chinese financial institutions. 50 Temasek has recently been subjected to domestic and international criticism over shortcomings in corporate governance.

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International experience shows that privatisation of large enterprises, particularly those in infrastructure, is typically the main attraction for foreign investors and precipitates higher levels of FDI inflows. For example, a World Bank/IFC Foreign Investment Advisory Service (FIAS) study by F. Sader (1996) found that every dollar of privatisation revenues attracted on average an additional 88 cents in FDI for a sample of 36 countries implementing privatisation programmes. But the slow pace of large-scale privatisation in the Kyrgyz Republic, especially privatisation of the infrastructure and public utilities sectors, has hampered higher levels of FDI inflows to the non-gold economy. The potential for attracting non-oil FDI in the Kyrgyz Republic through multiplier effects of privatisation has largely been un-exploited. It is important that support be provided to promote an accelerated process of privatisation of the big four, as well as of Manas Airport and local irrigation systems51. Priority in ADB support in this domain should be on privatisation of the big four. Their privatisation has been held back by a lack of political commitment, a desire to obtain (unrealistic) valuations and sale prices above market valuation and what potential foreign investors are willing to pay and objections to their privatisation among certain sections of the public. These constraints, however, could perhaps be met by their partial and gradual privatisation rather than their immediate and full divestiture. But their privatisation is much more likely to move forward if the Government adopts a different paradigm of privatisation and employs a different privatisation modality based on a more commercial and long-term perspective that could benefit the country more. Staged Privatisation for Value Creation and Realisation. ADB could consider providing technical and financial support for the design and implementation of a programme and operational roadmap for the privatisation of the big four in stages but within a clear and agreed time frame. Assuming that due diligence of their balance sheets, operations, business plans and prospects have been done, the first stage could involve the sale of a sizeable minority share to a foreign strategic investor who would assume operational management and control. The authorities should not seek to maximise privatisation proceeds at this stage: i.e., it should not be concerned if the sale price to the strategic investor is below their expectations (which have tended to be over-ambitious and unrealistic). Instead, their strategy should be to seek and maximise capital gains from subsequent sales of remaining state shares at a higher price when the strategic investor, following investment, initial recapitalisation, restructuring and improved management result in improved performance and prospects that raises value of the enterprise. This means that the initial sale of minority shares to the strategic investor would contain terms and conditions on investments, restructuring, performance and development for the turn-around of the enterprise. The incentive for the strategic investor would largely be in capital gains and value creation and realisation through turn-around and subsequent listing of the enterprise. To ensure powerful incentives for the strategic investor to adopt a long-term development of the enterprise (and to prevent preoccupation with short-term gains through limited service delivery and asset stripping), the strategic investor should be given share options to be exercised at agreed triggers.

51 As discussed in previous sections of this report, this involves divestiture of state ownership to the WUA, with state ownership retained only for irrigation structures of national and regional importance. The ADB and the World Bank are supporting these efforts in their respective agricultural development programmes.

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The second stage of the privatisation of the enterprise would be the raising of significant investment capital through a public listing or initial public offering (IPO). The domestic capital market is too small and weak for this purpose, and the listing should be overseas, say in London. If, however, the legal and regulatory framework for the domestic securities market in the Kyrgyz Republic is sufficiently strengthened at that time, then it might be possible to do dual and simultaneous listing in both the domestic and overseas market. Domestic listing would offer opportunities for the Kyrgyz public to participate in and benefit from the process, but overseas listing is needed not only to access the sizeable amount of funds necessary but also to impose standards of international best practice in the corporate governance and management of the enterprises. The authorities at this stage can decide on what percentage of state shareholdings they are willing to divest at this stage. The issue of full privatisation (or otherwise) can therefore be postponed to this stage and not be an issue in the initial stage of privatisation, thus allowing the process of (staged) privatisation to commence without political constraints. The ADB could provide technical assistance to develop and implement the roadmap for this model of stage privatisation. The technical assistance should also involve a component on developing specific pilot PPP or public-private partnerships arrangements in investment co-financing in infrastructure. This will require, amongst other things, a review of the adequacy of the existing legal framework in the Kyrgyz Republic and recommendations for developing and implementing the necessary legal basis for PPPs in infrastructure. Ideally, the proposed technical assistance to accelerate infrastructure privatisation should also have a concrete result in the form of a pilot PPP in a selected infrastructure enterprise. The ADB (and possibly other donors such as IFC and EBRD) might also want to consider taking an equity position through its private sector operations window, alongside the strategic investor to provide comfort and ensure good corporate governance. 4.6 Strengthening the Regulatory Framework for Competition The privatisation of infrastructure industries, and of the big four in particular, will transform state monopolies into private monopolies. Even if they are unbundled and divested, they will still enjoy considerable market power and market share in certain sub-sectors and localities. In such cases, a state monopoly becomes a private monopoly. The regulatory framework for these industries (except possibly for telecommunications) is currently weak. Their privatisation will need to be underwritten by concomitant initiatives to significantly strengthen the regulatory framework for these industries. Industry-specific regulatory agencies need to be created or strengthened. The respective responsibilities between existing industry regulators and the Anti-Monopoly Committee are insufficiently delineated, as are their hierarchal powers and relationships in policy formulation, investigation and fines or referrals. The Anti-Monopoly Committee (AMC) implements laws on Anti-Monopoly, on Natural and Permitted Monopoly, on Commercials (advertising) and on Consumer Rights. It currently has 38 functions, the major ones relating to implementation of the above-mentioned laws, protection and development of competition, regulation and control of natural and permitted monopolies, regulation of energy complexes, pricing of services provided by public agencies and coordination of the activities of NGOs on issues of commercials and rights. It is a “state body” but is not officially part of the Government; as such it resembles a NDPB although it is unclear to what extent it operates in reality at arms-length from the Government and is insulated from political interference. A fact-finding visit to the AMC and consultations with Government and businesses by the author of this report suggest that the AMC’s institutional capacity is weak. It may be somewhat effective in enforcement of a limited range of laws and regulations in a few markets but it clearly lacks the capacity for pro-active measures to

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develop competition (and to develop a competition law in line with international best practice) and for regulating the energy complex – the latter due to powerful vested political interests as well as weak technical expertise in competition issues. It also appears not to have any substantive partnership mechanisms with private business. Consideration should be given by the ADB to support the strengthening of the entire regulatory framework in the Kyrgyz Republic in general and of industry regulators and the AMC. A technical assistance in this area should include the following components. First, there should be an assessment of the legal framework and of the existing institutions for competition with recommendations for their improvement, with the possible development of a generic competition law in line with international best practice. This will require recommendations for developing a competition policy which should inform reforms in the legal framework for competition. The anti-monopoly law in the Kyrgyz Republic deals with monopolies, but competition involves more than anti-monopoly. In many countries and regions (such as the United Kingdom and the European Union), competition law is aimed at protecting the public interest in a variety of ways and includes unfair trading practices even by non-monopolies. A national competition law should also cover the financial market (which in the Kyrgyz Republic is currently the exclusive competence of regulatory bodies in banking and securities) and external trade. Second, the hierarchy of regulators and respective responsibilities, functions and powers of a national competition agency and industry-specific regulators should be clarified52. Third, efforts to strengthen the effectiveness of competition and unfair practices should focus on building up the institutional capacity of regulators in key areas of infrastructure scheduled for privatisation, concomitant with ADB or other donors’ support to accelerate the privatisation of these industries. And fourth, the technical assistance should help to strengthen the independence and operational autonomy of these regulatory agencies. At the very least they should be clearly distanced from Government agencies and line ministries to ensure that the Government is no longer both a regulator and operator. It should be noted that a strengthened regulatory framework for competition and unfair trading practices will not only enhance the country’s economic efficiency and international competitiveness, but it would also contribute significantly to the improvement of the business environment and investment climate. Corruption, bribes and other illegal and extra-legal acts by both Government officials and businesses distort markets and constitute unfair practices undermining competition and a level playing field. A strengthened and effective competition framework would therefore be another key measure for addressing these constraints to business and investment. 4.7 Accelerated National Privatisation Programme: Full Divestiture of Non-

infrastructure SOEs The Government’s privatisation programme excludes enterprises in a range of activities. It is debatable whether state ownership in many of these industries is warranted or useful. It also envisages a slow pace of privatisation for those permitted to be divested. The Government should consider a more ambitious and accelerated pace of privatisation.

52 In the United Kingdom and the European Union where competition law and institutions are probably the most developed as they are in the United States and Australia, industry regulators (in electricity, gas, transport, telecommunications, finance, etc.) have powers to investigate monopolistic behaviour and unfair practices and to fine companies violating laws and regulatory standards. The national competition commission also has powers to do so but it is also is empowered to resolve disputes between companies and industry regulators which can further be challenged by companies by resorting to litigation through the courts.

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Aside from those in defence and certain public services (such as education and health), all commercial enterprises, including many in cultural activities, media, publishing, etc., should be fully privatised. The argument that they need to be retained under state ownership to ensure the minimum provision of essential goods and services is not credible because many of these markets are already open to private sector against whom the state lacks the investment resources or management skills to compete53. The argument that the state is unable to achieve expected sale prices for the assets of these enterprises is also not a realistic reason for not privatising them fully and as soon as possible. The only basis for determining their real value is the market or what investors are prepared to pay for them. In many cases their assets have little or no value, and these enterprises should be closed or auctioned off for whatever price they can fetch. There are also minority state holdings which are reportedly difficult to sell because they would not provide full or majority control that potential investors are seeking. State shareholdings should simply be offered at discounted prices to existing private owners on a pro rata basis proportionate to their current shareholdings – and be given free to them in the worst case. All state shareholdings in non-essential enterprises need to be fully divested as soon as possible because they impose a financial and administrative burden on the state where the costs outweighs the benefits. It is needed to clean up the state’s balance sheet, to facilitate the rationalisation and streamlining of the public administrative apparatus and to ensure success of the proposed SHC. The divestiture of some of these enterprises, such as Kyrgyzaltyn, could perhaps be eventually be undertaken through listing on the Kyrgyz Stock Exchange as a means for enabling the Kyrgyz public to participate and of promoting the development of the securities market. The ADB could consider a technical assistance to the Government to develop a feasible and operational programme for the full and accelerated privatisation of these enterprises. This proposed initiative is made separately from the proposed one (above) on supporting the privatisation of infrastructure in order that objections to this option do not prejudice consideration of the other. Possible ADB support to the initiative in creating a SHC (as proposed above) could be made contingent upon agreement to accelerate the full privatisation of all non-essential enterprises. ADB support for facilitating the full divestiture of these enterprises could include the following areas of assistance: (i) development of a comprehensive privatisation programme to fully divest these enterprises, enlarging the scope and number of SOEs to be privatised in the 2007-08 period, with an objective of complete privatisation by 2010; (ii) technical assistance in simplifying the modalities and procedures for valuation and sales (of viable enterprises) and liquidation or closure of unviable and non-operational ones; and (iii) technical and possibly financial assistance in creating a fund, using privatisation proceeds, earmarked for alleviating the social impacts of privatisation, including re-training and one-off lump sum compensation for dismissed enterprise staff and employees as well as those resulting from closure or downsizing of existing industrial ministries. The formulation of a revised and comprehensive privatisation programme would assist the Government in clarifying the purpose and objective of state ownership and the appropriate role of the state in the economy generally. 4.8 Economic Diversification and Export Development

53 The state’s position in these markets, however, is in some cases currently protected by preferential policies – including perhaps insulation from invasive inspections and other regulatory burdens imposed on private business.

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There is significant but hitherto unrealised growth potential in agriculture, livestock, agro-processing and light industry based on prevailing inter-sectoral linkages in the economy. These linkages can create considerable spill-over effects and economic stimulus to other sectors with strong positive impacts on employment and income opportunities. In considering initiatives for promoting economic diversification and exports, it is useful to note what may be advisable as well as what may not be advisable. The process of economic diversification and the development of export industries, in terms of the sectoral pattern of their development (i.e. which sectors and industries), should be market-driven and demand-led. This market-driven process can then reveal the direction and areas of the country’s comparative and competitive advantage. Kyrgyz policymakers (as well as donors) should be cautious in trying to select “winners” in promoting economic diversification and export industries. This does not mean that sectoral priorities should or cannot be determined or that sectoral development programmes should not be pursued. However, it is not clear how sectoral priorities (e.g. mining) in the draft CDS have been determined. Nor does it mean that an industrial policy should not be developed, although methods of industrial policy implementation should not involve those that distort markets or pose difficulties for exit54. The state’s role should instead focus on creating the enabling environment for private investors and market-led forces to operate efficiently. The Government should be cautious in trying to implement an industrial policy to promote particular sectors without a rigorous analysis of where the country’s comparative advantage may lie. The technical basis of economic policymaking in the Kyrgyz Republic is still relatively weak due both to the shortage of well-trained and qualified economists capable of rigorous economic policy analysis and to the lack of reliable economic data. Much of economic policymaking, except for that by the central bank, appears to be largely ad-hoc, “intuitive” and based on anecdotal evidence, resulting sometimes in economic policies that lack integrity, coherence or realism. This allows politicians and vested interests to pursue policies whose soundness cannot be tested and verified by proper economic analysis. In this context, the initiative proposed here to promote economic diversification and export development comprises two sub-components: (i) developing the Kyrgyz authorities’ capacity in policy analyses of the economic structure in terms of their inter-sectoral and interregional dimensions to identify the best entry points for economic diversification and export growth; and (ii) developing rural markets and supply chain with a facility for long-term financing. 4.8.1 Inter-industrial and Interregional Policy Analysis The Kyrgyz Republic’s comparative advantage at this stage is unclear due to the paucity of rigorous analysis. The two best studies of this subject to date that the author of this report is aware of are the World Bank’s CEM (World Bank 2005a) and the Investment Climate Assessment (World Bank 2005b). The CEM shows that the Kyrgyz Republic’s international competitiveness is weak due to low levels of labour productivity and enterprise efficiency. The Social Accounting Matrix (SMA) analysis of the Kyrgyz economy in the CEM identifies where intersectoral linkages are most developed and strongest, indicating where and how development of certain sectors or industries could have the greatest knock-on multipliers effects on employment, output growth and incomes in the national economy. However, some of the findings of the SAM analysis are curious and which the author of this report finds

54 International experience shows that a major shortcoming of industrial policy is that a government providing preferential policies to support particular industries often do not know how or when to disengage due to powerful vested interests and potentially adverse social impacts that would result from discontinuation of state support.

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ambiguous, as do members of the National Statistics Committee (NSC) of the Kyrgyz Republic who provided the input-output tables used in the CEM’s SAM analysis. The NSC is now engaged in their own SAM analysis. The CEM’s SAM analysis is nevertheless important and invaluable, but it needs to be updated and refined so that it could serve as a basis for policymaking. The CEM provides detailed recommendations for overcoming external and domestic trade barriers in promoting export-led growth, with emphasis on regional trade cooperation. These recommendations constitute a rubric of measures within which specific initiatives in trade development could be formulated. The World Bank’s Investment Climate Assessment also makes detailed recommendations for measures to improve Kyrgyz enterprise efficiency and competitiveness. These relate mainly to improvement of the business environment and investment climate, for which this report has suggested possible specific initiatives. It is important to update and strengthen analyses of the sectoral interdependencies and dynamics in the Kyrgyz economy, building upon the pioneering SAM analysis undertaken in the World Bank’s CEM. An updated and more detailed SAM would provide policymakers with a better understanding of where initiatives to support for economic diversification and export development could be targeted: i.e., identifying the main structural bottlenecks and sectoral entry points for intervention which could have the maximum positive impact. It is also important that local Kyrgyz capacity in such analyses be developed. A good knowledge and research experience base for such analyses exists in the country. Western interindustry and interregional economic analyses mainly employ input-output methodology derived from the system of material balances that formed the foundation of Soviet-type central planning during the FSU period. Kyrgyz economists, especially those at the NSC, have skills in these areas. The NSC is receiving some technical and financial support from the World Bank in its own efforts to update the analyses but the support is limited. The ADB could consider providing further support to develop the analysis in two key dimensions currently either lacking or insufficiently explored. First, the analysis should include a regional dimension to describe inter-regional as well as inter-industry linkages. This could be invaluable to the formulation of regional development policies in a country where profound income disparities exist between oblasts and between urban and rural areas. This would require the development of a regional input-output table. Second, the external sector in input-output analysis should be developed further, possibly along the lines of export-dependent computable general equilibrium (CGE) models. Possible ADB support for these activities should be seen as an investment in developing Kyrgyz economic policy-making capacity that could potentially yield sustained and wide-ranging benefits in the long-term. 4.8.2 Rural Market Infrastructure Development and Long-term Financing In line with the principle of market-driven economic diversification and export development, another initiative that the ADB could consider supporting is to promote higher value-added agri-business and processing (such as in horticulture) by strengthening the rural market infrastructure and the value chain. Essentially similar initiatives have been undertaken by the ADB elsewhere in the CAR, such as in Uzbekistan. Initiatives in this area are also being taken directly and indirectly in the Kyrgyz Republic through ADB’s Agricultural Area Development Project (in Chui oblast) and the World Bank-supported Agribusiness and Marketing Project, amongst others. The objectives of this initiative would be to facilitate higher levels of investment, access to a more diversified range and better quality raw materials and intermediate inputs, transfer of cultivation and processing technology,

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development of management and marketing skills and market organisations as well as more direct and better access to domestic and foreign markets. Such an initiative could comprise three main elements: (i) support to current Government efforts to strengthen legislation on land ownership and sales, use of land as collaterals and privatisation of local irrigation networks; (ii) development of market infrastructure and backbone services; and (iii) credit lines to rural SMEs. This proposed initiative would build upon on-going projects and support in these areas being provided by the ADB, World Bank and other donors. The existing ADB and World Bank projects in these areas are well-designed and aim to address the key issues in rural development. The proposed initiative therefore seeks mainly to increase the financial and technical resources available for existing projects and to broaden the localities covered, rather than develop a new type of project altogether. However, the positive impact of such an initiative could be increased if a facility for long-term financing is included. The development of rural industries, especially in agro-processing, will inevitably be a main basis for economic diversification and export-led growth in the Kyrgyz Republic. Most of these enterprises are SMEs, and a significant if not the overwhelming proportion of rural economic activities occurring in the informal sector. One of the most serious constraints faced by these enterprises is difficulty in access to finance. The problem of access to short-term loans is being addressed to varying degrees of success by donor-funded facilities such as KAFC and various microcredit organisations. Short-term loans are mainly used to meet working capital needs in current production and to a limited extent for local trade financing. However, long-term financing needed by these enterprises to invest in expanded production and/or new product lines is practically non-existent for almost all rural SMEs. Unless they can access long-term finance, they are largely unable to play an increasing and significant role in economic diversification and exports. Improved access to long-term finance for SMEs would also provide a powerful incentive for enterprises in the informal sector to operate in the formal economy because short-term finance is available through informal channels in the informal sector but long-term finance is not. The ADB could consider a credit line for long-term financing earmarked for supporting SMEs, targeted at those seeking to invest in expanding production and/or entering new markets that would help the country diversify its economy and increase exports. The KAFC and some of the existing commercial banks, such as Ineximbank and Kyrgyz Credit Investment Bank (with greater experience in long-term financing in the country), might be candidates for on-lending in such a facility. The details of such a facility in terms of objectives, scope, modalities and size would need to be developed within the context of on-going and planned projects by the ADB, the World Bank and other donors in agricultural and rural market development. 4.9 Local Pilot in Improving the Business Environment Various initiatives by the Government to improve aspects of the business environment are either being undertaken or planned, many with the support of donors. These include projects supported by the ADB, World Bank and other donors in key areas such as modernisation of tax revenue administration, customs reform and modernisation and reform of the standards regime. Most of these projects are mainly aimed at building up the institutional capacity of state economic, public administrative and regulatory bodies. In the view of many Kyrgyz businesses, however, most efforts to date have not adequately or appreciably reduced unwarranted state interference in terms of number of inspections, arbitrary interpretation of laws and regulations and official corruption. In other words, laws and regulations may have

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improved but their implementation and enforcement remain weak55. While it is evident that the corpus of laws, regulations and policies in the Kyrgyz Republic relating to the business environment contains shortcomings and needs to be improved, it may be argued that overall they are basically sound – on paper. The problem is in their implementation and enforcement. There is therefore a need to provide more support to improve implementation and enforcement at the front line – at the grass-roots level – of state-private enterprise interaction. At the same time, the business environment is holistic, multi-dimensional and represents a “package” or bundle of a wide range of factors. Addressing even only the public administration aspects of the business environment would involve reforms in the implementation and enforcement capacity of a number of public agencies engaged in tax administration, customs administration and numerous regulatory bodies in charge of a wide range of standards. The Government lacks the resources and institutional capacity (and possibly the political power) to introduce measures to improve implementation and enforcement across a broad front nationally and simultaneously among a large number of agencies. In view of this constraint, consideration could be given to supporting a pilot to improve the business environment and investment climate in one locality through a holistic approach. This approach, involving a range of measures in an integrated, cross-cutting reform package, could potentially have significantly greater impact on the business environment. For example, economic reforms in China have largely been based on pilot or trial integrated reforms at the local (municipal and provincial) levels not only because an integrated approach can more easily be done at the local level for political and technical reasons, but also because they allow mistakes to be contained to one locality and measures to be fine-tuned and improved before being applied on a nation-wide basis56. Integrated reforms in one chosen pilot locality level could provide a critical mass which piecemeal or sectoral-specific measures lack. If such an approach succeeds, then it could provide a prototype and demonstration effects for reforms in other parts of the country. Moreover, measures to improve monitoring, transparency and accountability might be easier to implement at the local level given the more compact lines and structure of authority. The proposed local pilot would focus reform measures to address a few key issues. The priority issues would be tax administration, customs administration and the standards regime because these have been identified by Kyrgyz policy-makers and businesses as the most problematic. These issues are also which the ADB and the World Bank are already currently providing technical assistance and where further initiatives could maximise their impact and sustainability57. The scope of reform would be aimed at improving the implementation and enforcement at the local level of current policies and measures to address these issues. The criteria for selection of a locality (city or oblast) could include the presence of: (i) a pro-private sector and reform-oriented local leadership which could be a reform champion backing such a pilot and able to deal with local vested interests; (ii) significant activities in sectors, mainly export-oriented manufacturing in agri-business and light industry, that need to be promoted to diversify the economy and increase exports, as well as of a sizeable informal economy which could be graduated into the formal sector; (iii) financial institutions

55 Many in the Kyrgyz Republic complain of “reform fatigue”, with continual revisions of laws and regulations – none of which are effectively implemented in any case. 56 This reform strategy also involved experimentation with different reform models, policies and measures in different localities before the most successful ones were adopted nationally. 57 These are the ADB’s TA on “Preparing the Reform and Modernization of Revenue Administration” and the World Bank’s project on “Reducing Technical Barriers for Enterprises and Trade”.

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to support related measures for improving access to finance, especially to rural SMEs and agri-businesses; and (iv) an adequate transport and rural market infrastructure to support development of the value chain and trade, or on-going support provided by donors to develop them. The incentive for a local government to serve as a pilot will come from the potential gains in investment and economic development resulting from the pilot. The current national governance and fiscal arrangements do not give local governments (at the level of oblast, rayon, city, municipality, village municipality and communities), especially at the oblast or city level where the proposed pilot is best suited, the extent and scope of executive, administrative and budgetary powers necessary for them to take a lead in local economic development nor to be pro-active in adopting independent and innovative modalities and measures of policy implementation. The provisions of the Law on Local Governments and State Administration define the (limited) powers of local governments. A recently adopted national strategy for on “Decentralisation of State Administration and Local Government Development to 2010” seeks to enlarge the powers of local governments but also identify a range of unresolved issues preventing a substantive decentralisation of economic and financial powers to local governments. An action plan for 2006-07 was subsequently drafted to examine ways in which the issues could be addressed within the framework of the national decentralisation strategy. The proposed local pilot could therefore assist in the Government’s efforts to empower local governments with greater authority in local economic development. The pilot would focus on the legal, governance, fiscal and administrative as well as market reforms that would be need to be addressed if local governments are to undertake initiatives to improve the business environment and investment climate in their locality. The small size of the Kyrgyz Republic in terms of geographic area and population mean that the issue of economic decentralisation is not as important as it is in larger countries. Nevertheless, decentralisation might be an effective means for overcoming the difficulties and prolonged process of reforming national economic administration which have continued to undermine the business environment and investment climate. It might allow reform-oriented localities to move ahead with market reforms and private sector development. If this strategy is to be adopted, then and only then should the proposed local pilot be considered by the Government and the ADB. A draft report (Hasanov 2006) has been prepared by a local consultant who was recruited to examine the local pilot concept in more detail. The report outlines the governance, public administration, financial and economic issues that will need to be addressed in such a pilot58. The proposed local pilot could experiment with trial measures and its outcome could help inform the formulation of specific decentralisation measures within the context of the Government’s national decentralisation strategy.

58 The report is available from the ADB Resident Mission.

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APPENDICES

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Table A1: Macroeconomic Performance Indicators 2001-2005 2001 2002 2003 2004 2005GDP growth (%) 5.3 0.0 7.0 7.0 -0.6 Per capita GDP growth (%) 4.5 -0.8 6.0 5.9 -1.6 GDP demand components (%) Consumption 82.3 86.2 94.7 94.2 104.0 Investment 18.0 17.6 11.8 14.5 14.4 Net exports -0/3 -3.8 -6.6 -8.7 -19.1 Statistical discrepancy 0.0 0.0 0.0 3.8 -0.7 Gross domestic investment (% of GDP) 19.6 20.3 20.5 20.9 21.8 Private 14.3 14.3 15.8 16.4 17.6 Public 5.3 6.1 4.8 4.5 4.2 Public investment programme (% of GDP) 4.4 4.8 3.6 3.4 3.2 Gross domestic savings (% of GDP) 18.1 16.8 16.4 17.4 13.4 Private 18.6 16.9 17.3 17.6 13.6 Public -0.5 -0.2 -0.9 -0.1 -0.2 Balance of payments Trade balance ($ million) 40 -73 -133 -171 -419 Current account balance ($ million) -19 -49 -85 -76 -204 Current account/GDP (%) -1.3 -2.2 -4.2 -3.4 -8.1 Net FDI ($ million) -1 5 46 131 60 External debt/GDP (%) 110.0 111.1 102.4 95.1 80.9 Debt service (% of exports) 30.8 20.7 21.8 13.7 9.4 External debt/exports (%) 289.5 306.9 305.4 264.8 282.1 Overall budgetary balance (% of GDP) -5.0 -5.4 -5.1 -4.3 -4.2 Inflation (period average %) 6.9 2.0 3.1 4.1 4.3 Employment growth (%) 1.1 1.1 1.7 2.3 2.8 Unemployment rate (% of labour force) 7.8 8.6 8.9 9.0 8.7 Sources: NSC, NBKR, MOF, IMF, ADB database, NPRS Second Progress Report (2006) and CDS Draft (November 2006).

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Table A2: Commodity Composition and Direction of Trade (% distribution) 1995 2000 2001 2002 2003 2004 (1st half) A. Commodity Composition of Trade Total exports 100.0 100.0 100.0 100.0 100.0 100.0 Agriculture 10.5 9.3 9.5 11.6 5.2 5.0 Industry 89.5 90.7 90.5 88.4 94.7 95.0 Electric energy 10.0 15.8 9.8 4.5 3.3 1.8 Nonferrous metals 15.3 46.4 51.9 40.7 47.9 49.6 Machine building 10.9 10.6 12.4 11.4 7.9 6.8 Light industry 20.2 8.7 6.7 13.4 12.7 10.3 Food industry 19.4 2.7 2.6 3.5 4.2 6.6 Total imports 100.0 100.0 100.0 100.0 100.0 100.0 Agriculture 3.3 7.4 3.0 3.1 1.9 1.7 Industry 96.7 92.6 97.0 96.7 98.1 98.3 Oil & gas 31.1 20.0 22.6 22.1 22.2 25.9 Chemical & petrochemical 5.8 8.7 9.5 8.8 10.0 10.2 Machine building 19.8 27.2 22.1 23.1 20.1 20.1 Light industry 4.4 7.0 6.9 7.4 7.3 5.2 Food industry 16.1 8.5 11.7 11.9 12.6 13.3 Other industry 0.9 8.4 1.1 1.0 6.4 8.6 B. Direction of Trade Total exports 100.0 100.0 100.0 100.0 100.0 100.0 Non-CIS countries 34.2 58.9 64.6 65.3 65.5 61.7 CIS countries 65.8 41.1 35.4 34.7 34.5 38.3 Total imports 100.0 100.0 100.0 100.0 100.0 100.0 Non-CIS countries 32.4 46.1 45.0 45.0 42.8 38.2 CIS countries 67.6 53.9 55.0 55.0 57.2 61.8 Sources: IMF 2006a, NSC.

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Table A3: Privatisation by Sector and Types of Property, 1995 – 2006 (cumulative) 1995 1998 2000 2002 2003 2004 2005 2006* Privatisation by Sector 5,875 6,507 6,804 6,988 7,066 7,147 7,147 7,186 Industry 458 505 518 535 535 537 540 542 Consumer services 1,896 1,933 1,935 1,936 1,936 1,936 1,936 1,936 Non-productive sphere 411 454 528 560 584 597 598 599 Trade and catering 1,788 1,893 1,907 1,916 1,916 1,916 1,916 1,916 Agriculture 348 359 367 379 379 380 382 382 Construction 391 420 428 430 430 430 431 431 Transport 134 162 166 171 171 173 174 174 Other branches 449 781 955 1,061 1,115 1,754 1,170 1,206 Privatisation by Type 5,875 6,507 6,804 6,988 7,066 7,123 7,147 7,186 Conversion to JSC 1,426 1,628 1,658 1,676 1,677 1,680 1,681 1,681 Rented to subsequent purchase 73 104 118 134 150 156 157 165 Sale via commercial competition 1,106 1,190 1,197 1,231 1,254 1,272 1,275 1,280 Conversion to limited JSC 189 210 221 224 224 224 224 224 Sale to private parties Or workers collectives 2,693 2,887 3,096 3,197 3,205 3,219 3,228 3,235 Auctioned 388 488 514 526 556 572 582 601 *As of 1 December 2006. Source: CSPM. Table A4: Share and Sectoral Distribution of Private Sector Employment, 2000 and 2004 2000 2004 National Private National Private Thousands (average annual) 1,768.4 1,384 1,879.9 1,520.1 Private Sector Share (% distribution) Total employment 100.0 78.2 100.0 80.9 Agriculture 100.0 99.0 100.0 98.8 Industry 100.0 88.2 100.0 93.7 Mining 100.0 88.2 100.0 98.5 Manufacturing 100.0 95.0 100.0 97.5 Electricity, gas & water 100.0 49.5 100.0 73.4 Construction 100.0 88.9 100.0 94.2 Trade and repairs 100.0 98.5 100.0 99.6 Transportation and communications 100.0 70.3 100.0 81.8 Education 100.0 3.9 100.0 4.0 Health & social services 100.0 3.1 100.0 7.8 Source: NSC.

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Table A5: Enterprises by Size of State Shareholdings and Sectors, 2006 Size of State Shareholdings 100% 51-100% 50-25% 24-1%By corporate forms JSCs 14 71 15 13 Other corporate forms 7 8 3 1 Total 21 79 18 14 By sectors Industry 6 34 9 7 Trade 1 1 2 -- Agriculture 3 3 3 1 Construction 2 8 2 2 Transport 3 10 1 2 Health care -- 2 -- -- Other sectors 6 19 1- 2 Source: CSPM. Table A6: Percentage of Privately-owned SMEs, 2002, 2004 and 2005 (in %) 2002 2004 2005National economy 95.8 97.4 98.0 Small 96.8 97.8 98.4 Medium 88.7 93.1 93.7 Agriculture 89.7 90.8 89.4 Industry 94.8 95.7 97.4 Construction 94.6 96.8 97.7 Trade and repairs 98.8 99.3 99.4 Hotel and restaurants 97.9 96.3 96.3 Transport and communications 86.8 97.1 98.2 Source: NSC.

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Table A7: Number and Sectoral Distribution of SMEs, 2000 -- 2005 2000 2002 2004 2005A. Number of SMEs National total 181,125 281,810 414,701 471,752 Small 7,557 6,893 7,729 7,698 Medium 1,011 866 756 782 Individual entrepreneurs 101,394 122,525 259,701 163,119 Peasant farms 71,163 251,526 259,701 300,162 B. Sectoral Distribution (%) (Excluding individual entrepreneurs and farms) Economy total 100.0 100.0 100.0 100.0 Agriculture 3.9 4.3 4.2 3.9 Industry 21.7 21.5 20.8 19.6 Mining 0.7 0.8 1.1 1.1 Manufacturing 20.5 20.4 18.7 17.9 Electricity, gas & water 0.5 0.6 1.0 0.6 Construction 9.4 9.8 9.7 10.3 Trade and repairs 37.5 36.0 33.1 32.6 Hotel and restaurants 2.7 2.3 1.9 1.9 Transport & communications 7.3 7.1 8.6 9.0 Source: NSC.

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Box A1: Summary of Findings from National Business Opinion Survey (May 2004) External Finance. The majority of businesses reported that they have not used any external finance from financial institutions because of high interest rates, lack of long-term lending, difficult application procedures and high collateral requirements. The main source of external finance was friends and relatives. Only 12 percent of respondents used financial institutions. Surprisingly, businesses in the more developed areas, Bishkek and Chui, had the lowest use of finance from financial institutions (presumably because of their high shares of individual entrepreneurs and large informal sector). The agricultural sector has the highest use of financial institutions, due to involvement of KAFC and microcredit organisations. Tax regime. Only 25 percent of respondents reported that they can pay all taxes and still remain viable or develop their business. The majority of businesses stated that both the simplified small business taxation and the patent tax system have helped their businesses59. Only 5 percent of JSCs and LLCs admitted to voluntary compliance with the 20 percent corporation (profit) tax rate, with 49 percent saying they would comply fully if the corporation tax rate were set at 10 percent. Respondents also expressed concerns about high levels of VAT and social fund contributions, with reduction in VAT singled out as the reform most needed. Tax inspections were the most difficult inspection faced by businesses, with an average of two inspections per year. Fifty-five percent of respondents report abuses by tax inspectors. Business Competition. 25 percent of respondents said they faced unfair competition from illegal businesses and 19 percent face unfair competition from state enterprises. Supply Side Constraints. Availability of resources, inputs: majority of respondents, ranging between 60 to 70 percent, report difficulties in finding suitable premises, availability and high costs of raw materials, availability of equipment and technology and good workers. About 70 percent of respondents report a need to improve to significantly improve management and marketing skills. State Regulations and Corruption. A major difficulty with corruption was not only its pervasiveness among government agencies and the judiciary, but also among businesses (suppliers and customers). Difficulties also arise from instability and unpredictability of the legal framework, with legislation changing frequently. Only 17 percent believed business legislation is effectively implemented. Corruption is closely related to excessive state regulation and inspections. Permits are difficult to obtain, and businesses face an average of 12 inspections each year. The most difficult inspections are those relating to taxes, sanitation and epidemiology, police (MVD), fire prevention, local (oblast/city/rayon) government, social fund and traffic police (GAI). Source: PROMA and IBC (2004).

59 A simplified taxation system for small business was introduced in November 2001. The system is optional and allows small businesses with gross receipts of less than 3 million Som per year to adopt the system. The system allows small businesses to pay only one turnover tax of 5 to 10 percent depending on the sector and exempt them from profit, emergency, road and sales taxes. The patent system was introduced in July 2001 for a wide range of businesses where normal taxation is replaced by the purchase of a patent or license to operate the business.

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REFERENCES ADB (2003), Private Sector Assessment: Kyrgyz Republic. ADB (2005a), Country Strategy and Program Update: Kyrgyz Republic (2006-2008). ADB (2005b), Technical Assistance to the Kyrgyz Republic for Preparing the Reform and Modernisation of Revenue Administration Project. ADB (2005c), TA3757-KGZ: Institutional Support in the Transport Sector: Final Report. ADB (2006), Support to the Development and Implementation of the National Poverty Reduction Strategy II – Roads Sub Sector: First Draft Strategy (report prepared by Michael Sims under TA-4705 (KGZ)). Chamber of Tax Consultants (CTC) (2006), Rationale of Need for the Tax Policy Reform in the Kyrgyz Republic. EBRD (2005), Transition Report. IBC (2006a), The Business Agenda – What Does Business Want? IBC (2006b), Investment Now (periodical), Spring and Summer issues. Economic Forum on “Removing Barriers to Business” (31 May 2006), workshop handouts. Government of Kyrgyz Republic (2006a), Resolution No. 91 (13 February) on Program of Privatisation of State Property in Kyrgyz Republic for 2006-2007. Government of Kyrgyz Republic (2006b), Privatisation Programme in the Kyrgyz Republic for 2006-2007 (approved by Parliament on 5 June 2006). Government of Kyrgyz Republic (2006b), Country Development Strategy 2006-2010 (Novmber 2006 draft: English language version). Hasanov, Rafkat (2006), Framework for Pilot Projects. IMF (2005a), Kyrgyz Republic: Statistical Appendix (Country Report No. 05/31). IMF (2005b), Kyrgyz Republic: First Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility (Country Report No. 05/402). IMF (2006a), Kyrgyz Republic: Second Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility (Country Report No. 06/235). IMF (2006b), Kyrgyz Republic: Enhanced Initiative for Heavily Indebted Poor Countries – Preliminary Document (Country Report No. 06/417) IMF (2007), IMF Executive Board Concludes 2006 Article IV Consultation with the Kyrgyz Republic (Public Information Notice No. 07/3). IMF and IDA (2006), Kyrgyz Republic: Joint Staff Advisory Note on the Poverty Reduction Strategy Paper – 2004/05 Progress Report (April).

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