Report No 29150-KG Kyrgyz Republic Country Economic Memorandum Enhancing the Prospects for Growth and Trade (In Two Volumes) Volume I: Main Report January 24, 2005 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Document of the World Bank ACKNOWLEDGEMENTS This Report was prepared by a team of Bank staff and consultants ledby Sebnem Akkaya, and comprising Azamat Abdymomunov, Tyler Biggs, Vandana Chandra, Bill Fox, Bart Kaminski, Yasuo Konishi, Kathy Lalazarian, Natalia Pisareva, Carlo Segni, Philip Schuler, Ekaterine Vashakmadze. Additional contributions were received from Kanat Aubakirov, Burcu Duygan, Evgeny Polyakov, Daniel Roseman, Peter Wehrheim, Peter Wobst, and Marc Mueller. Dennis de Tray (Country Director) and James Christopher Lovelace (Country Manager) have sponsored the report and provided inputs into the design. Samuel Otoo (Sector Manager) provided invaluable suggestions at various stages of preparation. Daniyar Aitimbetov provided very capable team support. Virginia Sapinoso, Erlinda Inglis, and Marinette Guevara have undertaken outstanding work processing this report. The peer reviewers were Sandy Cuthbertsonand Hany G. Broadman. The Bank team is indebtedto many government officials and agencies, who provided inputsand invaluable help throughout the preparationprocess, especially those inthe Ministry o f External Trade and Industry, FDI Secretariat, Ministry o f Finance, National Bank of the Kyrgyz Republic, and National Statistics Committee. The team is particularly grateful to MessrsMmes: Abdrahmanova Chinara, Chechetkina Elena, Chukina Galiya, Doronina Elena, Ibragimova Shamsia, Kim Tsera, Kravchenko Valentina, Kulyaeva Galina, Kumetzova Nina, Muphtahutdinova Sania, Omushev Esenbek, Plesovskih Raisa, Salahitdinova Elza (National Statistics Committee); Esenaliev Damir, ImaralievaNasiba, (National Bank o f the Kyrgyz Republic); and Baitakova Marta (Custom Inspection under Revenue Committee) for their valuable contributions and support during the preparation of the Social Accounting Matrix for the Kyrgyz Republic. The team also greatly benefited from discussions with representatives o f various international organizations, including the IBC, IMF,DFID, Helvetas, Pragma, SADC and TACIS. ... 111 TABLE OFCONTENTS EXECUTIVE SUMMARY ............................................................................ vii CHAPTER 1 KYRGYZECONOMY: PRESENTSTRUCTUREAND SOURCESOF . GROWTH ............................................................................................................................. 1 A. ~TRODUCTION ....................................................................................................................... 1 B. MACROECONOMIC DEVELOPMENTSCHALLENGES.......................................................... AND 2 Macro Stabilization and Structural Reforms-An 2 Supply Side Responseto Macro Stability and Structural Reforms .................................. Overview .......................................... 3 Wages and Productivity Trends ...................................................................................... 6 Growth and Poverty Trends............................................................................................. 8 c. STRUCTURE OF THE KYRGYZ ECONOMY ............................................................................... 10 Accountingfor Sources of Growth and Employment: Social Accounting Matrix-Based Model ............................................................................................................................. 10 D. IMPLICATIONSOFTHEEXISTINGECONOMIC STRUCTUREFOR GROWTH .............................. 17 Inter-sectoral Linkages Revealed by SAM-basedModel............................................... 17 Needfor Export Diversificationfor Growth. Employment and Poverty Reduction ...... 19 E. GROWTH OUTLOOK-MEDIUM TERMVERSUSLONG-TERMCHALLENGES .......................... 24 GrowthAccounting and Simulationfor 2002................................................................ 24 Growth Prospects in Medium to Long Term ................................................................. 26 Towards Non-Gold Economic-cum-Export Diversijkation Strategy in Long Term..... 27 CHAPTER2 . EXTERNALAND DOMESTICTRADE BARRIERSTO INTEGRATION: `WTO RULESAND BEYOND'AS VEHICLE OFKYRGYZ REGIONALAND GLOBAL INTEGRATION ....................................................................... 30 A. TRADEREGIMEASSESSMENTA SNAPSHOTPICTUREOFDEVELOPMENTS AND INTRADE .....30 Policies and Outcomes-An overview ........................................................................... 31 External Policy Barriers................................................................................................ 36 Home-Made Trade-RelatedPolicy Issues ..................................................................... 41 Conclusion: NeedFor Convergence in Attacking Problems at Multilateral. Regional and Domestic Levels ...................................................................................................... 46 B. TURNINGWTOMEMBERSHIP SPRINGBOARD FORREGIONALAND GLOBAL INTOA INTEGRATION ..................................................................................................................... 46 WhatDoes Kyrgyz Republic Get Out of WTOMembership?........................................ 46 Improved and PredictableMarket Access..................................................................... 47 Dispute Settlement......................................................................................................... 47 External Policy Anchor: Using Multilateral Disciplines to Effect Regulatory Reforms48 A Seat at the Table: How to Maximize Benefitsfrom It?.............................................. 54 Conclusion ..................................................................................................................... 56 c.INTEGRATION INA REGIONALSETTING TRANSFORMING WEAKNESSES INTO STRENGTHS ....56 TradeFlows: Implicationsfor Kyrgyz Foreign Economic Policy................................ 57 Regional Ramifxation of External Economic Interaction............................................. 58 Conclusions and Summary of Policy Recommendations............................................... 70 iv D. THEROADAHEAD:THENEED A TWO-PRONGED FOR STRATEGY AND ITS ORGANIZATIONAL UNDERPINNINGS ................................................................................................................ 71 CHAPTER3 . CROSS-CUTTINGISSUESFORBUSINESSDEVELOPMENTAND IMPROVEDCOMPETITIVENESS ........................................................................................ 74 A. STRATEGY FORBUILDINGCOMPETITIVENESS...................................................................... 74 B. IMPROVINGTHEINVESTMENTCLIMATE ............................................................................... 75 Investment Climate-Why is it so Important?............................................................... 75 Much Has Been Done Over the Decade to Improve the Investment Climate................77 WhatAreas Still Need to be Improved? ......................................................................... 84 c. CHALLENGES FOR IMPROVED COMPETITIVENESS ............................................................... 100 Strengthening Enterprise Capability and IncreasingProductivity ............................. 100 Developing More Robust Financial Systems............................................................... 106 Improving Efficiency of TradeFacilitation Services................................................... 107 UpgradingInfrastructure ............................................................................................ 108 Building Institutions and TrainingPrograms to Support Agriculture and Meet International Product Standards ................................................................................. 108 D. ROADMAP FUTURE FOR REFORM........................................................................................ 110 ANNEXES ................................................................................................................................. 114 ANNEX1.A . PROSAND CONSOFTHE SAM-BASED MODEL ................................................... 115 ANNEX1.B . FROMGROWTH HOUSEHOLD TO INCOMES-ACLOSERLOOK .......................... 117 ANNEX1.C . KYRGYZ REPUBLIC'S NATURAL RESOURCE ENDOWMENTS ................................ 121 ANNEX 1.D . NON-GOLD EXPORTS -DIVERSIF~CATI~N INDICATORS ..................................... 123 ANNEX 2.A . THEKYRGYZ REPUBLIC AND MARKET ACCESS NEGOTIATIONSDOHA INTHE ROUND ............................................................................................................................. 125 ANNEX2-B. GATSAND KYRGYZSTAN'SINSERVICES .............................................. TRADE 129 ANNEX 3. KYRGYZ REPUBLIC'S 2003 LEGISLATIVE REFORMSTO IMPROVE INVESTMENTAND BUSINESS CLIMATE.......................................................................................................... 137 REFERENCES .......................................................................................................................... 141 V BOXES Box 1.1: Basic Features ofthe Kyrgyz Social Accounting Matrix ( S A M ) ................................. 11 Box 1.2: FromGrowthto Household Incomes-A Closer Look............................................... 24 Box 2.1: How Kyrgyz Exports Respondedto GrowingExternal Demand from Neighboring Russia and Kazakhstan?........................................................................................................ 36 Box 2.2: Three Reasons Why There ShouldbeNo Place for Antidumping inFTA andNational Legislation............................................................................................................................. 63 . . Box 2.3: Services inRegional Agreements ................................................................................. 66 Box 3.1: Highlights o f Financial Sector Reforms........................................................................ 78 Box 3.2: Highlights o fPrivatization Program ............................................................................. Box 3.3: Kyrgyz Republic'sConsultative Approach to Strengthenthe Investment Climate ......78 79 Box 3.4: Costs Imposed on Firmsby Investment Climate Problems: Dairy IndustryValue Chain Analysis................................................................................................................................. 85 FIGURES Figure 1.1: Featureso f Recent Economic Outlook........................................................................ 3 Figure 1.2: RelativeUnit Labor Cost inIndustry. SelectedCIS Countries. 2002......................... 6 Figure 1.3: RealEffective ExchangeRate. 1995-2003.................................................................. 7 Figure 1.4: Structure o fthe Economy and Sources of Employment. 2001-SAM ...................... 12 Figure2.1: Exports of Goods and Services with andw/out Gold in 1995-2003 (inmilliono f Figure 3.1: Production. Exports. andDomestic Sale o f Goods Produced inFEZ (mil.US$) .....34 US$) ...................................................................................................................................... 90 TABLES Table 1.1: Gross Domestic InvestmentinSelectedTransition Economies. 2002 ......................... 4 Table 1.2: Structure and Sources of InvestmentinFixedCapital. 1999-2002.............................. 4 Table 1.3: Financial Intermediationbythe Banking Sector inSelected Transition Economies. Table 1.4: The Kyrgyz Republic and Selected CIS Countries: Relative UnitLabor Cost, 2002 .7 2002......................................................................................................................................... 5 Table 1.5: The Kyrgyz Republic and SelectedCIS countries: Total Factor andLabor Productivity Growth, 1998-2002................................................................................................................. 8 Table 1.6: Kyrgyz RepublicGDP, Consumption and Poverty, 1996-2003................................... 9 Table 1.7: Output and Labor, 1996-2002....................................................................................... 9 Table 1.8: Sources o f Growth and Employment inAgriculture, 2001 ........................................ 12 Table 1.9: Sources o f Growth andEmployment inManufacturing, 2001................................... 13 Table 1.10: Significance of GoldMining inKyrgyz Republic.................................................... 14 Table 1.11: Sources o f Growth andEmployment inMiningand Energy, 2001 ......................... 15 Table 1.12: Sources o f Growth and Employment in Services, 2001........................................... 15 Table 1.13: Trade Margins as a Share o f Total GDP, 2001......................................................... 16 16 Table 1.15: S A M Multipliers andNon-GoldDiversificationIndicators, 2001........................... Table 1.14: Patternsof Export and Main Trading Partners in2001 ............................................ 18 Table 1.16: Critical InputsofEconomy, 2001............................................................................. 21 Table 1.17: Relationship Between Occupational Skills, Employment, and Income from Labor 23 Table 1.18: GrowthAccounting for 2002: Negative Shock inGold and Energy andNormal Table 1.19: Implications o f Gold-Shock for the Kyrgyz Economy- An Illustration..................25 Growth inthe Other Sectors ................................................................................................. 27 vi 32 Table 2.2: CIS Countries' Exposure to the International Economy. 2000-2002.......................... Table 2.1: CIS Countries' MFNTariff Schedules. 2001-2002 .................................................... 33 Table 2.3: Gross Domestic Product. ForeignDirect Investment. Exports and Imports of Goods and Services in 1996-2003.................................................................................................... 33 Table 2.4: Kyrgyz Comparative Export Performance inKazakhstan and RussianMarkets in 1996-2002 ............................................................................................................................. 35 Table 2.5: Share o fKyrgyz Trade with FTA Partners, 1996-2002 ............................................. 36 Table 2.6: MFNTariffs o fMajor Non-FTA Partners, 2001........................................................ 37 Table 2.7: PrincipalExports to the World, 2002 ......................................................................... 38 Table 2.8: Transportation's Contributionto the Cost ofKyrgyz Imports (in% o fthe value o f imports in2002) .................................................................................................................... 40 Table 2.9: Tariff Escalation inManufacturingIndustriesin2002............................................... 43 Table 2.10: Kyrgyz MembershipinWTO Accession Working Parties...................................... 55 Table 2.11: PrincipalExports to the CIS, 2002 ........................................................................... 57 Table 2.12: Kyrgyz Participation inRegional Trade Integration ................................................ Table 2.13: Characteristics of Structure o f Tariffs inthe Kyrgyz Republic and Russia .............59 69 Table 3.1: Conditions inEntryto Private Business Activity in 1997 and 2002 .......................... 80 Table 3.2: Central Asia GovernanceIndicators, 2002................................................................. 87 Table 3.3: Numberand Employment o f SMEs andIndividual ................................................... 89 Table 3.4: Cross-country Comparison o fVAT and Collection Rates, 1999-2002...................... 90 vii EXECUTIVESUMMARY The Kyrgyz Republic has made major strides inthe past decade inits transition to a market-based economy: a complex challenge exacerbated by its small size and geographical location. Its trade and investment policies are arguably the most liberal among the member countries o f Commonwealth of Independent States (CIS). Despite the generally progressive stance on structural policies and a sound record o f macroeconomic management in recent years, economic growth has been modest, living standards are low, a large burden o f external debt has been accumulated and integration into global production and trade remains limited. This report is aimed at helping the authorities identify factors explaining the apparent divergence between policies and outcomes, with a view to determining priorities for reform in the coming period. The mainmessageso f the report are: 0 Kyrgyz policymakers should take advantage of the currently favorable nexus of a stable macro-environment, relatively strong gold production and international prices, and fast- growing neighboring markets to address lingering policy and institutional deficiencies that limit the efficient restructuring of the economy away from its dependence on primary agriculture, mining and hydro-power. Action is needed to provide for more rapid progress with poverty reduction and to mitigate the impact on the economy of an expected major decline ingold production by the end o f the decade. Detailed quantitative analysis conducted for this study reveals a significant unrealized growth potential in agriculture and livestock products, agro processing and light manufacturing based on prevailing inter-sectoral linkages inthe Kyrgyz economy. Moreover, the potential spillover of economic stimulus from these sectors to other sectors o f the economy i s very high, with important implications for expanding employment and income opportunities. The report highlights the critical role o f a supportive service sector infacilitating these changes. 0 The prospects for successfully changing the growth pattem and trajectory depend fundamentally on accelerated investment and export diversification. The contribution of FDI to non-gold real sector investment has been minuscule over the past decade, limiting opportunities for much needed technology transfer and access to global value chains. The weaknesses o f the export sector are reflected in the steady erosion o f the Kyrgyz share o f traditional regional markets. Kyrgyz firms have failed so far to fully capitalize on opportunities created by strong growth in import demand in two neighbors-Kazakhstan and Russia-ven comparedto some CIS competitors that have reformed more slowly. Although there was a surge in non-gold exports and in FDI in 2003, this i s from a very low base and muchneeds to be done to expand and sustain these gains. 0 The report proposes a strategy for economic-cum-export diversification that requires simultaneous actions to address external and domestic trade policy issues. Formal and informal transit and transport costs are a major constraint to expansion of trade within and beyond the Kyrgyz Republic. Poor infrastructure, limited competitive pressures and low- level corruption, however, combine to raise trading costs to often prohibitively high levels. Safeguard measures remain a potential problem, and technical barriers to trade are pervasive inthe CIS countries and elsewhere, although their impact on Kyrgyz exports has apparently been modest to date. The Kyrgyz Republic i s signatory to several regional preferential trade agreements and regional cooperation arrangements, some specific provisions of which have not been agreed with key neighbors or are not respected in practice. The regulatory environment, standards regime, customs administration and backbone services such as trade finance and telecommunications all pose severe challenges for efficiency and Vlll ... competitiveness. The benefits of reform will depend to some extent on neighbor policies and practices. The most promising route forward on many of these issues lies through the WTO. For instance, the adoption o f WTO-consistent disciplines in areas such as transit, antidumping, services, customs and standards would significantly reduce transactioncosts for all firms operating in the Eurasian Economic Community (EURASEC), covering Belarus, Kazakhstan, the Kyrgyz Republic, the Russian Federation, and Tajikistan. 0 Over the past few years, the government has adopted a range of measures aimed at reducing administrative barriers and strengthening the commercial legal system through a highly participatory reform process. However, implementation and enforcement have been sorely weak. The number one priority for Govemment must be to improve its implementation track record. Increased predictability in the investment climate, and reduced instability and uncertainty in the rules o f the game, would address the biggest concems expressed by investors. This means greater emphasis on improved governance, which will entail, among other things, resolute implementation o f ongoing public sector reform and capacity-building efforts. Equally important i s faster progress with ongoing reforms in the regulatory regime, taxation, and the legal system. 0 In the end, however, it is firms not countries, that are on the front line of international competition and business development. Favorablenational circumstances, such as supportive macroeconomic conditions, friendly investment climates and market-expanding trade agreements, contribute to competitiveness, but they do not guarantee success. Individual firms must, therefore, develop strategies and organizational structures and improve their technical capabilities to compete at home and abroad. Growth accounting analysis and the industry case studies provide evidence that Kyrgyz companies are already having some success on this front in food processing, and in few other manufacturing production lines. Both sources also show that in order to expand exports and compete more effectively at home, a wider spectrum of producers will have to do more to remove vestiges o f the old Soviet system and many new firms will have to enter. The efficiency o f investment will, however, depend on the learning rate of firms; this, inturn, will be largely determined by the strength and efficiency o f technology transfer through foreign private enterprise, capital and know-how. The learning process can be assisted in a variety of ways, including public- private training partnerships, and donor/NGO training and technical advisory services that are already available ina limitedway and need to be considerably expanded. MAIN FINDINGS RECOMMENDATIONS AND The Government's stabilization-cum-structural reform program, launched in 1993 shortly after independence, has been broadly successful in securing macroeconomic stability while gradually transforming the economy to a market-based system. Despitethe disruptions o f a regional financial crisis in 1998-99, the last five years have seen major improvements in fiscal and extemal imbalances, reasonable real GDP growth, declining inflation rates, some moderation o f excessively highinterest rates and a fairly stable currency. There has also been a significant decline inthe poverty headcount, although over 40 percent o f the population i s still below the poverty line. While the fiscal reforms are far from complete, improvements to date are expected to underpin an extemal debt stock reduction by Paris Club Creditors in early 2005, which will increase flexibility and predictability in public expenditure management and help further strengthen the country's fiscal outlook. The supply-side response of the Kyrgyz economy to an otherwise stable macroeconomic environment and liberal regime o f foreign trade and investment has, however, been slow. Relatively strong recovery in agriculture, backed by land privatization early in transition and by import substitution in food consumption, supported the recovery from the severe contraction of the early 1990s. In 1997, ix gold miningemerged as a key export activity, further facilitating the economic recovery through its inter- sectoral linkages. By 2001, goldproduction comprised the country's third-largest economic activity, after agriculture and livestock, and retail/wholesale trade. The economy has largely concentrated on primary goods production and, with the exception of gold, i s still in the early stages o f defining its comparative and competitive advantages inthe production of goods and services. Overall, investments inthe economy are low and are concentrated in industry (miningand power) and services (transport and communication). Donors funding and own-capital from local enterprises (includingjoint ventures with a large state share) constitute the main sources o f investment financing. Except gold mining, FDIcontributes relatively little to real sector investment. Despite significant emphasis on public investments in infrastructure in the past decade, Kyrgyz producers must grapple with difficult mountainous terrain, limiting access to internal markets and contributing to high domestic transport/trade margins across various sectors. Similarly, in spite o f seemingly abundant endowments o f hydro-power and water, the prevailing problems with accessibility and reliability of energy supply reflect the lack o f a coherent energy policy and poor management. The high costs andor poor accessibility/quality of key services such as transport and energy make for an unattractive climate for both foreign and local investors. Export growth performance has been weak. Much o f the growth in the Kyrgyz Republic's export performance has been driven by the rise of gold since 1997, which now accounts for close to 40 percent of total exports. Data on regional trade patterns suggest that Kyrgyz exporters have failed to fully capitalize on a large increase inimport demand inboth Kazakhstan and Russia, major trading partners, over the last five years. While the value of total Russian imports doubled between 1999 and 2003, the value of Kyrgyz exports to Russia fell 7 percent. The value o f Kyrgyz exports to Kazakhstan in 2003 stood 24 percent above its 1999 level, but Kazakhstanimports increased 156percent over this time. Most of the decline innon-gold exports i s attributable to the overall slow recovery in non-gold GDP associated with underdevelopment o f commercial agriculture, manufacturing and services sectors. Sluggishexport growth i s also attributable to competitiveness gap vis-a-vis other CIS countries. Measured by relative unit labor costs, the competitive gap between the Kyrgyz Republic and CIS comparator/competitor countries i s significant. Concerning the two underlying factors influencing competitiveness, i.e. the real exchange rate and the wage-productivity ratio, the former has improved over the mid-l990s, signifying an increase in competitiveness, while the latter has deteriorated. The Kyrgyz Republic has lower wages than many o f its CIS comparators/competitors, except Tajikistan, providing a competitive advantage. But it has sizable productivity gaps with many countries in the region. A major reason for this i s that the total factor productivity started increasing in CIS-7l countries in 1998, but the average growth rate of the labor productivity inthe following four years was slow, at around 1.4 percent, inthe Kyrgyz Republiccompared with a CIS-7 average of4 percent The productivity gaps that resulted from these differential rates o f productivity growth are larger than the wage differentials observed between the Kyrgyz Republic and these other countries, suggesting that the Kyrgyz Republic's low wage advantage i s being eroded by a larger productivity disadvantage. The consequence is higher unit labor cost andtrouble competingat home and abroad. These difficulties are compoundedby the limitedfinancial intermediation capacity o f the banking sector, with high real interest rates, expensive collateral-based credit, and a very limited long-term financing, even when compared to CIS countries that have reformed more slowly and shown weaker macroeconomic performance. Among the factors explaining these weaknesses are a segmented and underdeveloped banking system, a small deposit base, and delays in the development o f a sound regulatory framework for financial intermediation. In addition, incentives for firms to remain in the informal economy and operate outside the banking system keep monetary depth low, while both 'CIS-7 countries comprise Armenia, Azerbaijan, Georgia, Kyrgyz Republic, Moldova, Tajikistan, Uzbekistan. x increasing costs and the risk o f bank lending. Finally, the low disbursement rates o f existing numerous donor-financed credit lines suggest that private credit might have been constrained by the lack of bankable projects. Overall, growth has not yet led to commensurate increases in the number of jobs. Trade and agriculture account for a disproportionately high share o f total employment. Wages in agriculture and trade, on the other hand, remain very low, reflecting the presence of a large pool o f jobless and discouraged workers. A good deal of activity takes place inthe informal sector in services, street trading and subsistence farming. Addressing the problem of low formal job creation and promotingjob creation outside agriculture are critical not only to furthering poverty reduction but also insuccessfully alleviating highurbanpoverty inthe Kyrgyz Republic. This picture highlights the importance of not only the level, but also the pattern o f growth for poverty reduction. It also suggests that the growth agenda needs to address more carefully the constraints to greater supply-side response to ongoing reforms, one that can facilitate a broad based growth of economic activity and exports. Risks to sustainability o f current growth rates and continued poverty reduction will otherwise remain high as will the economy's vulnerability to extemal shocks. This report i s aimed at assisting the authorities in this endeavor by focusing on three key challenges: a. Identifying strategic options to strengthen prospects for medium-and long-term growth and poverty reduction (Chapter 1); b. Assessing ways of leveraging domestic trade policy reforms and existing regional and multilateral trade agreements for further regional and global integration (Chapter 2); and c. Identifying key areas where greater efforts are necessary to facilitate improvements in enterprise capability and productivity (Chapter 3). Options for StrengtheningMedium- andLong-TermGrowthProspects In order to understand how different growth patterns will influence employment and poverty, a social accounting matrix (SAM)-based model o f the Kyrgyz economy was developed based on input- output data for 2001. The analysis focused on: (i) the potential o f the non-gold economy and exports, as future drivers o f growth; (ii) strength of the spillovers from goldproduction to the rest of the economy the and, hence, the likely implications o f the expected halving in the gold-production over the next five to seven years; and (iii) keyunderlyingreformelements o fthe medium-and longterm growth agenda. The model indicates that a notable feature o f production patterns in the Kyrgyz Republic i s the dispersion o f non-gold economic activity and exports, which entails broad, even if not uniformly strong, backward and forward linkages from agriculture and livestock to manufacturing. With the exception o f a few traditional agricultural commodities and power, this basket does not reveal a particular comparative advantage. However, it does suggest natural comparative advantages through its linkages to the country's natural and other economic resources as well as human capital. Most o f the activities in the basket currently have small shares inproduction and non-gold exports, but their growth potential i s high on two counts: first, value added in production i s high, particularly so in agriculture and livestock, but also in light manufacturing; second, the potential for spillover from growth in any o f the activities in these sectors i s high. This suggests a large potential payoff to policies that facilitate both raw material and higher value addedproduction from the same supply chains, especially inago-processing and other light manufacturing (e.g., cotton, wool, textiles, etc.). Finally, the data show that the share of non-gold exports, excluding the top three traditional exports, i.e., cotton, tobacco and power, i s much higher in GDP than their contribution to total exports, pointing to the potentially high growth payoff to be derived from a broadening o f the export supply base. x i The analysis also shows that primary agricultural and livestock activities/exports in principle generate relatively more but low-wage jobs, compared to processed agricultural gooddexports, other manufacturers, and services, which generate relatively fewer, but high-wage jobs, absorbing relatively better educated workers. This confirms that not only is higher growth essential for higher incomes, but economic diversification toward higher value added production inmanufacturing and services i s the only way to create relatively higher wage jobs and, hence, to achieve faster poverty reduction in the Kyrgyz Republic. Finally, the analysis suggests that gold production entails surprisingly high inter-sectoral linkage multipliers and induced income multipliers. As a consequence, the growth accounting simulations undertaken to estimate' the growth-dampening impact of the expected halving o f gold production point to likely dismal growth outcomes towards the end of the current decade. They also point to the likely erosion in household incomes, resulting both from reduction in incomes generated in the mining-sector, which are significantly higher than the average income in the rest of the economy, as well as fromj o b and profit losses in other sectors. This, in tum, could depress the demand for commodities and services produced domestically, exacerbating the effect o f the original shock. The objective o f the S A M analysis i s to illustrate possible future growth outcomes assuming the prevailing economic structure remains unchanged on average, rather then pre-judging future growth outcomes or identifying "winners." The analysis points to the importance o f greater efforts to facilitate development of: 0 Critical agricultural services and high value commercial agricultural commodities by diversifying away from traditional crops, e.g., grain and potato3(Chapters 1and 3); 0 Efficient supply o f critical public inputs such as energy and transport4(Chapters 1-3); 0 Development o fbackbone services, including through regulatory reforms (Chapter 2); 0 Facilitating economic re-structuringand re-entry5 (Chapter 3); 0 Policy and institutional reforms to deal effectively with a range o f domestic and extemal trade policy barriers (Chapter 2), and factors that hinder development o f enterprise capability and productivity (Chapter 3); and 0 Human capital through better and higher educationand skills training (Chapter 3). Leveraging Domestic Trade Policy Reforms and ExistingTrade Agreements for Further Regional and Global Integration. For a landlocked small country such as the Kyrgyz Republic, export-led growth i s the only option for the long term. What are the barriers to exports and imports? H o w can they be overcome? The analysis o fthe report provides support to three broad conclusions: 'A similar analysis to replicatethe impact of the temporary decline in the gold productionin 2002 demonstratesthat SAM-based modelperformsreasonablywell in accountingfor actual growth pattemsin2002. 3 See "Kyrgyz RepublicAgriculture and Agribusiness: Growth Opportunitiesand Obstacles." World Bank, June 2002. See also Volume I1ofthis Report. See forthcoming World Bank Study on "Central Asia: Regional Electricity Export Potential," and "Kyrgyz Republic Public ExpenditureReview: FiscalPolicy for Growth andPovertyReduction," The World Bank, March2004. This is an areathat requires further study againstthe backgroundofthis report's findings. See also Volume I1of this Report. xii 0 First, external barriers to the Kyrgyz Republic's integration into regional and global markets are formidable, but at present they are neither related to tariffs nor to safeguard arrangements and technical barriers. The most biting among external barriers are transit and transport costs, both formal and informal. Safeguard measures remain a potential problem, and technical barriers to trade are pervasive in CIS countries and elsewhere, but so far their impact on Kyrgyz exports has remained negligible. In fact, Kyrgyz exporters face low, if any, duties, in part because o f preferential CIS-related arrangements, and in part due to the low level o f processing embodied in exports in cases when they are destined to non- preferential markets. These issues should be addressed nonetheless. Besides neighbor's policies, however, domestic policies-largely those that go beyond trade issues-have also contributed to the Kyrgyz Republic's weak external performance (e.g., distortions induced by the tariff schedule for some sectors, customs administration, cumbersome standards regime, weak regulatory capacity in services administration). There i s an urgent need to deal with both. 0 Second, a liberal foreign trade and investmentregime and WTO membership brought benefits in several important ways, even though the Kyrgyz Republic has not realized all of the benefits o f accession. This calls for exploring ways to use the WTO as a vehicle for further structural reforms. 0 Third, the Kyrgyz Republic has not realized much o f the benefits from participation in regional integration arrangements, notably the EURASEC. Since good relations with a number o f EURASEC members and an enabling regional trade environment are critical to the Kyrgyz Republic's economic welfare, there i s a needto explore ways o f tapping the potential benefits. This report recommends development and implementation o f a two-pronged strategy for dealing with the domestic and external dimensions o f the Kyrgyz Republic's trade challenges set against the background o f the WTO rule-based system. The answers to three questions below provide major ingredients o fthe strategy. What can be done to maximizefuture beneJits of the Kyrgyz Republic's WTOmembership? First, the government could further leverage its obligations under WTO rules to accelerate reforms in domestic trade related policy constraints. Although it appears that WTO obligations have helped lock in the program o f trade liberalization initiated in 1994, they failed to motivate accelerated reforms in the standards regime, customs administration, and services administration, particularly in telecommunications. Combined, these delays weakened the supply response to the liberal trade and investment regime in the Kyrgyz Republic. In addition, although, the structure o f Kyrgyz applied MFN tariff rates does not create significant distortions in domestic production and consumption pattems,` the Kyrgyz tariff schedule, nonetheless, introduces unnecessary differentiation in protection in few sectors, which also requires attention o f policy-makers. The report provides a set of technical recommendations to assist the ongoing reform efforts. 0 Inefficiencies in customs administration impose significant costs on exporters and importers alike, thereby, further distorting competition in domestic markets and erecting barriers to export-oriented business activities. It takes at least between three and five days to release inbound consignment, largely because o f excessive bureaucratic requirements. This is a Kyrgyz Republic's maximum tariff rate of 15 percent is low by any standard. So is the dispersion o f tariff rates. Both the levels and the structure of MFN tariff rates in the Kyrgyz Republic are quite close to the best intemational practice o f a uniform tariff rate. xiii faster release time than inmost CIS economies, but it still constitutes a major impediment to Kyrgyz traders since goods are charged for each day under customs, which further exacerbates already high transaction costs. While the well-established (and well-connected) firms seem to be less affected with this problem, it greatly complicates entry into international markets o f small and/or new firms. Other problems imposing significant costs on traders include the absence of licensed customs brokers, mandatory inspection o f all shipments, and lack o f electronic data interchange between traders and the customs administration and between the customs administration and other government agencies as well as customs bureaus o f neighboring countries. Combined these factors result in traders both spending unnecessarily long times in the clearance process and making unofficial payments on top of ad valorem customs fee of 0.15 percent.' The weaknesses inthe Kyrgyz customs administration are not unique: similar complaints are raised against other customs bureaus inthe region and around the world. Yet, altogether they create significant barriers to internationaltrade activities. The recently revised customs code appears to be largely consistent with international best practices (including WTO rules and the revisedKyoto convention). Inparticular, it corrects problems inthe current customs code that has blocked emergence o f licensed customs brokers. Yet, as will be discussed below, without simultaneously addressing bottlenecks in neighboring countries through intensive cross-border cooperation, the `expectedpayoffs from this effort might fail to materialize. The government and the customs administration should intensively promote regional cooperation to advance the pace o f customs reform. Finally, both reform and modernization o f customs administration and an enhanced administrative cooperation with neighboring countries are crucial for paving the way for full implementation o f the WTO Agreement on Customs Valuation,8 without opening the door to fraud and reducedcollections o ftariffs, excises and VAT. 0 The standards regime followed in Kyrgyz industries inherited from former Soviet central planners, which is characterized by mandatory inspections and certifications, unique national standards, overlapping agency responsibilities for regulations, and heavy government involvement in all dimensions of the standards system: standardization, accreditation and conformity assessment. The system i s unnecessarily complex and confusing. Its compulsory quality significantly increases firms' production costs through significant payments for tests and other procedures. Clearly, streamlining quality testing procedures and removing other unnecessary administrative barriers would dramatically increase competitiveness o f Kyrgyz firms.' The standards regime also places a heavy burden on the state budget as standards development, conformity assessment and enforcement is costly. The government's recently intensified efforts to streamline the certification and inspection requirements and to improve standards and technical regulations are important steps forward in addressing these problems. The key recent measures on the institutional front include vesting conformity assessment responsibilities o f the Kyrgyzstandart in a new organization 'Incidentally, the ad valorem fee violatesthe WTO ruleof chargingfor actuallyrendered service. The agreement requires that customs inspectors in WTO member countries rely on the transaction value-the price paid or payable in the market-when calculatingad valorem duties insteadof using referenceor minimumprices that are set artificially bythe govemment. This meansrelyingprimarily on what traders write down on their invoices. For instance, the dairy industry value chain analysis demonstrates that the removal of informal payments promoted by the existing standards and the certificationregimes could increase net profits of small enterprises in the Kyrgyz dairy industry by 140percentandthose of largeenterprises by 40 percent. xiv that i s separate from accreditation and standardization; and on the legislative front include a new Law on the Fundamentals of Technical Regulations, which explicitly prohibits the national standards body from issuing regulations. The critical next steps during the implementation o fthese new measuresmust include the following: 9 Standardization: Shift the burdenof standards development out ofgovernment agencies (and other entities under substantial state control or direction) and into the hands of private sector bodies, especially those operating at the regional or international levels. 9 Accreditation: Promote bothaccreditation ofKyrgyzconformity assessmentprovidersto international standards and the acceptance o f international accreditation o f conformity assessment procedures, accelerate accession o f Kyrgyz accreditation bodies to the International Laboratory Accreditation Cooperation and other multilateral arrangements, and accept as valid laboratory results o f any foreign conformity assessment providers that are accredited to international standards. The Kyrgyz national accreditationbody should also participate inthe regional "Central Asian Cooperationon MAS-Q." 9 Conformity Assessment: Shift the burdenofconductingtesting out ofthe government to the private sector and ensure free trade inconformity assessment services. Accept, to the maximum extent, feasible manufacturers' self-declaration o f conformity assessment. Expand the validity o f certificates so that fewer tests are required. P Recognition: Accept as equivalent foreign governments' technical regulations that are based on international standards, even when those governments have not entered into formal mutual recognition treaties with the Kyrgyz Republic. It should be noted that the above recommendations would not jeopardize access of Kyrgyz products to CIS markets, simply because CIS members recognize each other's certificates of conformity. Simultaneously, once conformity assessment providers obtain international accreditation, Kyrgyz exports will have easier access to world markets. Furthermore, Kyrgyz recognition o f laboratory results o f foreign conformity assessment providers that are accredited to international standards would not have any regional implications. This should, however, not suggest that the government withdraw from playing an active role in the CIS- wide Council on Standards, Metrology and Certification to dismantle what remains o f the GOST andcooperate closely with EURASEC countries. 0 The regulatory environment fostering competition inservices sectors is important for trade in services as well as for trade in goods. The present Kyrgyz regulatory environment underpinning such backbone services as telecommunications, transport, financial services (banlung, insurance, securities trading), distribution and business services (legal, accounting, consulting) fails to enhance competition, both domestic and competition from international providers. Tackling this problem through further liberalization calls for reforms in a wide range o f domestic policies concerning, for instance, rules for network access in telecommunication, licensing regimes, investment rules, rules on temporary movement o f workers and competition policies. The Kyrgyz Republic's schedule o f GATS commitments binds its telecommunications market to be open, and the Law on Electric and Postal Communications appears to be pro-competitive and up-to-date. Yet, leaving aside deficient infrastructure due to the delay in the privatization o f Kyrgyz Telecom-which postpones the injection of foreign capital and management know-how-the Kyrgyz Republic has yet to meet fully the non-binding GATS provisions on regulatory principles as outlined in the GATS XV Telecommunication "Reference Paper." For instance, while competitive safeguards against cross-subsidization and abuse of information by companies appear to be in place in the telecom sector, rules on network interconnection, the cost-based charges and the institutional separation o f regulators and regulees raise significant concerns. In addressing these problems, one option could be moving to a class licensing (also known as general authorizations) system for telecommunications and setting licensing fees to cover the actual costs o f processing license applications, monitoring the market, regulating prices and adjudicating disputes on a trial basis inorder to observe behavior under such a regime. Another important area requiring further attention is transport services. Several weaknesses stem from the absence o f enforcement or disciplines on contracting parties resulting in de facto exits from obligations under free trade arrangements. First, while the Kyrgyz Republic's CIS partners have committed themselves to levy transit fees reflecting the cost of services rendered and while they adhere to the principle of national treatment o f transport companies, contracting governments tend to apply these rules only to railroads-not to road transport. This does not help most Kyrgyz exporters, as volumes o f Kyrgyz exports are too low to take advantage of discounts that would make the railway transport mode competitive. Larger use o f railroad transport may be achieved by promoting alliances o f local forwarders, who offer intimate knowledge o f their local market, with global forwarders, who hold regional and worldwide contacts. By consolidating shipments from various sources and coordinating handling and storage, which are major cost factors, freight forwarders would help to bring down unit costs thanks to the use of cheaper and less illicit payments-prone railroad transport. Hence, the Kyrgyz Republic needs to create an environment hospitable for freight forwarders, domestic and foreign alike. It has already bound itself open with respect to these services under the GATS. Greater presence o f foreign-owned service providers might have another beneficial consequence, i.e., it might create pressures from business groups on other EURASEC governments to follow transit rules generally accepted by the international community. But this alone probably would not suffice to effect change- cooperation among governments is urgently needed. A second requirement for increasing the future benefits o f the Kyrgyz Republic's WTO membership is to expand efforts and capacity to conduct commercial diplomacy. In Geneva, this will require the government to play a more proactive role in accession-working parties, as the government should use its WTO membership to insist on liberalization by its neighbors in the process o f admission. Kyrgyz negotiators should focus particularly on issues where existing regional agreements provide few avenues for addressing trade problems or where the influence of other WTO members can be brought to bear. The following actions are worth considering: 0 lobby for addressing transit issues-Kyrgyz exports are constrained by hightransit costs, but so are other countries' exports that need to passthrough the region; 0 pushfor greater national government discipline onrules set by sub-central governments; 0 push for the elimination o f indirect taxes and other fiscal policies that discriminate against imports; 0 pushfor lower access fees to useKazakhstan's fiber optic cable; 0 lobby for greater disciplines on the use o f antidumping and other "trade remedies;" and 0 ensure that customs and other fees are based solely on actual cost of services rendered. In contrast, the Kyrgyz Republic has little to gain from multilateral tariff liberalization for two reasons: first, it already has an almost duty-free access to relevant markets of WTO members; second, since Kyrgyz tariffs are almost fully WTO-bound and relatively low, proposed tariff-cutting formulas to xvi be used during the Doha Round trade negotiations on non-agricultural goods have no influence on its MFNtariff schedule. What can be done to maximizefuture benefits of the Kyrgyz Republic's EURASEC membership? The Kyrgyz Republic i s a party to a plethora o f various agreements under the CIS framework, both bilateral and regional, covering on the surface all issues pertinent to seemingly close cooperation. On the bilateral front, the free trade agreements (FTAs) signed by the Kyrgyz Republic would, intheir entirety, appear to be a full-fledged free-trade area. Their features are compatible with the WTO rules. There are, however, three important caveats: First, discretion enjoyed by customs and local authorities remains an important impediment to unfettered movement o f products, as various border and non-border charges on intra-CIS trade are not contractually bound. Second, administrative denials of access and antidumping actions constitute another impediment to bilateral trade. Last but not least, Belarus and Uzbekistan have yet to introduce a market-based foreign trade regime, and-in spite of FTAs-they impose various charges effectively suppressing imports. Kyrgyz exports have suffered in particular because of Uzbekistan's protectionist measures violating FTA. In consequence, important benefits o f a free trade area encompassing CIS economies are inadvertently lost. The best regional trade strategy for the Kyrgyz Republic would be to focus on EURASEC. This i s because EURASEC goes beyond FTAs, as it sets the goal of achieving deeper economic integration among its members. I t also offers an institutional venue where issues o f mutual interest can be more effectively addressed than in bilateral negotiations. The Kyrgyz Republic's weak bargaining power, because o f its small size and geographic location, i s much less a problem in EURASEC organizational context than in bilateral negotiations. Furthermore, many initiatives serving economic interests o f all EURASEC members stand a better chance of being implemented on a regional, rather than bilateral, basis. The WTO rules can be used to provide guidelines for reforming the EURASEC framework for regional trade, which could significantly reduce transaction costs for all firms operating in EURASEC. All members of the EURASEC face pressures to reform customs administration and reform domestic standards regimes, for instance. This calls for lobbying for a well-defined regional agenda. Considering the major regional barriers to the Kyrgyz Republic's external economic interactions, its major items should include: 0 Border and customs procedures: The improvements inKyrgyz customs procedures, although highly desirable, will have limited impact, albeit a clearly positive one, without similar improvements in neighboring countries. Hence, there is the need for close cooperation, includingjoint border controls, an exchange o f information between customs authorities, and regulatory cooperation regarding transport equipment. These arrangements exist among NAFTA members. They also exist between Central Europeancountries on the EUaccession path. Early stages of EU integration provide illustration of good practices in that respect. SouthEast European countries, which are part of the Stability Pact for the Balkans, have been also moving inthat direction, albeit slowly. 0 Conditions o f transit: Although transit has been a subject o f bilateral and regional discussions, the principle o f national treatment should be extended to all service providers and enshrined into EURASEC agreements. These arrangements should also allow for commercial presenceo f service providers. 0 Technical standards: The Kyrgyz Republic should move quickly on its own to establish a market-based system o f technical standards and replace GOST with international standards. This will yield higher returns if EURASEC members move in the same direction and cooperate closely. The Kyrgyz Republic, as a small economy, can substantially lower costs xvii to domestic producers if for instance, conformity assessment, i s provided on a regional rather than national level. It would thus make sense to establish regional accreditation bodies and ensure their membership in the International Laboratory Accreditation Cooperation. Similarly, private-sector conformity assessment providers could benefit from economies of scale ifallowed to operate inmore than one country. 0 m:The Kyrgyz Republic should seek to, first and foremost, ban the use of antidumping measures in intra-EURASEC; second to replace antidumping provisions in EURASEC with safeguard provisions of the GATT Article XIX; and, last, ifnot successful in the above, convince its EURASEC partners to adopt stringent rules of their use. 0 Services: Issues pertaining to service sectors should be addressed in their entirety and brought under the EURASEC umbrella. As a first step, measures restricting market access should be listed and bound, i.e., subject to a standstill. This i s a long-term project, as it involves the regulatory overhaul o f sectors, with often-powerful vested interests. 0 Air transport: This is an area where `going it alone' is not very productive for a small country. The Kyrgyz Republic can gain much from regional regulatory cooperation in air transport. It should lobby for `open skies' among Central Asian countries, fashioned after the EU`European CivilAviationArea' Model. What organizational changes are needed to pursue the two-pronged strategy? Successful implementation o f the two-pronged strategy requires enhancing the government's institutional capacity to affect both regional and domestic policy outcomes. Weaknesses in the institutional and administrative capacity further exacerbate the paucity of internet connections and lack o f knowledge o f languages used in international business and organizations. These are significant shortcomings, as the various trade agreements will need to be pursued as a means o f helping Kyrgyz businesses integrate into the world economy. The organizational arrangements should take into account the need for: 0 Enhancement o f the govemment's capacity concerning its ability to assess tradeoffs and links betweenmultilateral and regional environment simultaneously, taking into account the impact o f external policies, which the govemment can influence, on domestic businesses; 0 Institutional setting that would deal with a full WTO and EURASEC agenda within one coordinating unit; 0 Enhanced capacity of the govemment to carry out analysis, policy formulation and strategy, negotiations, implementation and monitoring and evaluation. The change should not be confined to altering relationships within and across various ministries. The issue of the government/private sector interface also needs to be addressed. Institutionalization o f a two-way communication between the government and the private sector in trade specific matters would provide trade negotiators with knowledge about the problems exporters face in external markets and would offer a channel to keep domestic businesses informed about international opportunities. This government-business interaction needs to be transparent. It needs to counterbalance inevitable efforts by import-competing industries to capture the state through outreach to import-using and export interests. FacilitatingImprovementsin EnterpriseCapabilityand Productivity A key element o f the growth strategy should be to put in place the necessary conditions for improved enterprise competitiveness and sustained growth, based on the Kyrgyz Republic's comparative advantages and the small country strategy for export success of flexible specialization in niche markets. xviii The SAM-based growth accounting analysis, industrycase studies, survey findings and observations from interviews with private sector representatives collectively point to two critical ingredients for the growth strategy: (i) a supportive climate for investors and business managers; and (ii) ability o f entrepreneurs the to "learn" and be fast, flexible, and responsive to changing market conditions. Other key factors for competitive success, which are amenable to pro-active support form government and donors, include interventions ranging from promoting working capital instruments, and improving trade support services, to upgrading infrastructure and supporting highvalue production inagnculture. Improving the Investment Climate. The Kyrgyz Republic has experienced a progressive economic recovery-albeit with interruptions due to external shocksto the economy-since the latter half o f the 1990s. Evidence from other transition and developing countries shows, however, that sustaining growth is more difficult than igniting it, and requires more extensive investment climate reforms to develop institutions that maintain productive dynamism and generate resilience to external shocks. This report assesses investment climate conditions in the Kyrgyz Republic, focusing on the so-called "second generation" policy and institutional reforms. The two central questions are: What has been accomplished? What still needsto be done? The institutional reform process inthe Kyrgyz Republic is based on "best-practice" mechanisms for identifying critical reform areas, giving entrepreneurs, donors and others a voice in the design and management o f reform activities. This process has facilitated an extensive legislative reform aimed at improving administrative and the commercial legal system over the recent past. Nevertheless, implementation of the reforms i s significantly lagging behind. Hence, the number one priority o f the government must be to improve the implementation track record, which, by increasing the predictability o f the investment climate and by reducing instability in the rules o f the game, will address the biggest concern of the investors. This calls for greater emphasis on better governance. An overall governance reform strategy has already been laid out, and reform efforts are ongoing. These efforts need to be intensified, notably in the areas o f public finance and administrative reforms. The focus on governance i s dictated by the fact that the difficult implementation challenge facing the government i s not simply a question of a hangover o f over-regulation from the command economy days. It is a perverse system o f governance resulting broadly from weak public finances, making it difficult to break from the present system o f legally mandated fees (for licenses, permits, inspections, and so on) and the abuse o f official authority. Any institutional reform effort that does not effectively address these public finance and civil service reform issues has little chance o f tangible success. Institutionalization o f sanctions against the abuse o f public official position should be an integral element o f these reforms. Other areas o f governance for increased attention include thejudiciary and local government. Second, a greater emphasis on capacity-building i s needed to increase the efficiency and effectiveness o f regulation and delivery o f public services. This should be facilitated through establishing, and making available for public viewing, formal ground rules on functions and responsibilities of public officials and the rights o f entrepreneurs. Timely publication and dissemination o f regulatory information to the private sector i s also critical. Equally important i s the establishment of feedback mechanisms on progress and problems with implementation o f policies and regulations. Better implementation will also require attention to the frequency o f changes in legislation and rules o f the game, both o f which are important for business planning. Many strong economies maintain policies for fixed periods o f at least five years and signal the private sector about upcoming changes in policy and legislation. It i s also essential to introduce reforms in a particular area concurrently rather then only partially; so that businesses can fully adjust to the changes at the time changes are made. Institutionalization o f the new regulatory impact assessment process should help in streamlining the regulatory reform process. Its effective operation calls for assignment o f monitoring and enforcement xix tasks to a qualified body responsible both for oversight o f regulations/administrative procedures and capacity development for impact assessment invarious government institutions. In addition, industrycase studies as well as recent surveys of the business community indicate that, despite progress in improving the investment climate, three specific areas remain as an important causes of unpredictability in the investment climate, i.e., the regulatory regime, taxation, and the legal system, calling for accelerated reforms: a The regulatory regime continues to be viewed by investors as overwhelmingly negative, as noted above. The lack o f clarity and consistency o f regulations, excessive discretion by public officials in interpretation, and limited recourse against arbitrary enforcement decisions are areas o f investor complaint. Regulations for business registration, licensing, standards, and inspections have been the subject of reform over the years but problems continue both because reforms are incomplete and because of poor implementation. Important priorities in the case of registration are rationalization of time spent in business registration, particularly outside major metropolitan areas; elimination o f duplication among registration agencies by increasing information sharing; and establishment o f a publicly accessible register for all licenses, permits, and technical regulations, detailing the rules, procedures, timing and costs. An improved licensing system requires completion o f amendments to all sector-specific statutes to cancel licenses that are inconsistent with the Law on Licensing. Extension o f the validity o f licenses from two to at least five years i s also necessary. The new Law's technical regulations are a major step toward establishing a market-oriented standards regime. Its effective implementation requires complementary actions in accreditation, conformity assessment, and mutual recognition discussed in detail in this report. Concerning permits, elimination o f all illegal permits and creation o f a price list for each legal permit approvedby the government, registered at the Ministry o f Justice and available for public viewing, i s essential. Finally, concerning the inspections system, broadeningthe current reform efforts to establish and make available for public viewing formal ground rules and procedures for conducting all official inspections, specifying clearly what constitutes compliance and non- compliance and the rights of entrepreneurs could help bringmuch-needed clarity inthe rules. a Taxation i s a cause o f unpredictability, according to investors, because the system i s often changed, tax laws are too open to interpretation, promoting a negotiation mode between the taxpayer and the tax inspectorate, and tax administration is poor. The ongoing efforts to streamline and unify the tax laws in the Tax Code should help address part o f this problem. This should be complemented with proactive measures to reduce incentives for abuse of official authority through investing in information technology as well as organizational changes for reducing interaction with the taxpayers, higher salaries, and further capacity building in the Tax Inspectorate. A specialized small business tax regime needs to be coordinated and harmonized with other relevant elements o f the tax regime and clarified to eliminate the incentives for remaining small or splitting into smaller firms. Weaknesses in the VAT administration need to be addressedby strengthening the procedures for recognizing and reimbursingVAT credits. The system itself also needs to be improved by exempting imports that are clearly for investment purposes, such as certain types o f industrial machinery, and identifying means for zero-rating the VAT on exported services. The tax burdenand compliance costs also need to be rationalizedthrough both eliminating cascading taxes and streamlining local taxes, inways that will bringrequisite revenues within a simpler system with increased compliance, and through strictly limiting the number o f tax inspections. a Lack of fairness and consistency inenforcing legal rights is another cause o f unpredictability. There i s much discontent with the alternatives available to entrepreneurs in seekmg recourse xx against public abuse and private contract enforcement. At the center of this problem are the courts, which are widely considered slow and unfair. Entrepreneurs have the right to appeal regulatory decisions to an altemative administrative justice system, but weaknesses in this system have reduced the willingness o f firms to bring appeals and to challenge official regulatory actions. Alternative methods for resolving disputes, such as private arbitration, are just being introduced. Reforming the court system, which should be a priority, will take time to implement and mature. In the meantime, increasing effectiveness of the administrative justice system and developingprivate arbitration shouldbe priorities. Poorly defined property rights, problems with secured transactions that hamper banks in using property as collateral, and problems of poor corporate governance also continue to undermineinvestor confidence. Property rights are improving for investors, but the property register i s not yet functioning effectively, and the inability o f foreigners to own land i s a disincentive for foreign investment in sectors where there are high levels of sunk costs. Lease and concession laws can potentially play an important role in mitigating such problems, but there i s no institutional capacity to support the use o f these instruments. Establishinga twinning arrangement with an organization, such as UK Partnerships, could be beneficial. A sophisticated registry is envisaged to support securedtransactions inthe Kyrgyz Republic, but it continues to be paper based and i s not yet fully operational. Gettingthis registry up to speed should be high on the near term reform agenda. Furthermore, secured transactions laws need to be amended. The pledge and mortgage laws have some conflicts with the Civil Code and are not sufficiently clear in their definitions o f assets and creditor rights. Also, these laws have no effective provisions for non-judicial foreclosure o f assets. The new draft Collateral Law will address both o f these issues when enacted; but it should ensure that provisions for non-judicial foreclosure are strengthened not weakened. Company, securities, and bankruptcy laws, which define corporate governance standards, are also weak. This i s a serious limitation on the ability o f joint stock companies to attract minority shareholders, access debt from the banking sector, and raise finance through securities markets. Improving enterpriseproductivity and competitiveness. Inthe end, however, favorable national circumstances, such as supportive macroeconomic conditions, stimulating investment climates and market-expanding trade agreements, contribute to competitive success, but they do not guarantee success. It is firms, not countries, that are on the front line o f international competition andbusiness development. Individual firms must, therefore, develop strategies and organizational structures and improve their technical capabilities to compete at home and abroad. Lacking large home markets, small country exporters are compelled to adopt strategies aimed at market niches and organizational structures focused on flexible production technologies. Growth accounting analysis, and the industry case studies (for agriculture, livestock, and light manufacturing value chains), undertaken as a background analysis for this report as well as by other donors, provide evidence that Kyrgyz companies are already having some success with this approach in particular areas such as food processing. They show, however, that to expand exports and compete more effectively at home, a wider spectrum o f producers will have to do more to remove vestiges o f the old Soviet system and many new firms will have to enter. Their feedback points to the following six factors as the major causes o f the Kyrgyz Republic's productivity problems (see pages 99-101 for specific examples): 0 Limited economies of scale: The Kyrgyz Republic's domestic market i s small, and incomes are low. But the market is made even smaller by several factors: First, a large portion o f the rural population is isolated from the market because distribution channels, which were disrupted after the collapse o f the Soviet Union, have not been fully re-established. Even in urban areas, distribution channels for basic manufactured goods remain underdeveloped. xxi Second, hightransport costs (because o f high fuel costs, old vehicles, poor roads, and bribes for roadpolice) and the lack of working capital worsen the situation. Inadequate government standards (GOSTFwhich are now being improved-and inadequate administration of the standards in industries such as building construction and others also reduce the size o f the market for companies that are manufacturing products such as construction materials and durable goods. With small market size, it i s difficult for Kyrgyz manufactures to shift from "job-shop'' production of a few units o f special-order products to batch production, where there are economies of scale and productivity is much higher. Domestic firms that become exporters in many countries often begin by first producing for the domestic market and then enter world markets only after their costs are brought closer in line with international competition. Consequently, alleviating some o f the constraints on the effective size o f the home market can influence the ability to enter into export markets. 0 Low capacitv utilization: All the case studies show that many plants are plagued by excess capacity, particularly those plants established inthe Soviet era when capacity was installed to meet export quotas to other FSU countries. Many large plants operate at 40 percent of capacity or less, which reduces technical efficiency of production substantially. They also struggle with substantial debts and out-dated equipment. Other problems that exacerbate the excess capacity problem are management problems, weak channels o f distribution, working capital shortages, difficulties getting consistent raw materials supplies and infrastructure problems. Facilitating speedy progress in unfinished economic restructuring efforts and new entry into the formal economy should be at the top of the growth agenda. 0 Oualitv o f machinery: In many industries, machinery in use i s vintage Soviet equipment, designed for mass production o f standard products and cheap energy. In many cases, equipment is inefficient and i s not suitable for the flexible specialization and differentiated product strategy which Kyrgyz firms must adopt for future competitive success. Vintage equipment is also responsible for frequent breakdowns, which stop production and result both inproduction delays and inincreasingcosts due to frequent repair andmaintenance as well as expensive importation of spare parts. Keeping the cost of imported equipment as close to the world market price as possible could help enterprises deal with these problems. 0 Management capabilitv: An important reason for low productivity i s weak management, resulting from two factors: inadequate know-how and pre-independence business style/practices that continue to cut initiative and drive. As will be discussed below, expending opportunities for management and business training for existing managers and business owners shouldbe among the priorities o f the growth agenda. 0 Worker efficiency: Task-level efficiency o f workers i s poor compared to international competitors. This seems to apply even in situations where equipment in use is relatively modern and up-to-date. A major factor underlying this problem i s the lack o f mechanisms for worker training. Industry specific training institutions have closed and with them facilities to train workers. Companies do not have the resources to develop training programs for basic skill development. There i s also a "brain drain" of educated and talented workers to higher wage countries in the region. As will be discussed below, filling the gaps in this area i s key to improved competitiveness. 0 Lack of specialization: Kyrgyz firms often produce too many products. The reason for this lack of focus, particularly in the case o f exporters, seems to be serving both domestic and international markets, and, in those markets, serving too many market segments. Lack of specialization can reduce productivity, because it increases shop floor complexity and reduces throughput. Companies also find it much more difficult to trackjust how much profit xxii each individual product provides and they often end up selling products that do not make money. What steps can be taken to improve enterprise productivity and enhance competitiveness? The main competitiveness challenge for the Kyrgyz Republici s creatingthe conditions for rapid and sustained productivity improvement. Studies in many transition countries show that a key driver of productivity improvement i s enterprise "leaming." Learning takes place by way o f the transfer of technology- defined broadly to include new ideas, new capital equipment, sound management practices, marketing strategies, and the like-ffom more advanced countries. The strength and efficiency o f the mechanisms for technology transfer in a transition country determine the enterprise-learning rate. The depth o f financial markets, supportiveness of the investment climate, and other factors that influence investment rates are important for productivity growth, too, but the efficiency of investment will depend on the technical ability o f firms to acquire, adapt, and efficiently use new capital equipment andnew ideas. The industry case studies illustrate that, as with strategic planning and marketing, private technology transfer mechanisms for technical leaming are weak or missing in the Kyrgyz Republic. Good public and private technical training resources external to firms are also few in number. Donor, NGO, and business association training and technical advisory services do exist and are making an important contribution, but these programs are limited in scope and resources, concentrated in a few places and cannot substitute for all the weaknesses inprivate technology transfer mechanisms, given their present makeup. The deficiencies in learning mechanisms inthe Kyrgyz Republic need more attention if firms are to upgrade their technical capabilities and productivity to compete internationally. These efforts should include government and donor support to continue buildingup and improving institutions. They should be managed by private sector entities and focus on management training and business advisory assistance. A key aspect o f such programs should be to assist firms to link up with advanced country sources o f expertise and improve their skills." Assistance to develop technical and vocational training institutions (public and private) is also necessary. These institutions must cooperate closely with the private sector in developing and providing innovative programs for worker training. In addition, cost- sharing grant schemes are needed to assist firms in developing their own innovative, in-firm training programs, inhiringexpert consultants, and insearching for new technologies and markets. Strengthening mechanisms for technology transfer depends, critically, on the quality of the investment climate too, as a sound investment climate increases the likelihoodo f more foreign investment and of expanding other modes o f foreign technology transfer. An improved investment climate also increases incentives for local firms and investors to leam and adopt new technologies. Depthof financial markets, better trade support services and adequate investments in strategic infrastructure (particularly energy, transport and irrigation) and the maintenance o f networks are also among the critical factors that will influence investment rates andproductivity growth inthe Kyrgyz Republic. The excellent prospects for exports o f agricultural primary and processed goods suggest scope for rapid progress if government and the private sector work together. Finally, keepingthe cost of imported equipment as close to world market prices as possible, including through re-consideration o f present VAT rules, i s another relatively straightforward way to stimulate the transfer o f newtechnology into the country. loGood examples of such institutions are the Center for EnterpriseRehabilitation and Management Assistance in Georgia, and the Agency for Restructuringand Assistance in Moldova. xxiii CHAPTER 1. KYRGYZECONOMY: PRESENT STRUCTURE AND SOURCES OF GROWTH A. INTRODUCTION 1.1 The Kyrgyz Republic has made major strides inthe past decade in its transition to a market based and globally integrated economy, a complex challenge exacerbated by its small size and landlocked nature." Set in the mountains of Central Asia, the Kyrgyz Republic was one o f the lower income republics o f the former Soviet Union (FSU), although it had relatively diversified economy and well- educated labor force.I2 The emergence o f state borders within the former Soviet economic space, together with boththe break down of traditional supplychains and the termination o f substantial transfers from the Soviet Union, hit the Kyrgyz economy particularly hard. Output fell by over 50 percent, and inflation exploded duringthe first five years of transition. 1.2 The government's response to these daunting problems was to adopt a bold program o f stabilization-cum-transformationreforms, with early emphasis on price and trade liberalization as well as integration into world trading arrangements. Starting inthe mid-1990s, the macroeconomic situation was turned around, though external debt has also grownrapidly and has not always been used efficiently. In 1998,just as the economy was recovering, it was hit, first, by a series of natural disasters, and then by the Russianfinancial crisis, resultingin a substantial real depreciation (43 percent in 1998) and an increase in the external imbalance. These external shocks accentuated the underlying structural and fiscal weaknesses o f the economy, and mandated renewed reform efforts, with a strong emphasis on fiscal adjustment, power and banking sector reforms, as well as increasing attention to institutional reforms. 1.3 The last five years have seen significant improvement in the country's overall macroeconomic performance, with real GDP growth averaging at about 4 percent per annum. Despite this progress, the Kyrgyz economic recovery remains fragile, hingingcritically on agriculture, gold miningand, to a lesser extent, the services sector. The external indebtedness is a heavy burden for the Kyrgyz economy-even considering expected further debt relief by Paris Club creditors in 2005-with future fiscal and debt sustainability calling for continued fiscal adjustment and reform. Despite a remarkable 15 percentage point reduction inthe poverty headcount since 1999, about 41 percent of the population i s still below the poverty line.13 Severe poverty (at PPPUS2.15 per day) affects 10percent o f the population. 1.4 Kyrgyz policymakers have limited options in the growth agenda. There is no alternative to facilitating the diversification o f the non-gold economy in the medium-term (next three to four years), if the economy i s to remain on a modest growth path over the long run. Over the medium term, stable macro environment, expected relatively strong gold production, and fast-growing neighboring markets, offer a window o f opportunity for policy makers to maneuver away from prevailing dependence on primary agriculture, mineral and hydro power dependent growth path towards a more diversified structure that i s grounded inhigh-value agriculture (including livestock), manufacturing and a service sector, which generate positive spillover for the economy through inter-sectoral linkages. The tasks for the policy makers are: The Kyrgyz Republic is small, with an area of approximately 200,000 sq kms, surrounded by Kazakhstan, Uzbekistan, Tajikistan and China. ''The economic structure was characterized with more than 40 percent of industrial share in the output and well developed industrial base, encompassing power, mining, machine building, metal processing, construction materials producing, light and food processing sectors, diverse agriculture, and tourism sites attractinga largenumber oftourists, mostly from the FSU. I3These figures reflect preliminary results from the 2003 householdbudget survey. 1 0 first, to assess the potential and requirements for triggering a stronger private sector-led supply response to the ongoing economic reforms and growing regional markets in the medium-term; 0 second, to leverage domestic trade policy reforms and existing regional and multilateral agreements for further regional and global integration; and 0 third, to facilitate improvements inenterprise capability andproductivity. 1.5 The purpose o f this chapter i s to focus on the first challenge by taking a snapshot picture o f the existing economic structure o f the Kyrgyz economy and to identify strategic options for strengthening medium and long term growth prospects. The next two chapters focus on the remaining two challenges, addressing the critical underpinnings o f any future growth strategy. The outline of this chapter i s as follows: Section B, briefly reviews the outcome o f the reforms thus far, which led to macro-stability, growth and poverty reduction but fell short o f directing the economy towards generating productive dynamism. This discussion highlights why not only the level, but the pattern o f growth, matters for poverty reduction. Section C outlines the key features of the Kyrgyz economic structure by employing a Social Accounting Matrix (SAM)-based model, which reveals a relatively detailed picture of the supply side o f the economy. Section D turns to the nature and pattern o f growth and its nexus with employment and poverty based on the model. The last section analyses the growth, employment and poverty implications o f the diminishing gold production and presents key elements o f a broad-based growth strategy capable o f leading to economic diversification and generating sufficient employment to reduce poverty. B. MACROECONOMIC DEVELOPMENTSCHALLENGES AND Macro Stabilization and StructuralReforms-An Overview 1.6 The Government's stabilization-cum-structural reform program, launched in 1993 shortly after independence, has been instrumental in improving macroeconomic stability, while gradually transforming the economy to a market-based system. The main elements o f the structural reform program, which are further discussed in the next two Chapters, encompass: introduction o f a new convertible c~rrency,'~ liberalization o f commodity prices, trade and foreign exchange regimes, financial sector reform as well as land reform and privatization o f small scale enterprises. The program also included fiscal adjustment through the rationalization of budget expenditures and modernization o f the tax system. Restructuring, and privatization o f large-scale public enterprises were also among the key objectives of the reforms, but their implementation remains the weakest element o f the reform process thus far. More recently, reform efforts have been broadened to cover extensive legislative changes to improve the business and investment climate, which proved to be a challenging endeavor, with implementation and enforcement lagging behind. 1.7 Despite the disruptions of a regional financial crisis in 1998-99, by 2001, the leading indicators signaled the strength o f the macro-fundamentals by the rapid rebound in, and the return of, a stable macroeconomic environment (see Figure 1.1). The last five years have seen major improvements infiscal and external imbalances (equivalent to about 7 and 13 percent o f GDP, respectively), steady real GDP growth (4 percent on average15 annual terms), and declining inflation rates (3.1 percent in 2003). Reflecting the improved confidence inthe economy, excessively highnominal and real interest rates have declined and the som stabilized after 2001 at an average o f 47 som per US$-after depreciatingby almost 50 percent in 1999, and a further 20 percent in 2000. At present, the fiscal and financial accountability l4The national currency Somwas introduced inMay 1993. Significant disturbances from a landslide at the Kumtor gold mine and the reduced external demand for power in 2002 repressedthe overalleconomic growth in2002, althoughthe non-gold economy grew. 2 systems are undergoing further reforms to improve the fiscal discipline, transparency and efficiency in delivery of public services. While the fiscal reforms are far from complete, substantial improvements to date are expected to underpin much needed debt stock reduction by Paris Club Creditors in early 2005. This will help further strengthen the countries fiscal outlook. Figure 1.1: Features of Recent Economic Outlook The recent years have seen improvementintwin imbalances, relativelyhigh realGDP growth and declining inflation. 7 - - 4 0 17- 6 - - 35 5 - - 3 0 i 4 - -25 - 20 I 3 1 , - 15 2 - 10 5 - 1 - - 5 3 - 0 0 1 - 1999 2000 2001 2002 2003 -1 - 1999 2000 2001 2002 2003 1 I __ =Real GDP rowth (LHS) FiscalDeficit as share ofGDP ~~~ I I -inflation (I?I-IS) 0CurrentAccountdefiat as shareofGDP I Economyis largly consumptiondriven, investmentsare low and non-goldexport performance remains stagnant. 100 - -21 I 1 2 0 - 100 I 80 - 60 1 4 0 - 20 17 - 0 1999 2000 2001 2002 2003 -Investment - as % ofGDP (RHS) r= Non-gold merchandiseexports inUS$________ 1999 2000 2001 2002 2003 (LHS) Consumptionas % of GDP -~ __________.__. (LHS) 0MerchandiseimportsinUS$(LHS) ~ -Som/US$ RER(99=100: uo=aoureciation\(RH9I Source: WB staffestimatesbased on official data. SupplySideResponseto Macro Stabilityand StructuralReforms 1.8 The supply-side response o f the Kyrgyz economy to an otherwise stable macroeconomic environment and liberal regime o f foreign trade and investment has, however, been slow. As discussed in Chapter 3, despite some improvement, the combination o f poor business enabling environment and deficient tax policy and administration are among the factors hindering investment and growth in the formal sector o f the economy. They also contribute to increasing informalization o f the economy- varying between 20 to 40 percent based on official and unofficial sources, respectively. 3 1.9 Since 1995, economic recovery in the Kyrgyz Republic has been driven largely by Table 1.1: Gross Domestic Investment in Selected growth in consumption, which has been about Transition Economies, 2002 85 percent o f GDP in recent years, down fiom Total Public Private much higher levels in the mid-1990~'~(see Figure Azerbaijan 37.1 6.1 31.0 1.1). Public consumption has been gradually cut Baltics (average) 29.0 4.3 '25.0 back, while private consumption, after being Kazakhstan 26.7 3.7 23.0 repressed by the regional financial crisis, is on the Albania 25.0 7 18.0 rise. As a share of GDP, overall investment at 18 Belarus 24.4 3.2 20.4 percent in2002 was low by all standards, certainly Romania 24.1 3.7 20.4 Ukraine 22.1 2.1 20.3 with respect to comparator transition countries, Armenia 23.6 5.2 18.4 which have grown faster (see Table 1.1). S A M 21.5 4.9 16.6 Bulgaria 20.7 3.7 17.0 1.10 The sectoral structure o f fixed investments Russian Federation 20.3 2.1 18.1 reflects high share o f industry (mining and power) Poland 19.2 3.6 15.6 and services (transport and communication). The Georgia 18.4 2 16.4 agricultural sector, the largest single contributor to Kyrgyz Republic 18.4 6.3 12.1 GDP, has a modest share intotal. This imbalance Moldova 18.2 2.3 15.9 Tajikistan 17.8 6.2 11.6 reflects both weakness o f the private sector as well as availability/destination o f donor financing and Source: Official datafrom World Bank SIMA database FDI. Donors and the own-capital from the local enterprises(including joint ventureswith large Table 1.2: Structure and Sources of Investment in state share) are the main sources o f investment Fixed Capital, 1999-2002 financing. Their combined contribution was 1999 2000 2001 2002 2001-02 63 percent Avg Of the in 2o01-02' KY%Yz Total Investments in Fixed Assets 100 100 I 0 0 100 100 households contributed an additional 19 percent to induslrr 37 42 17 26 22 5 the total, while the government contributed 9 4 7 4 6 Manuracturing industry 5 14 5 11 6 percent fiom its own budget. FDI contributes Pouer Sector Ezrl:ev 27 22 6 9 6 Agiculture 4 4 4 5 4 relatively little, about 9 percent, to real sector 2 1 4 5 5 investment-food processing, mining, trade and 58 53 75 64 69 catering are the main sectors benefiting from FDI ~ a ~ ~ ~ ~ ~ ~ . 6 ~ ~ 7 ~ 18~ ~ 19~ ~ 19 l i o n j Otherserrices 20 14 23 25 24 inflows inrecent years (see Table 1.2). Compared Sou~$l;;~;;;ent 100 100 100 100 100 49 48 34 to the late 1 9 9 0 private investments are estimated ~ ~ Financing" 20 27 Foreign grants 2 1 0 2 1 to have nearly doubled over the past four years. Budgetaryresources 6 9 8 1 0 9 Enterprises& organizalions'own funds 22 20 29 41 36 Nonetheless, an accurate division o f investments Eyholdsavings 14 9 21 17 19 5 13 7 11 9 across public and private investments is difficult Source World Bank siaffesiimatcs bared on official data due to weaknesses in data, which seems to result 'investmentby secmrsrepresentsonly pan oftotal grorr fixed investmentrecorded in GDP. The sectoral invcrimcntdocs includechangein liverlockand stock ofequipmenr apprccialionrelated lo in overestimation theprivateinvestment. an of 17 equipmentrepair.non-tangiblc assets. e~ However, even with this caveat, at 12-13 percent o f GDP, private investment levels are low. 1.11 Despite significant emphasis on public investments in infrastructure in the past decade, Kyrgyz producers must grapple with difficult mountainous terrain, limiting access to intemal markets and contributing to high transpodtrade margins across various sectors-as high as 5 percent o f GDP in agriculture and 14 percent o f GDP inmanufacturing (see Table 1.2 and Volume 11, value chain analysis). Similarly, in spite o f seemingly abundant endowments of hydro-power and water, the frequent and l6Expenditureon consumptiongrew in mid-1990sas aresult of depreciationof Som and high import costs following the Russian crisis of 1998. Public investment data include only those investments that are financed through the state budget, while private investmentare calculatedas a residual out of the total gross investments. Therefore, private investments within the GDP by expenditures are quasi-public, as they include asignificant amount of funds investedby state-ownedenterprises (outside of the Public Investment Program). 4 lengthy energy supply disruptions, the unpredictable power surges and the low voltage of electricity all constitutes serious concems in all regions, pointing to a disorganized energy policy and poor management.I8 The high costs andor poor accessibility/quality of key services, such as transport and energy, make for an unattractive investment climate. Combined with other major problems with the investment climate, these factors probably explain the slow trickling in o f FDIand the equally low levels ofprivate investment. `*12 These are by the Table 1.3: Financial IntermediationbytheBanking limited financial intermediation capacity o f the banking sector, with high real interest rates and a Sector in Selected Transition Economies, 2o02 marginal capacity to provide long-term financing, Domestic even when compared to CIS countries that have credit to private Real reformed more slowly and have shown weaker sectors M2 Spread'' Lending macroeconomic performance (see Table 1.3). Hungary 35.3 44.1 2.8 -0.5 Factors responsible for this outcome and their Czech Republic 33.4 73.1 4.0 3.5 implications in terms of firm level development Estonia 29.2 39.9 4.0 2.5 are discussed in other parts o f this report." Poland 28.8 43.3 5.9 10.3 Important points to be emphasized in this section Tajikistan 18.8 7.2 5.0 -6.4 Kazakhstan 18.6 17.0 0.1 -0.7 are that a segmented and underdeveloped banking Bulgaria 18.4 39.6 6.6 5.3 system and a small deposit base-which limit the Ukraine 18.0 24.8 17.4 21.4 capacity of banks to develop their product base- RussianFederation 17.6 22.9 10.8 0.4 and delays in the development o f a sound 17.6 26.3 9.3 14.3 framework for intermediation-including Lithuania Belarus 14.2 27.2 5.1 6.9 9.1 12.7 10.0 -3.6 supervision, property and creditors' rights, Romania 8.3 21.3 16.3 20.0 accounting and auditing-contribute to high Georgia 8.1 10.8 22.0 23.9 lending risks; they also force banks into expensive Armenia 6.9 13.6 11.5 18.5 collateral-based credit. In addition, incentives for A k d a 6.8 59.8 6.8 8.7 firms to remain in the informal economy and Azerbaijan 5.6 12.5 8.7 16.5 operate outside the banking system keep monetary Kyrgyz Republic 4.2 12.8 18.9 22.0 depthlow, increasing of bank while costsand risk Source: Official data from World Bank SIMA database. lending, Finally, low disbursement rates of " Differencebetweenlendinganddepositrates. existing numerous donor-financed credit lines suggest that private credit mighthave also been constrained bythe lack ofbankable projects. 1.13 As discussed in detail in the next chapter and the Volume I1 o f this Report, the export performance i s one o f overall stagnation and increased concentration o f non-gold exports. Kyrgyz exporters have failed to capitalize on a large increase in import demand in both Kazakhstan and Russia, major trading partners, over the last five years (see Chapter 2). Most of the decline innon-gold exports is attributable to the overall slow recovery in non-gold GDP associated with underdevelopment of commercial agriculture, manufacturing and service sectors. As will be discussed below, this has also been exacerbated by competitiveness problems vis-a-vis other CIS countries and major international exporters, one o f the mainchallenges facing the Kyrgyz Republic today. See Kyrgyz Republic Public Expenditure Review: Fiscal Policesfir Growth and Poverty Reduction, World Bank, March 2004, and Kyrgyz Republic: Enhancing Pro-Poor Growth, World Bank, September 2003. l 9 See Chapter3, and "Financial Services and Trade Finance" and "Value Chain" analysis o f selective industries in Volume 11. 5 Wages and Productivity Trends 1.14 A widely used measure to assess country competitiveness i s relative unit Figure 1.2: Relative Unit Labor Cost inIndustry, Selected labor cost expressed in a common currency. CIS Countries, 2002 Table 1.4 below presents estimates o f economy-wide average unit labor cost for r6---- - - 2 0 the Kyrgyz Republic and several other CIS I 5 - L 1 7 countries. It shows that the Kyrgyz Republic has relatively high labor costs 4 - compared with other CIS countries. The 3 - ~ observed competitive gap i s large: the 1 2 Kyrgyz Republic has 66 percent higher unit I 1 - labor cost than comparators/competitors ' such as Armenia, Georgia, and Russia, 2.5 0 - Georgia KR Kazakh Moldova Russia Armenia Tajik times higher cost than Tajilustan, and more ~ _ _ _ _ . - than three times the unit labor cost of -Relative nominal US$ monthly wages (KR=I)(LHS) D R e l a t i v eLabor Productivity (KR=l)(LHS) Kazakhstan. As such economy-wide -~ -Relative Unit Labor Cost level (KR=I)(RHS) __ ~ ~~~ ~~ comparisons o f unit labor cost can be influenced by the economic structure o f the Source.WB staffestimates basedon official data countries:' and data on employment and wages in agriculture can be subject to large margins of error in these economies, Figure 1.2 presents relative unit labor cost focusing only on the industrial sectors of these countries. The results show that Kyrgyz Republic's relative cost position remains largely unchanged when agriculture is excluded.21 1.15 What explains the Kvrnvz Republic's relativelv hiah unit labor cost? The unit labor cost index isolates two major factors influencing competitiveness: the wage-productivity ratio and the exchange rate.22 Exchange rates can play an important role in generating differences in unit labor cost across countries. Independent o f the productivity o f the nation's labor force or wages paid, an overvalued exchange rate raises costs. Incountries where the exchange rate i s largely market determined, such as the *'For instance, the proportion of agriculturein GDP in Russia is only about 6 percent, and inKazakhstanabout 8 percent, while in the Kyrgyz Republic it is 37 percent. 2' Economic structure clearly plays some role in these results as, for instance, industrial output in Kazakhstan and Russia is heavily influenced by oil exports. But putting these countries aside, the data still indicate that the Kyrgyz Republic has a competitivenessgap with other countriesin the regionhaving similar economic structures (for further detailed analysis see Elena Loukoianova and Anna Unigovskaya, 2004, Analysis of Recent Growth in Low-Income CIS Countries, IMF Working Paper (WP/04/151). It might also be noted that, while the Kyrgyz Republic's relative competitiveranking in the CIS can be a matter of some debate consideringthe quality of the data and issues of comparativeeconomic structure, it is not the only important factor. To improve its export position, the Kyrgyz Republic must also think about its competitiveness in comparison with major exporters in other regions producing similar products. As evidence indicates that the CIS is a relatively high unit labor cost region of the world, the Kyrgyz Republic's competitive position in the CIS is a harbinger of competitive difficulties with important exportregionsof the world. 22Relativeunit labor cost is measuredby the index: RULC = [W/Q/L] x (lie) where (W) is the currentwage, (Q) is ameasureof (physical) output, (L) is workers employed, and (e) is the exchange rate. The measureignorescosts other than labor, such as raw materialsand finance costs, under the assumptionthat these costs will generally be more similar across countriesthan wages and labor productivities,given capital mobility and worldwide commodity markets. In the Kyrgyz Republic's case, as discussed in the section of this report dealing with financial markets, financing costs are high and access to finance is limited because of prevailing risks and under-developed financial intermediaries. However, most of the countries inthe CIS face similarly high cost of financing, as they are subject to the same types of institutional weakness and under-developed financial intermediariesfound in all transition economies. Kyrgyz firms may face somewhat higher raw material costs, however, because the country is landlockedandtransportationcosts are high. 6 Kyrgyz Republic, the effect of the exchange rate on competitiveness is, however, a short run phenomena.23 Table 1.4: The Kyrgyz Republic and Selected CIS Countries: Relative Unit Labor Cost, 2002 Armenia Georgia Moldova Kyrgyz Kazakhstan Russia Tajikistan Republic Average nominal monthly 46.1 47.2 44.1 40.3 130.3 140.8 10.3 wage (US$) Relative nominal US$ 1.1 1.2 1.1 1.o 3.2 3.5 0.3 monthly wages (KR=l) Relative Labor Productivity 2.0 2.0 1.2 1.o 10.5 5.7 0.7 (KR=l) Relative Unit Labor Cost 0.6 0.6 0.9 1.o 0.3 0.6 0.4 (KR=1) Real average monthly wage 252.1 366.3 123.6 151.8 161.4 154.5 77.8 (index 1995=100) Note: The selected CIS countries inthis table are either potentialcompetitorsfor the Kyrgyz Republic ingrowing Russianand Kazakhmarkets and/or are marketsfor Kyrgyz products Source: World Bank staffestimatesbased on the official data. 1.16 Figure 1.3 shows that the Kyrgyz Republic's real effective exchange rate Figure 1.3: Real Effective Exchange Rate, 1995-2003 (REER) has actually improved over the period, signifying an increase in , competitiveness. REER (deflated by the 120 - CPI) depreciated by more than 30 percent in 110 - the years 1995-1999 and then remained IO0 - relatively stable.24 Most trade in the Kyrgyz 90 - Republic i s conducted in U S dollars; 80 ; however, a significant amount also takes 70 -1 place in Russian rubles and Kazakh tenges. I 60 - The relative stability of the REER since 2000 'I 50 SomiKazakhtenge ~ reflects the compensating effects o f the I simultaneous appreciation of the som against 40--- 1995 1996 1997 1998 1999 2000 2001 2002 2003 the U S dollar, along with appreciation of the Russian ruble and Kazakh tenge against the U S dollar. Thus, the Kyrgyz Republic's Source. WB staffestimatesbasedon official data. comDetitiveness problem does not stem fiom an exchange rate issue. A search for the underlying causes of high unit labor cost has to focus on the wage-productivity ratio. 1.17 Conceming the wage-productivity ratio, it should first be noted that superior competitive performance (i.e., low unit labor cost) can occur in high wagehigh productivity countries as well as in low-wage/low productivity countries. It would be no surprise that Taiwan (highwagehigh productivity) 23A lack of competitiveness would meanthat a country is running a persistent and unwelcomecurrent account deficit, which, in due course, would requireadjustmentby a mixture o fdeflation and depreciation. Competitivenessis viewed inthis situationas a real exchange rate issue and the focus would be on short run macroeconomic management to retum the country to external balance. 24Real exchange rate = EjkPjVPk, where E is the nominal exchange rate, P is price of traded goods, andj and k are indexes of major trading partners. The real exchangerate measuresa country's competitive position resulting from changes in the nominal exchangerate andcost-pricerelationshipsrelative to tradingpartners. The price series used as adeflator is the CPI. 7 and Kenya (low-wage/low productivity) both can be competitive on world markets in some industries. Poor competitive performers will be countries with highwages and low labor productivity-i.e., countries with wages too highto be supported by current productivity levels. 1.18 The Kyrgyz Republic i s shown in Table 1.4 to have lower wages than all its CIS comparatorskompetitors, with the exception o f Tajikistan-an average Russian and Kazakh worker earn a monthly wage that is more than 3 times the average wage o f a Kyrgyz worker; and an average Kyrgyz worker i s paid about 9 percent less than a Moldovan worker, 13 percent less than an Armenian worker and 15 percent less than a Georgian worker.25 Only workers inTajikistan have significantly lower wages than Kyrgyz workers. Outside the CIS, evidence also indicates that the Kyrgyz Republic has lower wages than formidable trade competitors, such as China and India, where workers in garment factories in the export processing zones earn more than 2.3 times the average Kyrgyz wage, and, in advanced countries such as Ireland, where wood-processing workers earn as much as 14 times the Kyrgyz wage.26 1.19 Hence, differences inproductivity explain the Kyrgyz Republic's highunit labor cost. Table 1.4 shows that Kyrgyz firms in 2002 had significantly lower output per worker than most other countries in the region. Only Tajikistan had lower economy-wide labor productivity. Data for the industrial sector in Figure 1.2 and for total factor productivity and labor productivity growth inTable 1.5 provides the same evidence-the rates o f labor productivity growth inthe Kyrgyz Republic proceeded at about one-third the average for several other comparators in the region, with the exception o f Moldova. As Table 1.4 demonstrates, these productivity differentials are larger than the observed wage differentials, suggesting that the Kyrgyz Republic's low wage advantage is being eroded by its larger productivity disadvantage. The consequence is a higher unit labor cost and trouble competing both at home and abroad. Chapter 3 discusses some o f the major reasons for the Kyrgyz Republic'sproductivity problems based on evidence from various industry case studies. It identifies steps that should be taken to improve enterprise productivity and enhance competitiveness as part o fthe Kyrgyz Republic's growth agenda. Table 1.5: The Kyrgyz Republic and Selected CIS countries: Total Factor and Labor Productivity Growth, 1998-2002 1998-2002 - period average inpercent Armenia Tajikistan Georgia Moldova Uzbekistan Azerbaijan Kyrgyz R.CIS-7 Avg. Total factor productivity 8.0 6.9 6.3 4.1 3.8 1.9 1.3 4.6 Labor Productivity 8.1 6.3 7.8 0.2 3.5 1.6 1.4 4.1 Source: AnalysisofGrowth in Low Income CIS Countries, IMF Working Paper 151,2004. Growth and Poverty Trends 1.20 The steady downward trend inpoverty over the last several years underscores the importance of high and sustained domestic growth for poverty reduction (see Table 1.6). Growth has not yet lead to commensurate increases in the number o f jobs.27 Agriculture, trade and catering have been the main '_ sources o fjob creation-the former mostly inthe form o f subsistencefarming and the latter inresponseto 25The case study on the cottonindustry inthe Kyrgyz Republic pointedout that a Kyrgyz technician in a ginnery got paid about US$100 a month, but he/she could migrate to Russia and get paid USS300 to US$500 per month in the construction or mining industries. This wage differential is resultingina "brain drain" from the Kyrgyz Republic and making it difficult for ginneriesto get qualified technical staff. On the other hand, agricultural workers in the Kyrgyz Republic get paid much less than technicians in ginneries. The case study on the dairy industry indicatedthat the average wage of a Kyrgyz animal husbandryworker is about US$29per month. 26See ILO: Monthly Wage Data for ManufacturingWorkers, 2002. 27 The fall in employment was particularly important in transport, where large-scale privatization was important, and in construction, where output declined. In industry, the fall in employment largely reflected the collapse of economic output in manufacturing. 8 small scale privatization and private ownership (see Table 1.7). The 2003 Kyrgyz Poverty Assessment, undertaken jointly by the Kyrgyz authorities and the World Bank, demonstrates a strong correlation between poverty and employment status, with disproportionately highpoverty among the unemployed.28 The Study suggests that the persistence of widespread poverty reflects the presence o f a large pool o f jobless and discouraged workers (that i s imperfectly captured in traditional statistics), as well as the low level of formal job creation. While accurate estimates of the share of individuals engaged in the informal labor market are difficult to obtain, a good deal o f activity takes place in the informal sector in services, street trading and subsistence farming.29 Addressing the problem o f low formal job creation and promotingjob creation outside agriculture are, therefore, critical to further poverty reduction (see Section Dbelow). Table 1.6: Kyrgyz RepublicGDP, Consumptionand Poverty, 1996-2003 1996 1997 1998 1999 2000 2001 2002 2003 2000-03 Average RealGDP growth rate (%) 7.1 9.9 2.1 3.7 5.4 5.3 0.0 6.7 4.4 GDP per capita uss (averageex. rate) 392 374 343 255 279 308 322 383 32.3 GDP perecapita growth rate ("A) 5.5 8.3 0.6 2.3 4.3 4.5 -0.6 6.1 3.6 Consumptiongrowth rate (YO) 6.3 -8.1 15.1 0.9 -2.9 1.4 3.7 7.0 2.3 Consumptionper capitagrowth ("A) 4.7 -9.4 13.4 -0.5 -3.9 0.6 3.1 6.3 1.5 Consumptionper capitaindex (1996=100) 100 91 103 102 98 99 102 108 102 Povertyheadcount("Aof population) 43.5 43 54.9 55.3 52 47.6 8.6 40.8 46.2 Officially estimatedunemployment 7.8 5.7 5.9 7.4 7.5 7.8 na 8.0 Source: World Bank staffestimatesbasedon official data. Note: Consumptiondata for 2003 is preliminary. It is projectedresidually,based on actual data on GDP and foreign savings, and projected dataon investments, and could, therefore, be subject to overestimation. Table 1.7: Output and Labor, 1996-2002 EmploymentStructure RelativeWages Average Growth Rate 1999-2002 1996 2002 (agric.= 1) GDP Wage Employment Total 100.0 100.0 2.2 3.6 3.7 1.5 Agriculture,hunting, fishery, andforestry 47.1 52.7 1.o 5.3 3.1 3.4 Industry 14.6 10.3 3.4 0.1 3.3 -4.3 Mining" 0.6 0.4 2.6 0.9 -3.9 5.1 Manufacturing" 9.3 6.2 3.7 -2.1 4.1 -6.3 Productiionanddistribution of utilities 1.2 1.2 4.4 4.1 8.4 2.0 Construction 3.5 2.5 2.6 8.3 0.0 -2.4 Services 38.3 37.0 2.0 4.3 3.8 0.9 Trade, repair services, hotels, and restaurants 10.2 12.0 1.9 7.5 3.1 2.8 Transport and communications 4.9 3.8 2.4 1.7 5.6 -2.2 Public administration 3.8 3.7 3.1 0.7 6.5 1.3 Socialservices 13.8 12.5 1.2 12.9 1.4 0.2 Source: World Bank staff estimatesbased on official data. " ManufacturinginGDPin 1996-1999includesmining. From2000onwards, manufacturingincludesonly Kumtor-relatedgoldmini. 28See Chapter 4 of the Kyrgyz Republic: Enhancing Pro-Poor Growth, World Bank, September2003. 29 An important characteristic of the Kyrgyz labor market is the large incidence of informal employment. The collapse of industrial enterprises, combined with the impossibility to survive in unemployment and the lack of formaljob opportunitieshas seen the emergence of a widespread informal sector. The informal sector often acts as a safety valve for the large unemployed anddiscouragedpopulationthat is imperfectly capturedin official statistics. 9 1.21 The distribution of wages across economic activities was also uneven (see Table 1.7). Wages grew fast in the power sector, transport and communication and to a lesser extent in manufacturing. Wages in agriculture and trade-sectors that make the largest contribution to employment-remained the lowest. Disproportionately low wages intwo most labor-intensive sectors again illustrate the fact that far too many people inthe Kyrgyz Republic rely on self-subsistence agriculture and informalktreet trade for survival. This also suggests that despite average GDP growth of 4 percent per annum, there i s significant slack in the labor market to keep wages depressed. The official unemployment rates o f 8 percent in recent years do not reveal the slack related to significant hidden unemployment in the informal and agricultural sectors. 1.22 These macro relationships between growth, unemployment and poverty underscore the importance o f understanding the linkages between sources o f economic activity, the labor market and poverty, which i s an outcome o f household income and consumption. This, in turn, will help in identifying options for promoting linkages from growing segments of the economy to the rest and expanding the numbero f those who benefit from growth. Next section analysesthese relationships. c. STRUCTUREOFTHEKYRGYZ ECONOMY Accounting for Sources of Growth and Employment: Social Accounting Matrix-Based Model 1.23 An analysis of the economy's underlying structure is critical to understanding how different growth patterns will influence employment and poverty. In order to achieve this, a social accounting matrix (SAM)-based model i s employed to inform the rest o f the discussion inthis Chapter (see Box 1.1). This section discussesthe keyfeatures o fthe Kyrgyz economic structure basedonthe model's feedback. 10 Box 1.1: Basic Features of the Kyrgyz Social Accounting Matrix (SAM) The Kyrgyz S A M is built from two Input-Output tables for 1998 and 2001, national accounts, data from the 2001 household budget survey, 2002 labor force survey, as well as various other statisticsand information provided by the National Statistical Office, the National Bank of the Kyrgyz Republicandthe CustomsDepartment of the RevenueCommitteeunder the Ministry of Finance of the Kyrgyz Republic for the year 2000 to 2002. The basic purpose of the S A M was to present, in as consistent a manner as possible, a relatively disaggregated supply-side picture of the economy. In the SAM, there are 88 activities and 86 commodities, trade margins, 9 occupational skill categories for labor, 1 type of capital, 2 types of households-rich and poor-for each of the 8 oblasts. Detailedtax and expenditurecategoriesas well as trade accounts with the country's maintrading partners-Russia, China, UzbekistanandKazakhstan-and the rest of the world are also included. Pros and cons of the S A M multiplier model are discussed in detail in Annex 1-A. While the model has limitations in many aspects, its simplicity offers certainadvantages: Q+ First, its underlying assumptions of fixed pricesand fixed technologyin an economy with ample underutilizedcapacitysuch as the Kyrgyz Republic seem reasonable in the medium term and possibly also the early phase of the longer term. Simulationswith a simpler modelstructure are also easier to understandand track. Q+ Second, the model is useful to understandthe nature of the backward and forward linkagesin the economy, an issue that is in general less well understood, yet critical to assessing the economy's underlying structure and examining how shocks (positive and/or negative) and various development strategies may influencegrowth, employment,and poverty. B Third, the purposeof the modelis not to estimateexactlyhow muchaparticularsector can supply ifsubject to an extemal demand shock; rather, it is to understandthe nature and quantity of inputs such as water, electricity, skills, etc. that will be required to obtain a certain level of growth. If policy makers have this information, they can focus on the types of interventionsrequiredto ensurethat critical materialinputs will be availableto meetgrowth targets. Inthis, the S A M model simulations provide useful information based on 2001 data, and seem to adequately depict the present economic structure (see SectionF). Fourth, keeping the model simple permits both easy tracking of information gaps that need to be filled for improving future similar analysis that the govemment authorities are planning to undertake, and easy transfer to them at this stage of ongoing technicalcapacitybuilding. Key Features of Kyrgyz Economic Structure-Reflections from SAM-based Model 1.24 Since mid-l990s, the basic structure o f the economy remained unchanged with one exception: in 1997, gold mining emerged as a key export activity. By 2001, gold mining, along with gold processing, comprised the country's third major economic activity, after agriculture and livestock, and retaiVwholesale trade. Manufacturing, composed o f hydropower, fuels, and water resources, was small, just above the energy sector (see Figure 1.4). Sources o f employment largely concentrated in agriculture, as noted above. The agncultural sector employed more than half of the labor force, while services accounted for roughly the same proportion as their share inthe economy. The mineral and energy sectors created only about 3 percent employment compared to their share of 15 percent inGDP, signaling a clear trade-off between growth and employment. The structure of the economy, as depicted by the 2001 S A M , remains broadly unchanged, except for marginal variations. 11 Figure 1.4: Structureof the Economyand Sourcesof Employment, 2001-SAM Transport I Trade&Cater T~~~~~~~Trade& Public 3% , 3% Manufact Catermg 9% 6% I 5% Gold (mmmg) 0% Power I 2% Construction- 5% I I Agriculture Agriculture 53% , I ~- ----- 34% ~- -__ ._ _ ~ _ _ Source 2001 SAM, World Bank 2004. 1.25 A number of salient characteristics define the sources and pattern of growth in the Kyrgyz Republic: 0 Dispersion of economic activities. Table 1.8: Sources of Growthand Employment in The Kyrgyz economy i s marked by a Agriculture, 2001 dispersion of production across a Sharesof VA Share in fairly large number o f economic Shareo f Employment Gross activities. Most of these activities GDP (%) in total (%) Production produce 2 percent o f GDP or less. In Agriculture 25.1 45.4 63.0 agriculture, grain (mostly wheat) Grain 9.4 13.6 63.3 stands as an exception (share of Fruitsandvegretables 8.6 14.6 84.7 9 percent o f GDP), production of Potato 2.8 4.0 75.9 which in 2002 was 1.3 times Vegetables 3.8 5.7 75.1 (2.8 times for wheat) higher than the Fruitsandberries 1.9 4.6 91.O 1991 levels, occupying about Nuts 0.1 0.2 97.0 60 percent (40 percent for wheat) o f Cottonandother cash crops 3.5 9.2 91.4 the cultivated land. One o f the main Cotton 2.5 7.0 95.6 reasons behind the remarkable gain in Tobacco 0.8 2.1 94.4 Sugarbeet 0.2 0.2 84.3 grain production has been the shift Fodder 2.0 3.2 80.9 away from traditionally export- Other crops 1.8 4.8 93.4 oriented crops towards import Livestock 10.3 8.0 38.3 substitution both as a subsistence Meat 6.0 4.1 28.8 farming as well as production for the Milk 3.2 2.0 29.1 domestic markets. Of the remaining Other livestock 1.o 1.9 51.0 agricultural activities, only four others Eggs 0.6 1.3 62.5 have a critical mass o f 3 or more Wool 0.1 0.1 41.4 percent of GDP-potatoes, vegetables, Other animals 0.2 0.4 53.8 meat and milk, which are produced Huntingand forestry 0.1 0.2 91.2 Fisheryand fish breeding both for subsistence and - 0.0 0.0 36.0 commercially. Even cotton, a Total 35.4 53.4 66.1 Source: 2001 Kygyz SAM, The World Bank, 2004 traditional crop with important forward linkages to manufacturing, accounts for no more than 2.5 percent o f GDP (Table 1.8). 12 There is greater dispersion in Table 1.9: Sources of Growth and Employmentin manufacturing. For instance, cotton and Manufacturing, 2001 wool manufacturing involve at least 10 distinct activities from ginning to yam Shares of VA Share in Shareof Employment Gross to cloth production butjointly account for GDP (%) intotal (%) Production only 1percent o f GDP. The processing of Light Manufacturing 4.0 3.1 45.6 agricultural commodities, spread across a Cotton and wool manufacturing 1.1 0.6 33.1 range o f traditional and emerging Cottonginningand yarn 0.3 0.1 54.4 activities, contributes 3 percent o f GDP. Cottonfabrics 0.1 0.1 56.3 Similarly, broad range of production lines Wool yarn and fabrics 0.1 0.0 57.1 varying from traditional minerals, metals Knitted items and clothings 0.5 0.3 53.7 Other textileindustry 0.1 0.0 19.8 and machinery to emerging rubber and Agro-processing 2.9 2.5 27.3 plastic, and bulbs and glass sheet are Flour milling 1.6 1.5 20.0 evident in heavy manufacturing, although Sugar refining 0.2 0.2 62.4 their collective contribution is small at Meat, dairy, and other processing 0.6 0.6 16.1 4 percent o f GDP (see Table 1.9). A high Beer. vodka, and mineralwater 0.2 0.1 13.5 Tobaccoand other food processing 0.4 0.2 17.4 degree o f dispersion makes efforts focused Heavy Manufacturing 4.0 1.9 21.3 on marketing and logistical support to Timber, paper, and chemicals 0.2 0.2 32.5 enhance agricultural and manufacturing Rubberand plastic 0.1 0.0 15.9 production, more challenging, as these Metals and machinery 1.1 0.9 40.2 efforts are likely to be stretched thin across Bulbs and glass 0.4 0.3 37.6 Total 8.0 5.0 32.6 the large range o f activities. A high Source: 2001 KyrgyzSAM, The WorldBank, 2004 degree o f dispersion across many small scale-activities might also be impeding a much-needed increase inlow productivity rates across the board (see SectionB above and Chapter 3 for further discussion). 0 Signs of diversification in production towards high-value products, which are going to be increasingly important for sustainability of growth beyond the medium term. Two critical souyces of growth in the Kyrgyz economy, agriculture (including livestock) and manufacturing, seem to be starting to show much-needed signs of diversijkation towards high-value products, albeit, slowly. As will be discussed in the next section, the advantage o f high-value production in either agriculture or manufacturing i s that it generates positive spillovers for the remainder o f the economy through backward and forward linkages. For instance, increasing productiodexports of light-bulbproduction, ifsustained, can lead to the development of the glass, metals, cardboard and other service activities. Similar promise is associated with some other emerging andor restructured manufacturing sectors (e.g., rubber and plastic and glass sheet production) and with ago processing. Traditional activities such as cotton and wool manufacturing, meat and dairy also offer significant scope for diversification towards higher value added manufactured products for the domestic and export markets, if constraints, resulting both from government-policy and market failures, are eliminated." 0 Basic elements of critical supply chains are available but government-policy and market failure disadvantages constrain an efficient supply response. Kyrgyz producers enjoy the advantage o f having the basic elements of the supply chains o f a number of activities in place. Consider the case of cotton and wool. Apart from the production o f raw material, there i s installed capacity for ginning, production of yam, cloth and garments. Unlike most countries, the Kyrgyz Republic enjoys availability o f water and cheap power. It i s also fortunate to have an educated labor force, and reasonable domestic and regional demand for manufactured cottodwool goods. However, value chain analysis indicates that constraints to efficient production and marketing o f manufactured goods (ranging from difficulties in access to inputs and working capital, 30For further discussion, see Chapter 3 and Volume 11, Value Chain Analysis for cotton, wool, and dairy industry 13 inconsistencies inraw material, vintage equipment, and high margins inmarketing explained by the lack o f formal competition, to those resulting from weaknesses in structural elements of investment climate, encouraging informalization), frequently lead to prohibitive transactions costs, which significantly constrainthe scaling up o f production and diversificationtowards high-value products. The argument i s similar inthe case o f supply chains inalmost all other product lines (see Chapter 3 and Volume I1 for specific examples for agricultural production, with linkages to light manufacturing and agro processing). 0 Gold mining and refining are an important yet Table 1.10: Significanceof GoldMiningin "finite" source of growth and export?' For Kyrgyz Republic every 1 million Som o f gold output, the Som Share of gross contribution to GDP is about 64 percent from Intermediate Inputs million production (%) mining (see Table 1 .lo). While contribution of Fuels, gas, and oil 76 0.7 gold refining to GDP i s much smaller, it produces Gold mining 712 7 a critical source o f export (40 percent of total Light manufacturing 355 3.5 Heavy manufacturing 1,074 10.6 exports). Gold production has fairly strong inter- Power 349 3.4 sectoral linkages. This creates additional demand Watere 52 0.5 for production in other sectors, which, in turn, Roads andother construction 42 0.4 generates additional demand for inputs, including Wholesale and retail trade 0 0 labor (see Table 1.15, showing inter-sectoral Other services 540 5.3 Transportation 163 1.6 multipliers of 2.6). For instance, gold mining Public administration 32 0.3 creates a demand o f Som 3.7 billion for Education and health 0 0 intermediate inputs, such as fuel and gas (7 percent Other public services 0 0 o f gross production), power (3.4 percent), services Total intermediate goods 3,749 36.9 such as transport, real estate, etc. (7 percent). Wages to labor 1,395 13.7 Rent to capital 5,195 51.1 Inter-sectoral linkages are weaker in the next Taxes 172 1.7 stage, i.e., gold processing, where raw gold i s the Gross "ition 10,157 100 single major input (82 percent of gross emplovment (iobsl3,000 production). Soiree: 2001 Kyrgyz SAM, The World Bank, 2004 0 Even though the distribution of factor income to labor suggests that the benefits from gold mining accrue largely to relatively more affluent households, the economy-wide spillovers from additional demand for intermediate inputs and household expenditures have much larger implications for overall growth and poverty reduction in the Kyrgyz economy. (see Table 1.10). While gold production does not favor the less skilled, who are mostly poor, it makes an indirect, yet considerable contribution to poverty reduction. It displays a relatively high induced household income multiplier, showing that the increase in household income and expenditure associated with gold i s second only to that o f agricultural activity: for every unit- increase (Som 1 million) ingold minedhefined, household incomes rise by Som 1.2 (see Table 1.15 for induced household income multiplierso f 1.2 in gold relative to 1.3 in agriculture). Combined, inter-sectoral linkage and induced income multipliers o f the gold production suggest that the expected halving inthe gold production beyond the medium term will have considerable economy- wide implications. This calls for the implementation o f a recovery strategy during the medium- term, before the economy i s hit by a "gold-shock;'' this time, unlike the temporary 2002 shock, a permanent one (see Section E for further discussion). 31 The gold sector's contributionto state revenue is insignificant, as about 80-90 percent of income generated by Kumtor is spent on extemal debt repayment, while only about 3 percent is paid to the state budget. 14 0 Energy is both a critical input to Table 1.11: Sourcesof Growthand Employmentin production and an important source of Miningand Energy,2001 exports. Overall, with a major value-added Sharesof VA Sharein content, it i s also an important contributor to Shares of Employmentin Gross growth (see Table 1.11 and Table 1.15). Activity GDP (%) total (%) Production Besides these factors that augur well for Mining industry 9.6 0.4 43 9 Coal mining 0.1 0.0 36.1 developing an efficient energy policy, there i s Natural gas 0.0 0.0 38.5 an additional rationale: given that energy Crudeoil 0.3 0.2 49.9 exports originate fiom hydropower, which i s Other ores 0.0 0.0 Othermining 0.0 0.0 13.1 plentiful in the country, energy may have the Gold mining 9.2 0.1 64 9 potential o f partially compensating for the Power 4.6 1.8 55.5 diminishing contribution of gold to economic Water 0.9 0.9 34.8 activity and exports. Preliminary studies Steam and hot water supply 0.8 0.6 40.6 Water intake, treatment. etc 0.2 0.2 29 0 seem to also suggest that participation in a Fuel (production and distribution) 0 0 0 1 regional energy pool may enable the Kyrgyz Total 15 2 3 1 29 4 Republic to access new export markets in Source 2001 QrBz SAM. The World Bank32004 Afghanistan and Iran in the future, although this requires relatively large investments and a challenging regional policy-malung. 0 Services play a supporting role in Table 1.12: Sources of Growthand Employmentin production, with significant room for Services, 2001 further enhancement. As in other Sharesof VA Share in countries, the service sector in the Kyrgyz Shares of Employment Gross Republic carries an important supporting Activity GDP (%) in total (%) Production role for the productive sectors. As discussed Wholesale and retaail trade 12.3 9.0 47.2 in Chapter 2, services often make up 10-20 Transportation 2.6 3.2 26.7 oiw Roadtransport percent of the production costs and all the 2.3 2.8 16.8 Agriculture service inputs 0.6 1.5 93 2 costs o f trading. The availability of high Mail and communication 1.4 1.4 59.5 quality services lowers transaction costs, Real estate 2.8 1.6 65.1 stimulates trade in goods, and attracts Hotel and restaurants 0.9 I.4 45.0 Lending 0.5 0.8 foreign as well as domestic investors to Maintenanceand repair of cars 0.3 0.2 40.8 engage in production activity. The Kyrgyz Insurance 0.0 0.1 services sector contributes equally to GDP Public administration 5.1 6.0 57.3 and employment (about 33 percent; see Educationand health 4.6 6.9 62.0 Education 3.2 4.7 59.8 Table 1.12). Roughly one-third of the Health 1.4 2.2 64.2 services are associated with public Other public services 0.5 0.7 57,2 administration and social services. Other services 1.0 1.1 38.6 Total 32.6 33.8 41.5 Backbone services such as oiw Backboneservices 7.3 7.0 50.4 telecommunications, transport, financial Source: 2001 K~~ SAM, The World Bank, 2004 services (banking, insurance, securities trading), distribution and business services (legal, accounting, consulting) are, however, fairly underdeveloped (altogether 7 percent of GDP). This stems, in large part, from the present Kyrgyz regulatory environment underpinning these services, which fails to enhance competition, both domestic and competition from international providers (see Chapter 2). If efficiently supported, tourism-as represented by hotels and restaurants accounting for 1 percent o f GDP-seems to be the only source whose growth i s not directly dependent on the demand for domestic production; it has the potential to generate external demand and respond to it. 15 e Trade margins are high, but not entirely due to Table 1.13: Trade Margins as a Share of Total difficult geography. Not only the land- GDP32001 lockedness, but lack o f internal integration of Internationa1 markets penalizes investors by increasing the Sector Total Trade transport and trade margins for producers, both for domestic and foreign markets by as much as 3-14 Agriculture 4.8 0.5 percent o f GDP3' (see Table 1.13 and Chapter 2). Livestock 3.3 0.0 Manufacturing 13.7 4.9 Specific insights from the value chain analysis Mining and minerals 3.4 2.0 suggest that informal internal controls further increase already high cost of trading and hauling powerandwater 0.3 0.1 products across the country. This significantly Source; 2o01Kyrgyz SAM, The Bank,2o04 renders the production o f otherwise lucrative products un-competitive for producers. For instance, extra delivery costs of milk to processors resulting from excessive police checkpoints on the roads (requiring either payments o f bribes or extra travel to avoid checkpoints), increase production cost o f each liter o f milk in the important dairy industry by an average o f 26 percent (35 percent for small farms and 18 for large farms).33 e As is the case for overall Table 1.14: Patterns of Export and Main Trading Partners in 2001 economic activity, there is a fair degree of non-gold Agricultural Mneral Light Heavy Bulbs and Products Fuels water Manufacturing Gdd Manufacturing Glass Power export dispersion in the Russia 612 1 7 0 0 146 0 0 167 428 0 0 Kyrgyz economy, although Kuakhstan 3 2 0 0 70 9 241 0 0 I9 6 5 9 327 only few products have a Uzbelustan 0 2 867 I 7 7 1 2 0 0 III 7 8 640 China 0 1 1 4 0 0 276 0 0 I 4 5 0 0 0 0 strong revealed comparative Rea of the World 352 103 114 325 1000 381 434 3 2 advantage (RCA). The Total Exports 1000 1000 1000 1000 1000 1000 1000 1000 number o f items exported- 'Swrce 2001 K y m z S A M The World Bank 2004 currently at about 130 Includesimportant regional export partners, in particular Tajikistant and other CIS countries i t e m ~ ~ ~ - iand has historically been high, compared to other landlocked countries. However only s 20 exceed the value of US$1 million (equivalent to less than 0.2 percent o f total exports). The top three non-gold export categories are electric current, cotton and tobacco. These are also the commodities with high RCA. Other major exports currently include hideslsluns, metal scrap (aluminum and lead), inorganic chemicals, vegetable and fruits (beans and edible nuts), sugar and some manufactured goods, and machinery and transport equipment (such as filament lamps, motor vehicle parts and semi-trailer tractors, asbestos and rolled glass sheets, and metal tanks).35 Among this later group, the only export item with highRCA is hideslskins, which are exported mainly to China and which appear to have a strong presence in the informal economy-i.e., its productionlexports might be much higher than what the available figures indicate.36 The hidelskins processing line also displays a high inter-sectoral linkage and income multiplier, and, hence, have a potential o f strong growthlpoverty impact, if it were to develop significantly inthe future (see Table 1.15). Nevertheless, as explained in detail inVolume I1o f this Report, this would require, first and 32 Trade margins represent a difference between the commodities valued at consumer prices and the final products valued at producer prices. Trade margins represent only domestic margins but are split between the three types of commodities-goods produced in the Kyrgyz Republic for domestic consumption, for exports, and goods importedaccordingto their respectiveshares in GDP. They take into account within the country trade costs per unit of a commodity and depend on the marketing channels used. While assessingthe total trade marginson exports and imports, the costs incurredoutside the Kyrgyz Republic, which are not partof domestic trade margins, need also to betaken into account. 33 For a detaileddiscussion, see Volume 11, Value Chain Analysis. 34These are exports with value>US$ 100,000 accordingto SITC 4 digit classification. 35 For adetaileddiscussion, see Volume 11, Trade Performance. 36 For further discussion see Volume 11, Value ChainAnalysis. 16 foremost, transforming the growing informal activity in this sector into the formal sector. It will also require addressing constraints to the growth of productive activity, without jeopardizing growth of other important livestock-based supply chains, particularly the wool-another critical product with a high inter-sectoral and income multipliers. The Kyrgyz Republic's most agricultural and manufactured commodities are exported to the larger economies of Russia, China and the surrounding countries of Kazakhstan and Uzbehstan (see Table 1.14). D. IMPLICATIONSOFTHEEXISTINGECONOMIC STRUCTURE FOR GROWTH 1.26 This chapter has so far illustrated that, with the exception of gold, and to a certain extent power, the Kyrgyz economy i s still inthe early stages o f defining its comparative and competitive advantages in the production o f goods and services. This section employs the SAM-based model to explore the implications of the country's existing economic structure for sources of sustainable growth, especially in the context o f diminishing importance o f gold production. First, it sets the context by providing an overview o f inter-sectoral linkages depicted by the model. It then tums to analyses o f much-needed economic-cum-export diversification for sustainability o f growth, and its implications for (i) the growth of the non-gold economy, and (ii) employment creation and poverty reduction. Inter-sectoral Linkages Revealed by SAM-based Model 1.27 The most important advantage o f a SAM-based model i s that it provides useful insights about the input and output relationships that exists between goods and services markets, as well as the inter- linkages between the demand for labor and capital inthe process of prod~ction.~'Thestronger the inter- sectoral linkages are, the larger thepotential for direct and indirect spillovers and growth. As noted earlier, a notable feature of production patterns in the Kyrgyz Republic i s the diversity o f production, which entails broad, even ifnot uniformly strong, backward and forward linkages from agriculture and livestock to ago-processing and manufact~ring.~~Policies that nurture the eflcient use o f the Kyrgyz Republic's natural resources39(arable land, pastures, water and energy) and facilitate increased entry and production intheformal economy can strengthen these linkages. 1.28 The SAM-based model provides a set o f comparable direct and indirect inter-sectoral linkage multipliers, which can be used to understand the relative importance o f each economic activity. They comprise the following: a Value-added in activities: The higher the value added by a factor, labor or capital, the greater the contribution of that activity to GDP and growth. The higher the value added by labor, the greater the remuneration to labor and the stronger the poverty impact o f an activity, ifitsshareinallactivitiesislarge. TheSAMindicatesthatonaverage,valueaddedbylabor inthe Kyrgyz Republic is 51.5 percent and capital 44 percent inGDP. Value added by labor i s the highest in agnculture, livestock and most service activities (70-1 00 percent) reflecting > 37 For instance, the production of grain requires intermediateinputs in the form of grain for seed, irrigation water, agricultural machinery, pesticides, fertilizer, as well as factor inputs such as workers, who may be skilled or unskilled, and capital. Besides making transparent the nature of these linkages, the SAM is also useful in showing patterns of domestic demand (from government and households) as well as demand from the rest of the world for the commodities produced by economic activities. This secondloop links wage and capital incomes to householdincomes, and household, government and the rest of the world's expenditures(throughexports and imports) to the productionof goods and services. 38 Examples includethe value chain from (i) fodder to livestock, and from livestock to dairy, meat and wool, and from wool to woolen textiles; (ii) grain productionto flour milling and from grain to beer and vodka; (iii)fruits to the productionofjuices; and (iv) from cottoncultivationto cottonginning, yam and textiles. 39 See Annex 1-C. 17 the prevalence o f relatively labor-intensive production technology (including the use of informal factors) as well as low intermediate input content. All industrial activities-mining, energy, manufacturing and construction-have a relatively lower value added content associated with labor (30-50 percent). As noted above, the relation between value added by labor and its impact on poverty reduction i s moderated by a sector's contribution to GDP. (see Table 1.15 and Annex 1-D) Table 1.15: S A M Multipliers and Non-Gold Diversification Indicators, 2001 Share of Share o f Export in Value Share o fValue Shareof Total Non- Linkage induced HH Employ Added in Share o f Added in Total Exports in Gold O W with Other Income per million Labor at Name o f Sector GDP("A) Production GDP Export Multiplier Sectors Multipliers SOM f,c. Agriculture Vegetables 3 8 75 0 1 0 4 1.2 2 7 1 3 83 54.0 Cotton 2 5 96 2 3 10 4 1 0 2 7 1 3 103 78.7 Sugar beet 0 2 84 0 1 0 2 1.o 2 8 1 3 93 37.4 Fruits, berries 1 9 91 0 1 0 6 1 . 1 2 6 1 3 101 72 1 Feeding stuff 2 0 81 0 0 0 0 1.1 2 8 1 3 88 53.8 Livestock Meat (live weight) 6 0 29 0 0 0 0 1 6 3 3 1 3 48 41 8 Milk 3 2 29 0 0 0 0 1.3 3 s 1 3 48 38.3 Wool 0 1 41 0 1 0 3 1.o 3 2 1 3 67 17.2 Other animal 0 2 54 0 0 0 0 1.o 3 2 1 3 98 48 4 Mining Coal 0 1 37 0 0 0 1 1.O 0 6 0 2 38 36 2 Crude oil 0 3 50 0 0 0 0 I O 3 5 1 0 36 57.2 Gold ores 9 2 65 0 0 0 0 1.1 2 6 1 2 2 21.2 Manufacturing Light muniifacrirring Cotton value chain 0 4 33 0 1 0 5 1 2 3 4 1 1 42 28.4 olw Cotton fabric 0 1 56 0 0 0 2 1 1 3 9 1 1 40 37.0 Wool value chain 0 1 57 0 0 0 2 1 0 3 6 1 1 40 35.4 Clothing 0 5 59 0 0 0 2 1 1 3 8 I 1 39 48.5 Hides & skins proc. 0 0 17 0 2 0 7 1.o 4 0 1 1 41 32.5 Agroprocessrng Sugar refining 0 2 62 0 1 0 5 1.o 1 8 0 6 40 70.8 Other food proc. 0 8 28 0 2 5 0 1.1 3 0 0 8 42 61.7 Dairy industry 0 5 so 0 1 0 6 1.1 3 9 1 1 39 82 2 Juices, fruits & veg proc. 0 0 18 0 1 0 3 1.o 2 3 0 7 40 72.3 Tobacco proc & products 0 1 17 0 1 0 3 1.4 1 7 0 7 54 12.6 Beverages 0 2 36 0 0 0 2 1.1 2 4 0 8 44 43 3 Mineral water 0 1 59 0 0 0 2 1 0 2 6 0 8 40 60.5 Heuvy monifiacturing Chemical production 0 0 16 1 3 5 7 1.o 0 3 0 1 42 56.7 Rubber and plastic prod. 0 1 16 0 7 3 2 1.o 1 0 0 3 40 55.0 Glass sheets 0 0 15 0 0 0 0 1.o 2 2 0 7 42 54.1 Bulbs 0 4 38 0 8 3 5 1.O 3 4 1 0 40 63.2 Other constiuction mat 0 6 27 0 4 1 9 1.1 2 9 0 9 40 79.1 Metallurgy & metal fab prod 0 2 49 1 4 6 2 1 .o 0 6 0 2 40 73.3 Machinery & equipment 0 7 37 2 6 1 1 4 1.o 1 3 0 4 40 62 7 Oil refining 0 3 18 o s 2 1 1.1 1 4 0 4 40 58.7 Power and water Power 4 6 55 3 0 I 3 4 1.1 2 1 0 9 48 24.4 Water I O 35 0 0 0 0 1.o 2 8 1 0 46 66.2 Services Agricultural services 0 6 93 0 0 0 0 1.o 2 7 1 3 103 67.3 Infrastructure 4 0 39 0 3 1 4 1 0 2 7 I O 38 77.6 Trade 12 3 47 0 0 0 0 1.1 2 8 1 2 52 49.5 Hotels & restaurants 0 9 45 0 9 4 2 1.o 2 2 0 8 51 88.5 Transport 2 6 27 1 3 6 0 1.o 1 9 0 7 47 67.5 Mail & communications 1 4 59 0 7 3 1 1.1 2 2 I O 40 70.1 Financial services 3 3 30 0 1 0 2 1.3 1 9 0 8 46 36.1 Public services 102 60 0 5 2.2 I O 3 0 1 3 51 81.5 Soiircr: 2001 Kyrgyz S A M , The World Bank, 2004 18 0 Various measures of multipliers: Multipliers inthe SAM-based model reflect how mucha unit-increase in the demand and production o f a commodity affects the demand for more commodities. A higher demand for activities, in turn, lead to higher wage incomes, higher profits and, hence, higher household incomes and government taxes, which are, once again, expended either on commodities produced domestically or imported. The multipliers in an activity are small, if the leakagesfrom an economy are large, which may be due to a large proportion of imported inputs, taxes and savings. As noted above, in production, large shares of intermediate inputs lead to low value added (to labor and capital) and, hence, small multipliers. Unlike most multipliersin some other low-income economies, large proportion of multipliersfor the Kyrgyz Republic 's production sectors are larger than 1 (often between 2 and 3). This impliesa fairly tight link between changes inthe demand for a commodity and the magnitude of its impact on other relevant sectors o f the economy. Our analysis focuses on four types of multipliers (see Table 1.15). % Value added direct multipliers-show how much a unit-increase in the demand for a commodity directly affects the demand/production o f the same commodity. 9 Inter-sectorallinkage multipliers-illustrate how much a unit-increase inthe demand for a commodity increasesthe demandhpply of commodities producedby other activities. 9 Induced household income multipliers-show how much a unit-increase in the demand for a commodity affects household income. % Emulovment multipliers-show how many jobs are ultimately created directly or indirectly as a consequence of a unit-increase (1 million Som) in the demand for a commodity. Sectors with high multipliers would have higher growth impact, but the gains from a large multiplier depend on the sector s size. For instance, while the largest inter-sectoral linkage multiplier of 3.9 i s in the dairy industry, its low share in GDP suggests that it presently has muchlower impact on growth andpoverty than it potentially couldhave, ifit were to develop significantly in the future. This would require, as explained in detail in the value chain analysis o f the dairy industry, addressing many constraints to the growth o f productive activities in this sector-including heavy administrative barriers, market failure constraints, severe lack o f scale economies invarious stages of production, weak mechanisms of learning and technology transfer (see Volume I1and Chapter 3). Other similar examples include the wool value chain and light bulb production. Ingeneral, agricultural activities create the most employment if one counts only the number o fjobs per 1 million Som. However, as will be discussedbelow, most o f these are low wage jobs closer to subsistence or informal wages. In contrast, livestock sector, mining, most manufacturing activities and even services generate about 40 to 50 jobs per million Som, but, as the quality o f these jobs are superior; so too i s the skill requirement. Need for Export Diversification for Growth, Employment and Poverty Reduction 1.29 For the Kyrgyz economy, export-led growth i s the only vehicle for the long term, given its small domestic market. With the expected sharp decline in gold production, which i s projected to be halved between 2009-2011, and to be marginalized in another four years (i.e., beyond 2015), the scope for export-led growth will be determinedby the potential o f the non-gold economy and by exports. This section employs the above-described measures to assess the implications o f economic-cum-export diversification interms o f growth, employment creation andpoverty reduction. 19 High Growth Potential 1.30 Economic activities that produce non-gold exports, except the top three traditional exports, i.e., cotton, tobacco, and power, presently account for about 40 percent o f GDP relative to their contribution of about 30 percent to total exports, indicating that an export diversiJicationstrategy has a highpayofffor growth. The growth potential o f these activities i s even more impressive. The value added in the total production o f non-gold exports i s the highest in agricultural commodities at over 75 percent. This share drops in light manufacturing and i s the lowest in heavy manufacturing, as the latter uses a large proportion of raw materials and intermediate inputs. Thepotential for spillovers from growth in any of the non-gold export activities is, however, considerably high in agriculture and livestock products, agro processing and light manufacturing, but lower inheavy manufacturing, as reflectedby highinter-sectoral linkage multipliersinthe range o f 2-4 (see Table 1.15 above and Annex 1-D). 1.31 Section C noted that, despite apparent diversification of non-gold export basket, very few- mostly primary-exports reveal a comparative advantage and even fewer export items show signs of emerging competitiveness in the regional markets (dairy industry and heavy manufacturing provides few example^).^' The present export basket, however, reflects strong backward linkages to country7snatural resource endowment^.^^ As reflected by the presence of supply chains in several sectors, there are also clear forward linkages, especially with respect to agro-processing, and light manufacturing, although these linkages are weak, particularly towards the upper end of the supply chain. A diversified export basket that takes advantage of the presence of these supply chains will facilitate not only the production and export o f raw materials from agriculture (including livestock), and industry, but also higher value added processed and manufactured products from the same supply chains. 1.32 Table 1.15 provides examples to the above-discussed case for export-diversification. For instance, raw cotton i s presently an important export, but cotton yarn, fabric, clothing and other textiles are also exported, albeit with miniscule shares. This signals ample scope for graduating from hitherto low value commodities to higher value-added commodities within the same supply chain, i.e., the scope for moving away from exports of raw cotton to higher value added cloth and fabrics. This could also work as a risk mitigation strategy to protect the cotton sector from terms o f trade and weather shocks. The same goes for wool value chain.42 Another example i s that of high value agncultural products. Industrial surveys and trade data show that crops such as vegetables, fruits and berries, which presently have a relatively high share of GDP, but miniscule share o f non-gold exports, have both significant growth potential-evident from their high value added shares in total production (in the range o f 75- 97 percent)-and export potential especially in fast-growing neighbors Kazakhstan and Russia.43 Existing forward linkages of these commodities to agro processing suggest that if their supply i s sufficiently expanded, they can generate even higher value inthe form o f processed food. The same case studies and surveys, however, also point to a range o f domestic barriers to development o f higher end o f these supply chains, which are beyond the quantitative analysis o f this chapter, but are addressed inother chapters o f this Report (see also Annex 1-D). 1.33 The presence o f an established heavy manufacturing sector i s further likely to aid the goal of higher growth through export diversification, by malung locally available machinery and equipment, packaging/canning and other construction materials required for the expansion o f the agro and light manufacturing sectors. For instance, the availability of glass and other raw materials as well as machinery/machine tools production lines presumably played a role in the increasing production o f light bulbs, which have a share of less than 0.5 percent in GDP but account for 3.5 percent of total non-gold 40See Chapter 2 and Volume 11, Trade PerformanceAnalysis. 4'See Annex 1-C. 42See Volume I,Value Chain Analysis. 43See Chapters2 and 3. 20 exports and are being exported widely across the CIS market as well as to Europe (e.g., Romania). The share o f most heavy manufacturers ranges between 3 4 percent in non-gold exports, altogether accounting for about 35 percent of non-gold export basket (see Annex 1-D). There has only been limited restructuring o f the medium and large industrial enterprises in the sector to date, and o f the remaining structures, not all are likely to be feasible for re~italization.~~ It is important that greater attention i s given to restructuringAiquidating the medium and large sate enterprises. Foreign investment can potentially play a key role here. 1.34 Finally, in the services category, hotels and restaurants, which are largely associated with tourism, account for about 4 percent o f the total non-gold export (goods and services) basket. International experience shows that the growth o f tourism depends critically on the availability o f crucial public inputs such as transport, roads, telecommunications, power and the like. But the spillovers for export growth from the efficient development of these critical public inputs apply more widely to non- service exports as well. This i s confirmed by their high inter-sectoral linkage multipliers (in the order o f 2-3) inTable 1.16. Table 1.16: Critical Inputs of Economy, 2001 Share of Share of Shareof Exports/Total Linkage Induced HH Share of Value Share of GDPKotal Exports/Total Non-Gold with Other Income Employment per Added in Labor Name of Sector GDP (%) Production Exports Exports Sectors Multipliers million SOM a t f c Irrigation water supply 0 2 93 4 0 0 0 0 2 8 1 3 101 8 61 7 Chemicalization service 0 2 88 9 0 0 0 0 2 8 1 3 101 7 60 4 Other agricultural services 0 2 97 2 0 0 0 0 2 7 1 3 IO4 9 79 9 Coal 0 1 36 7 0 1 0 1 0 6 0 2 38 2 36 2 Natural gas 0 0 38 5 0 0 0 0 0 2 0 1 40 0 39 8 Production & distribution of gaseous fuels 0 0 -7 6 0 5 0 9 2 5 0 6 44 6 -210 2 Steam &hot water supply 0 8 40 6 0 0 0 0 2 7 0 9 46 2 46 3 Water intake, treatment, & distribution 0 2 29 0 0.0 0 0 2 9 I O 45 3 86.1 Roads 1 2 39 0 0 0 0 0 2 8 I O 38 3 77.3 Irrigation network 0 1 39 0 0 0 0 0 2 8 I O 38 9 77.4 Wholesale trade 0 9 36 7 0 0 0 0 2 9 1.1 50 6 59.6 Retail trade 11 3 57 7 0 0 0 0 2 6 1.3 53.2 39.5 Operations, maintenance& repair services 0 3 40 8 0 0 0 0 2 7 I O 50 0 52 8 Road transport 0 9 45 0 2 5 4 2 2 2 0 8 50 9 88 5 Rail transport 2 3 47 8 0 3 0 6 2 1 0 8 39 9 91 4 Air transport 0 1 16 8 1 5 2 5 1 1 0 4 48 8 59 1 Auxiliary transport activities 0 1 12 3 1 7 2 9 1 5 0 5 57 1 38 8 Mail& communications 1 4 59 5 1 8 3 1 2 2 I O 40 0 70 1 Public administration 5 1 57 3 1 3 2 2 3 0 1 2 53 6 64 9 Education 3 2 59 8 0 0 0 0 3 0 1 3 52 0 81 9 Health care 1 4 64 2 0 0 0 0 3 0 1 3 51 8 91 2 Social services 0 5 57 2 0 0 0 0 3 0 1 3 47 5 88 2 Other services I O 38 6 2 6 4 3 2 3 0 9 52 9 61 5 Power 4 6 55 5 7 9 13 4 2 1 0 9 48 0 24 4 Source 2001 Kyrgyz SAM, The World Bank, 2004 44 Little enterprise restructuring has taken place, even among privatized firms, presenting one o f the most challenging parts o f economic reform. Some o f the privatized enterprises were restructured or closed, and this led to the massive lay-off and reduced working schedules observed in the early years o f the transition. Other privatized enterprises, however, are still awaiting restructuring or liquidation, despite the presence of new owners and the hoped-for results of their efforts to revive these companies. The number o f industrial enterprises has declined substantially in the earlier years o f transition, but in 2002, the number of industrial enterprises still operating stood at about 56 percent o f its 1991 level (for further discussion see the Bank's Poverty Report). 21 High Employment Creation Potential 1.35 In countries with a significant proportion of the population below the poverty line, the development debate often centers on the choice o f employment potential as the criterion for promoting pro-poor patterns o f growth. The choice o f a development strategy with export diversification at its core presumes that export growth i s the key driver o f quality employment and poverty reduction. Assessing the extent to which this could be realized in the Kyrgyz economy requires understanding better both the nature o f demand for labor (i.e., the relationship between the pattern o f growth, the potential for higher growth and its implications for skills and high-paying employment), and labor supply (i.e., the relationship between the availability o f skills, the types o fjobs they fetch, the associated wages and their implicationfor poverty). 1.36 In the Kyrgyz economy, the demand for labor reflects a direct mapping from high-value production to the quantity of employment. High-value commercial crops such as vegetables and h i t s contribute almost 9 percent of GDP, but as much as 15 percent o f total employment. The corresponding figures for cotton are 2.5 percent of GDP, and 7 percent o f employment. But there is a clear trade-off between the number and quality of jobs created. In general, agricultural activities create the most employment if one counts only the number o f jobs per 1 million Som. Grain, potatoes, and vegetables generate about 80jobs, while nuts and berries generate over 100jobs per million Som. However, as will be discussed below, most of these are low wage jobs closer to subsistence or informal wages, and unlikely to continue to reduce poverty significantly. In contrast, livestock sectors, mining, most manufacturing activities and even services generate about 40 to 50jobs per million Som, but, as the quality of these jobs are superior; so too is their skill requirement (see Table 1.15 andAnnex 1-D). 1.37 Against this background, it should be noted that, reflecting a combination o f the FSU-legacy of high literacy rates and a technically qualified labor force, and the collapse of employment in most productive sectors in the post-independence production in the Kyrgyz economy appears to favor higher skills, even in rural activities, which typically employ unskilled or elementary workers in developing countries. For instance, o f the total value added by labor in the economy, the share contributed by highly and medium skilled workers (all except plant and machine operators and assemblers, elementary laborers and subsistence farmers) exceeds 50 percent in dairy and cattle, poultry, forestry, agriculture, manufacturing and service sectors.46 Similarly, in clothing and textiles, for instance, 30 percent o f the value added comes from less skilled plant and machine operators, and 20 percent from craftsmen and tradesmen (high skilled), while the remainder comes from highly skilled technicians, professionals, managers, supervisors, etc. Subsistence agriculture and informal activities are the only sectors that use mostly less slulled labor. 1.38 The quality of employment is determined by the demandfor occupational skills, supply of skills and the corresponding wages (Table 1.17). In 2001, legslators and senior officials, accounting for 4 percent o f total employment, earned the highest wages. Other high-skilled workers represented professionals and technical employees, earning, on average, less than half of the highest wages and comprising about 16 percent of total employment. Medium-skilled workers, skilled in agricultural production, clerks and servicemen, represented about 64 percent o f all employed. Of these, workers in industryand constructionwere the highestpaid, followed by clerks and other servicemen, while those in 45The labor market experienced large sectoral re-allocation o f labor duringthe initial phase o f transition process. Employment in the most productive sectors has collapsed and there was a shift towards agriculture where labor productivity is the lowest. To a large extent, employment growth in agriculture resulted from the relative improvement inthis sector and from the success o f land redistribution. Employment growth in agriculture has also acted as a safety valve for many o f the unemployed. For further discussion, see Kyrgyz Republic: Enhancing Pro-Poor Growth, World Bank, September 2003. 46 Occupational categories are legislators and senior managers, professionals, technical and associate professionals, clerks, service workers, shop and market salesmen, skilled agriculture and fishery workers, craft and related trade workers, plant and machine operators and assemblers, elementary laborers and subsistence farmers. 22 agriculture earned on average the lowest wages. Clearly, compared to the rural sectors, medium skills in industry, manufacturing and services fetched higher wages. The remaining 16 percent of the employed labor force was low-skilled and engagedmostly inelementary occupations, including subsistence farming or informalactivity. Table 1.17: RelationshipBetweenOccupationalSkills, Employment,andIncomefrom Labor Wages Share of Employment (value in wages in Average as a share of mln.Som) GDP wage" Employment ' total (%) High Skill 11,313 15.8 419,132 19.9 Legislators, senior officials & managers 4,649 6.5 41,148 82,892 3.9 Professionals 3,803 5.3 19,764 183,724 8.7 Technical & associateprofessionals 2,861 4.0 18,096 152,s 15 7.2 MediumSkill 19,550 27.3 1,347,046 63.8 Clerks 626 0.9 14,916 39,755 1.9 Service workers, shop & market sales workers 6,704 9.4 18,816 335,518 15.9 Skilled agriculture & fishery workers 7,47 1 10.4 9,348 799,183 37.9 Skilled industry, construction, transport2' 4,749 6.6 25,176 172,589 8.2 Low Skill 6,031 8.4 343,551 16.3 Plant & machine operators & assemblers 3,580 5.0 24,708 144,905 6.9 Elementary occupations 2,450 3.4 12,336 198,646 9.4 Source; 2001 Kyrgyz SAM, the World Bank, 2004 andNational Statistical Office. Note: " Excludes gold-mining, 21Includes communication, geology, and craft workers. 1.39 As noted above, higher skills, especially professionaland technical, were remunerated more than low-level skills; butfor the same level of skill, employment in manufacturing, industiy, government and services, paidfar more than employment in the agricultural sectors. Hence, the prevailing concentration of employment (53 percent of the jobs) and poverty in the latter has a direct and compelling implication for growth: not only is higher growth essentialfor higher incomes, but economic diversiJication towards high-valueproduction in manufacturing and services is the only way to create relatively higher wagejobs and hence to achieve a higher poverty reduction. 1.40 In sum, insights from the S A M suggests that, first, an export diversijkation strategy that will strengthen the non-gold economy will also have-a positive impact on employment creation, but with a trade-ofl As noted above primary agricultural and livestock exports inprinciple generate relatively more but low-wage jobs when compared to processed agricultural exports, and to manufacturing, which generate relatively fewer, but high-wage jobs, absorbing medium and high-skilled workers. Hence, the higher the transition of exports from raw material to manufacturedproducts within a supply chain, the larger the demandfor and contribution to better quality employment creation (see Table 1.15 and Annex 1-D). 1.41 Second, the diversification of exports away from gold will affect poverty differentially. Two factors matter. First, as described inBox 1.2 below, household incomes are comprised almost equally o f wages and profits?' Growth of export commodities that generateprimarily low-wagejobs (such as those created by the production of primary agricultural and livestock products) will reduce poverty less compared to export of commodities that employ medium and high skilled workers, who earn higher wages (such as in manufacturing). Second, exports of commodities that generate a relatively high share of value added by labor are likely to be more pro-poor, provided their share in GDP is also high. For 47See Annex I-Bfor moredetailed presentation. 23 instance, most agricultural activities and light manufacturers, as opposed to some heavy manufacturers, account for relatively larger share in GDP and display higher induced household income multipliers than the latter (see Table 1.15 and Annex 1-D). Box 1.2: From Growth to Household Incomes-A Closer Look Of the total national income, wage income accounts for approximately 51 percent, profits 44 percent-these accrue to capital owners in domestic and foreign firms as well as government-owned enterprises-the share of income earnedby labor is slightly higher than official statistics, as it has been adjusted to include income from subsistence agriculture. Of this total, which accounts for approximately 90 percent o f GDP: about 74 percent accrues to rich households while the poor households getting about 26 percent. This picture suggeststhat (i) higher growth has a direct and positive impact on householdincomes, as at least 90 percent of it flows to households; (ii) both capital and labor-intensiveactivities increase householdincomes; and (iii)rich and poor householdsdo not benefituniformly. Broad Distribution of Household Income, 2001 Value Share (YO)oftotal income Rich households 48,198 74.3 Poor Households 16,642 25.7 Total householdincome 64,840 100.0 Source:2001 Kyrgyz SAM, World Bank2004 The distribution of household income is not only uneven between rich and poor householdsbut it also reflects sharp inter-oblast disparities: About 87 percent of total householdincomeis concentratedin four oblasts (Bishkek, Jalal-Abad, Osh and Chui), and within them, in rich households (see Annex 1-B for details). This is explained, to a large extent, by the concentration of occupational skills. For instance, the bulk of labor income in Bishkek households is associated with relatively high wage employment across all occupational skills, except median skilled agriculturaljobs and elementary occupations, both of which fetch wages below the poverty line. Incontrast, in the poorest oblast, Talas, the bulk of wage income is generatedby the lowest paying occupations. The economic implications o f this distribution are clear. Faster poverty reduction in the poorest oblasts requires economic diversijkation towards high-value agricultural and livestock production and development of high-value manufacturing and services in the countiy, i.e., towards activities that pay higher wages. But thesejoint growth-diversification and poverty-reduction objectives also require more and better skilled workers, reinforcing the positive policy implications oj increased efforts towards the accumulation of human capital (see Chapter 3). E. GROWTH OUTLOOK-MEDIUM TERMVERSUSLONG-TERM CHALLENGES 1.42 The expected decline in the contribution o f gold production to the Kyrgyz economy, starting around 2009, suggests contrasting prospects for growth inthe medium term (2004-2008) vs. the longterm (2009 onwards). Inthe mediumterm, favorable gold prices along with a planned start-up of extraction in a new gold mine are expected to keep production around the 2003 level. In the long term, on the other hand, expected depletion of gold reserves i s projected to halve the gold production compared to its 2003 level. This will have implications in terms o f long-term growth prospects, as witnessed by the growth- dampening impact of a temporary decline in gold production in 2002, a question, which this section explores. The section first considers the suitability o f the SAM-based model for this exercise by examining its ability to predict the recent past. It will then turn to the analysis of the impact o f a decline in gold production starting around 2009. It will conclude by exploring the basic elements of a growth strategy to keep the economy growing inthe post-goldshock era. GrowthAccountingand Simulationfor 2002 1.43 Growth accounting simulations in Table 1.18 show that the SAM-based model performs reasonably well in accounting for growth patterns in 2002, when the non-gold GDP grew at about 3.6 percent, but gold production was depressed duringpart of the year due to a landslide inthe country's main gold mine (Kumtor). The non-gold industry also grew more slowly in 2002, as demand for power exports was depressed because o f abundant rainfall in neighboring countries, which import power from 24 the Kyrgyz Republic. Overall, GDP growth was zero as the dampening effects of the shocks in gold and energy were offset by modest growth in non-gold production. Table 1.18, shows (i) the impact of the temporary gold shock to the economy in 2002 (Scenario 1); (ii)cumulative impact of key non-gold sectors to the growth in 2002 (Scenarios 2-5); and (iii)overall economic growth driven by the actual performance o f gold and non-gold sectors o f the economy in2002 (Scenario 6). Table 1.18: Growth Accounting for 2002: Negative Shock in Gold and Energy and Normal Growth in the Other Sectors CumulativeEffectsof Sectoral GrowthPattersnin2002 Actual 11% Fall in 3% 7yo 4% Economy 20% Gold Power Agricultural Manufacturing Services Other SAM Indicators Scenarios in 2001 Shock Production Growth Growth Growth for 2002 1 2 3 4 5 6 Share of Contribution Share of GDP at to Growth GDP at f.c. GDP Growth (%) f.c. (%I Total GDP 100 -4.6 -6.1 -5.5 -2.9 0.0 100.0 0.0 Gold mining & refining 11.5 -20.3 -20.3 -20.3 -20.3 -20.3 9.2 -2.3 Agriculture 37 -2.8 -3.7 -2.4 0.6 2.9 38.1 1.1 Power & fuels 6.2 -2.9 -15.7 -15.4 -13 -10.9 5.5 -0.7 Manufaturing 6.5 -3.2 -4.2 -3.8 5.0 7.2 6.9 0.5 Construction 4.8 -0.5 -0.7 -0.6 0.8 1.4 4.8 0.1 Services 34.1 -2.5 -3.3 -3.0 -1.1 4.1 35.5 1.4 Estimated incremental effects of sectoral growth rates in 2002 Mln. Soms % YO YO Total HH income 64,840 1.3 1.7 2.0 Rich HH 48,198 1.3 1.7 2.0 1.44 The table indicates that a decline on the scale o f the decline in the gold production in 2002 (20 percent), depresses the overall growth significantly (by about 4.6 percent), including through its spillover effects on the rest of the economy, which are highest in the industry.48Clearly, the lower demand for power exports in 2002 exacerbated the negative impact o f the gold production on industry, further dampening its growth significantly. Other sectors ofthe economy grewbybetweenover 1percent (construction) to over 7 percent (manufacturing), bringingthe overall growth o f the non-gold economy to over 3.5 percent. The marginal contribution to growth from the non-gold sectoral sources was above 1percent each, from agnculture and services, and 0.5 percent from manufacturing. All in all, the growth accounting exercise confirms that, when actual 2002 growth performance o f the economy i s replicated, simulationresults from the SAM-based model (Scenario 6) are similar to the official estimates. 1.45 Nevertheless, the crux o f this analysis lies inunderstanding how each source of growth affects the overall growth potential of the economy, rather than how much it contributed to growth in 2002, a year for which official estimates are available. For instance, as the contribution o f gross production to GDP i s the highest in agricultural activities (60-100 percent), and the sector has a large share in GDP (about 35 percent), it stimulated the growth significantly, both directly and through its forward linkages with the other sectors of the economy. With its higher induced household income multipliers than most other sectors, its poverty impact was also significant, despite its relatively low growth performance in 2002. This is reflected by changes in household incomes, which grew overall by about 1.3 percent, and were pro-poor, favoring poor households, whose incomes grew more than those o f rich households. High 48 Itshould benotedthat marginaldemand shocks to each sector have spillovers for all other sectors inthe economy. 25 growth rates in manufacturing and services contributed both to growth and poverty reduction in 2002; their transmission'mechanismswere different from those inagnculturalproduction. Growth Prospectsin Mediumto LongTerm 1.46 The 2002 growth accounting exercise presented above i s also helpful in demonstrating expected growth trends inthe medium term, when gold production i s projectedto remain fairly strong-n average at around its 2003 level-according to the official estimates. While the Kumtor gold mine, the leading gold producer, enters into a diminishingproduction track in the medium term, the expected start-up o f extraction inanother, smaller mine (Jerui) in2005 accounts for overall favorable outlook. Another factor i s the optimism related with higher gold prices, which are expected to hold in the medium term. Barring any major or prolonged external shocks, how much economic growth is to be expected in the medium term depends on the realization o fthese projections as well as the strength o f the non-gold economy. 1.47 Ifthe non-goldeconomy maintainsits last five year's averagegrowthrate ofabout 4 percent, and the authorities' goldprojectionshold then the overall economy i s likely to experience growth rates of over 4 percent. The inter-sectoral linkages and transmission mechanism, which inrecent years enabled modest economic growth to filter down to households through higher incomes, are also likely to prevail in the mediumterm. Stronger growth in the non-gold economy, driven by shift towards higher value added production, would clearly bring higher overall GDP growth in the mediumterm. But, more importantly, such a shift will be instrumental in preparing the economy for facing the difficult challenge o f maintaining modest growthrates inthe post-goldperiod. 1.48 The SAM-based model results inTable 1.19 above is illustrative of the economy, when it is hit, on average, by 50 percent decline in gold production over the long term. The present gold production projections suggest that this scale of decline is likely to be realized during 2009-2011, with the extraction in the country's main gold-mine (Kumtor) is largely terminating by 2010.49 The simulation results suggest that the likely growth-dampening impact o f this decline on the economy i s substantial (on average about 11percent) eroding household incomes by similar magnitude (Scenario 1). The main driver behind this dismal growth outcome will be the non-gold economy in which agriculture, industry and manufacturing and services are all likely to decline (on average by about 7-9 percent). The dismal performance o f the non-gold economy will ensue partially from depressed direct demand for key industrial and service activities such as energy, fuels and water that are inputs into mining and refining, machinery and equipment, as well as transport, construction, and other general services. The spillovers from these would occur economy wide. The decline in incomes will result both from reduction in incomes generated inthe mining-sector, which are significantly higherthan the average income inthe rest of the economy, as well as from any job and profit losses in other sectors-altogether hurting richer households slightly more than the poor. The shrinking household incomes would, in turn, depress the demand for commodities and services produced domestically, causing second and third round multiplier effect to wave through the economy, exacerbating the effect of the original shock. 49 The other smaller mine, in which the extraction activity is expected to start in 2005, is likely to operate through 2015, but with a much lower scale of production compared to Kumtor. 26 Table 1.19: Implications of Gold-Shock for the Kyrgyz Economy An Illustration - 50% Decline 2% Post-Gold inGold Shock Ex-Post Shock Scenarios Economy in2001 Production Recovery Economy Share of GDP at Share of GDP at f.c. Scenario 1 Scenario 2 f.c. Total GDP 100.0 -11.8 2.0 100.0 Gold mining & refining 11.5 -49.9 -49.8 5.6 Agriculture 37.0 -7.2 12.1 40.6 Power & fuels 6.2 -9.1 6.3 6.5 Manufaturing 6.5 -8.2 10.9 7.0 Construction 4.8 -1.2 5.4 4.9 Services 34.1 -6.7 5.7 35.3 Employment No. employed Growth inemployment (%) No. employed 2.109.729 -5.5 6.8 2.253.44 1 Household Income Mln.Som Growth inHHincome(%) Mln.Som Rich HHs 48,198 -10.6 1.8 49,086 Poor H H s 16,642 -9.1 3.9 17,286 Total HHincome 64,840 -10 2 66373 Pre-requisites Mln.Som Growth ininputsneeded(%) Mln.Som Agricultural inputs 489 -7.7 8.2 529 Power and other fuels 8,592 -11.6 7.8 9,262 Transport 4,773 -8.8 7.7 5,14 1 Other services 20,522 -4.3 7.1 21,972 No. of skilled No. of skilled Skills required workers employed Growth in skills needed(%) workers required High 419,132 -2.2 0.1 422,990 Medium 1,347,046 -6.0 7.5 1,447,989 Low 343,551 -7.6 11.3 382,462 Source: 2001 Kyrgyz SAM, The World Bank, 2004 Towards Non-GoldEconomic-cum-Export Diversification Strategy in Long Term 1.49 The above picture shows that successful diversification o f the Kyrgyz non-gold economy i s likely to be critical to maintaining a reasonable growth momentum in the mediumto long-term. It also shows that there are neither easy solutions, nor quick fixes in this endeavor. As earlier sections o f this chapter indicated, the Kyrgyz economy presently has a fairly dispersed but relatively small non-gold productiodexport basket, if the activities with tangible contribution are counted. With the exception o f few traditional commodities and power, this basket does not reveal comparative advantage in any particular commodity. However, it does suggest natural comparative advantage through its linkages to the country's natural and other economic resources as well as human capital. The challenge for policymakers is not to try "pick winners" that fit this profile, but to provide the general policy and institutional underpinnings for faster development o f formal private sector activities in the Kyrgyz Republic, which (i) into higher value elements o f this basket that can create high wage employment; tap and (ii) meet the scale and quality requirements of regional demand. 27 1S O This calls for greater effortsto facilitate development of: 9 processingandmanufacturingvaluechains; P efficient supplyofcritical inputssuchas energy andinfrastructure; P tourism-a small industry compared to favorable environment providing considerable potential-development o f which require much better capacity inbackbone services as does the other sectors; and P humancapitalthroughbetter andhighereducation andskills training. 1.51 Clearly, progress on these fi-onts will place considerable demand on policy-makers administrative and decision-making capacity, an issue that is vital for successful diversification, but which cannot be made explicit in the SAM-based model. It is, however, a subject matter of the next two chapters. The intention in this chapter i s highlighting important underlying elements o f an export-led development strategy, rather than providing a fully detailedreformblueprint. Yet an important point to be emphasized i s that the measures needed to strengthen the domestic private sector are congruent with those measures that will make the Kyrgyz Republic a more favorable destination for foreign investment for exports to regional markets andbeyond. 1.52 The modeling approach of this section takes as its starting point Table 1.19, which displays the results o f a 50 percent negative gold shock. Simulations seek a supply ignition in various productive sectors consistent with both productiodexport diversification and poverty reduction along the lines emphasized thus far. They are also aimed at demonstrating what it takes to keep the economy on a growing path, even ifmodest. The results (Scenario 2) suggest the following three-prong approach: 0 First, a relatively rapid development of manufacturing combined with high growth in agriculture. The underlyingelements o f this shift are diversifying away from traditional grain and potato crops towards high-value commercial products. The growth rates suggested by the simulations are high; but the existing base o f activities inagriculture and manufacturing i s presently miniscule, suggesting that the simulated growth performance i s attainable. This is, however, unlikely to happen without policy-response to range o f factors hindering investments in these sectors as well as measures to propel technological change, which alone can raise prod~ctivity.~'Finally, there is a need to adopt an efficient strategy to support the production o f critical inputs that can facilitate the growth o f agriculture sector at simulated high rates. Sans these efforts, the country's limited arable land will act as a binding constraint. 0 Second, concerted efforts at expanding the supply o f critical industrial activities, such as hydro-energy. Insights from the model show that without expansion in supply o f particularly the energy, diversification in the remainder o f the non-gold economy will be difficult to achieve. This will firstly require a faster progress in the ongoing energy reforms, which are critical to efficient operation and financial viability o f the sector; secondly consideration o f whether necessaryhigher growth rates can be supported by existing investments inthe sector and, if not, what should be the medium-term strategy to allow for adequate investments and gestation lags. Given the fact that hydro-energy i s not just a critical input for production in the country, but it is also one o f the few leading exports, any energy sector reform strategy should also have a vision o f how to capitalize on future demand in existing markets as well potential ones. These issues are discussed in a forthcoming World Bank Study on "Central Asia: Regional Electricity Export Potential." The objective o f analysis in this Report is to 50 For detaileddiscussion on these aspects see Chapter 3 andVolume 11, Value ChainAnalysis. 28 highlight the critical importance o f energy sector in facing the growth challenges over the medium to long term. 0 Third, support for development o f services as they play an important facilitating role for the productive sectors. This includes both publicly provided services such as education and health, and strategic support for increasing the enterprises' "learning rate"-which will be critical to maintain the regular supply o f skilled workers-as well as the development o f transport, telecommunications and other critical backbone services-which can rapidly become hurdles to private sector growth at the required scale. As revealed by the earlier discussion, the prevalence o f relatively high domestic trade margins suggests that an efficient transport policy i s a necessary ingredient for successful diversification strategy. Most importantly, availability o f critical agricultural inputs (such as fertilizers, chemicals, machinery and equipment, irrigation, etc.) i s essential to scaling-up high-value crops and livestock activities. Last but not least, tourism exports will needto be facilitated boththrough a stronger services sector and an investment-friendly environment. 1.53 Simulations highlight that the diversification strategy has a highpayoff for employment creation. It i s also pro-poor, with incomes o f poor households growing at rates twice as high as incomes o f rich households. Summary 1.54 In sum insights from the S A M based model in this chapter confirm that Kyrgyz policymakers have limited options in the growth agenda. The prospects for higher and productive investments, and growth will be enhanced through growth o f high-value commodities. This, in tum, among other things, depends on growth and diversification o f non-gold exports, given that gold is increasingly becoming a temporary export. The prospects for highwage employment, as a source o fpro-poor growth, hinge on the same factors. Success on these fronts will be determined by the ability o f the Kyrgyz economy to capitalize much more actively on opportunities created by strong growth in import demand in its critical trade partners as well as in other markets. As will be discussed in the next two chapters, this, in turn, requires dealing proactively with a range o f domestic and external trade policy barriers and factors that hinder development of enterprise capability and productivity. The above analysis highlights the critical importance o f fast and smooth progress inthis endeavor to keep the economy on a growingpath. 29 CHAPTER2. EXTERNALAND DOMESTICTRADE BARRIERSTO INTEGRATION: `WTO RULESAND BEYOND'AS VEHICLE OF KYRGYZREGIONALAND GLOBALINTEGRATION 2.1 The Kyrgyz Republic is widely considered to have adopted the most liberal trade and investment policies among the member countries of Commonwealth of Independent States (CIS). It was the first to adopt a convertible currency, it abolished the state monopoly on international trade and investment early in the transition, and it was the first to join the World Trade Organization (WTO). Yet, the puzzle remains that, despite these open policies, the Kyrgyz economy has not achieved greater integration into the world economy. 2.2 What explains this apparent gap betweenpolicies and outcomes? What can policy-makers do to close thegap? Whereshould the government devote its commercial diplomacy? Inan attempt to respond these questions, this Chapter o f the report briefly describes the current situation and identifies the main policy problems that trade policy can solve. Section A provides an overview o f the trade regime, highlights developments in foreign trade and identifies obstacles to integration that are rooted in government policies, whether foreign or domestic. Opportunities for addressing these at the multilateral level are presented in SectionB. The report then discusses the regional dimensions o f the trade regime in Section C, focusing on options for using the Eurasian Economic Community (EURASEC) to increase integration into the world e~onomy.'~Finally, Section D outlines elements o f a strategy, using WTO- membership to bind regional and domestic prongs, as well as institutional changes to improve effectiveness inconducting external commercial diplomacy. A. TRADE REGIMEASSESSMENT A SNAPSHOT AND PICTUREOFDEVELOPMENTS INTRADE 2.3 Incontrast to other Central Asian countries, the Kyrgyz Republic haspursued atwo-track policy of simultaneous regional and multilateral liberalization. As for the latter, itbegan accession process to the WTO in February 1996 and became a WTO member on 20 December 1998. Kyrgyz Republic remains the only WTO member among its Central Asian neighbors. Likewise, not a single major trading partner among CIS countries i s a WTO member,'* which has, as will be discussed in below sections, important implications for the Kyrgyz Republic's foreign economic policy. 2.4 The creation o f the CIS was part o f a broader package o f agreements and arrangements to ensure a smooth and conflict-free break up of the Soviet Union, on the one hand, and subsequent economic cooperation, on the ~ther.'~ While the Kyrgyz Republic's decision to accede to the WTO was conceived as a component of the government's effort to establish a viable market economy, the mixture o f political and economic considerations have driven its pursuit o f regional integration within the CIS framework. Today, it i s tied into CIS through a complex architecture o f agreements, including both a network o f bilateral free trade agreements (FTAs) and a regional integration agreement, the EURASEC. The latter is 5`EURASECmembersinclude Belarus, Kazakhstan, the Kyrgyz Republic, the Russian Federation, and Tajikistan. Moldovaand Ukrainepresentlyhaveobserver status. 52Trade with other CIS countriesthat are WTO members-Armenia, Georgiaand Moldova-has been minuscule. 53M.Brill Olcott, A. Aslund, and Sh. W. Gamett, 1999, Getting It Wrong.Regional Cooperationand the Commonwealth of IndependentStates, CamegieEndowmentfor InternationalPeace, Washington, D.C. 30 the most prominent among the CIS arrangements and, as discussed in Section 111, important for the Kyrgyz Republic for the following reasons. First, EURASEC envisages deeper integration than other CIS arrangements. Second, the EURASEC members are the Kyrgyz Republic's major trading partners. Third, Kyrgyz exports and imports usingland transport from the EU and Central Europe transit through EURASEC members' t e r r i t ~ r i e s .Fourth, its immediate neighbors, except China and Uzbekistan, are ~ ~ EURASEC members. 2.5 A s noted above, the Kyrgyz Republic i s a WTO member surrounded by countries that are not WTO members, with the exception o f China since late 2001. By the same token, it does not benefit from the degree o f protection (i.e., rule o f law) that WTO disciplines might help to impose when Kyrgyz firms are conducting trade or transiting their goods through neighboring countries. Likewise, neighboring countries do not bring the WTO rules to bear on trade policies o f the Kyrgyz government and ways that firms conduct their business, thus reducing pressures that could have been otherwise effective in achieving higher standards in economic governance and lower transaction costs. Last but not least, even had all CIS members been WTO members, only a portion o f Kyrgyz trade would have fallen under the WTO rules, simply because the WTO does not have any disciplines on trade inKyrgyz major exports- electricity and water. 2.6 Inconsequence, the Kyrgyz Republic operates in a dual trade policy environment, i.e., regional and multilateral, although the two are neither mutually exclusive nor fully overlapping, albeit the fundamental difference is that the latter is fully rule-based, whereas the former i s yet to fully move in that direction. Policies and Outcomes-An overview 2.7 The Kyrgyz Republic has a formally liberal trade regime. In 1994 the government abolished the state monopoly on international trade, introduced a low and uniform tariff schedule, and adopted policies eliminating restrictions on foreign direct i n ~ e s t m e n t .By~virtue o f its preferential trade agreements with ~ other CIS countries, it imposes no customs duties or quantitative restrictions on imports from those countries-amounting to approximately half the country's total imports. Its nondiscriminatory tariff rates-also called the "most favored nation" (MFN) duties-are relatively low compared to countries at similar levels o f development and, perhaps more importantly, compared to the MFN rates imposed by other countries inthe region. Incomparison to the other EURASEC members (excluding Kazakhstan for which no recent tariff data were reported to UNagencies), its structure of tariffs i s the least distortionary (see Table 2.1). Moreover, the share o f specific tariffs, usually hiding high levels o f protection, i s remarkably low and all tariffs are "WTO bound."56 2.8 Furthermore, the Kyrgyz Republic's WTO membership includes extensive commitments made under the General Agreement on Trade in Services (GATS) to maintain open borders to cross-border trade and foreign investment in services. Virtually all sectors are included in its schedule o f commitments, covering liberalization in all modes o f delivery o f services. In most sectors there are no limits on foreigners' share o f equity. These policies are also "bound," i.e., irreversible inmost cases. A Liberal L a w on Foreign Investment implements WTOIGATS commitments allowing for commercial 54 Itis estimatedthat transit costs in developingcountriesare normally 2-4 times those in developed countries. But, in fact, as we will discuss laterthat maybe even higherfor Kyrgyz traders. 55 See Kyrgyz RepublicExternal TradePolicy. Report No. 12410-KG. 1994, World Bank, Washington, DC, for details on the pre- reform regimeand abrief summary o fthe reforms. 56 That is, if appliedtariff rates are raised above bound levels, an affected WTO-member country may seek compensation. The Kyrgyz Republic's `bounds' are at low levelsby the standardsof even moredevelopedeconomies. 31 presence o f foreign firms to provide services (e.g., establishing bank branches) and for the presence of natural persons (temporary labor mobility). Table 2.1: CIS Countries' MFNTariff Schedules, 2001-2002 Weighted Coefficient o f Share o f duty free Share o f specific Country Year Simple Average Average Variation tariff lines (x) tariffs (%) Armenia 2001 3.0 2.2 154 70 0 Azerbaijan 2002 8.7 6.2 75 1 8 Belarus 2002 11.0 8.8 55 0 I Georgia I999 10.6 10.1 27 0 0 Kyrgyz Republic 2002 5.4 90 42 I Moldova 2001 4.9 2.8 110 46 1 Russian Federation 2002 9.8 50 0 19 Tajikistan 2002 8.3 7.0 68 I 2 Turkmenistan 2002 5.1 2.9 326 80 2 Ukraine 2002 7.0 3.9 1I O 16 16 Uzbekistan 2001 11.0 6.1 106 40 0 Note: Coefficient o f variation is a measure o f tariff dispersion as a percentage o f the average tariff. Lower values reflect smaller distortions. Sources: Tariff schedules of Kyrgyz Republic and Russia were obtained from official data; other calculations are based on tariff and trade data reported by those govemments to UN agencies. Kazakhstan has not reported its recent tariff schedule. 2.9 Nevertheless, GATS/WTO commitments, as important as they are to avoid policy reversals, do not automatically assure the existence o f regulatory environment supporting efficient provision of services, such as transport, financial, telecommunications, distribution, and business ~ervices.~' In fact, the regulatory environment inthe Kyrgyz Republic falls well short of creating a business climate friendly to domestic and foreign investors alike. This i s despite the fact that some o f its important ingredients represent good practice. For instance, the Law on Foreign Investments i s liberal allowing for the commercial presence of foreign firms inboth industries and services. So are conditions for business start- ups, which appear to be the best not only among Central Asian countries, but also among CIS economies according to the findings o f a recent survey covering 110 c~untries.~'But conditions o f entry matter little ifthe entrance does not leadto operation ina sound environment. As Chapter 3 ofthis Report suggests, the Kyrgyz business climate remains far from conducive to private economic activity. 2.10 Reflecting in part these homemade policy barriers, the Kyrgyz Republic's integration into the world economy remains less than expected, despite its liberal regime of foreign trade and investment. As shown inTable 2.2 below, which contrasts various measures of international economic integration across CIS countries, the Kyrgyz Republic ranks in the middle of the CIS comparators, when integration is measured as the share o f merchandise trade in output. It ranks at the bottom interms o f services and FDI flows. On both the export and import side, the levels achieved in 2003 in terms o f the GDP were well below those in 1999-2000, andboth declined in2003 over 2002. 2.11 Developments in Kyrgyz foreign trade have displayed features common to other CIS countries: there have been similar changes in composition, direction o f trade and dynamics following the collapse o f 57 These are crucial to trade in both goods and services. In contrast to the former, the latter are non-storable involving flows o f people, capital, information and intellectual property rights between different jurisdictions. Poor quality o f backbone services acts as a deterrent to investment and trade in goods. Increasing their efficiency offers huge payoffs in terms o f greater product differentiation, lower prices and higher quality 58 See S. Djankov, R. La Porta, F. Lopez-de-Silanes, and A. Shleifer, 2000, The Regulation of Entv," Working Paper 7892, National Bureau o f Economic Research, Cambridge, Mass., September, and the 2002 update published in the World Bank website Doing Business. 32 central planning. As in other CIS exporters o f non-renewable natural resources, Kyrgyz export basket, especially CIS-oriented, shifted away from manufactures towards agricultural and industrial raw materials. Table 2.2: C I S Countries' Exposure to the InternationalEconomy, 2000-2002 Goods trade as share of Goodstrade as share Services flows as shareof Net FDIinflowsas Country goods GDP, 2000" of GDP, 2002 GDP, 2002 share of GDP, 2002 Armenia nld 59 17 4 Azerbaijan 92 68 27 17 Belarus 216 126 13 2 Georgia 32 31 17 4 Kazakhstan 78 72 21 9 Kyrgyz Republic 77 66 18 0.3 Moldova 177 104 28 7 Russian Federation 112 47 11 0.1 Tajikistan 291 127 14 3 Turkmenistan 77 83 35 3 Ukraine 154 88 20 2 Uzbekistan 72 55 nld 0.8 *I998 for Turkmenistan. Note: Services trade was only about 5 percent o f GDP in2001 inthe Kyrgyz Republic, with the increase in 2002 largely reflecting re-exports to US military base. Source; World Development Indicators 2003. All statistics are measured in U.S. dollars. 2.12 Similarly, the share o f CIS trade inits total trade has been on the decline. Incontrast to other CIS economies, except Belarus and Uzbekistan, exports and imports of goods did not recover by 2002 to their 1997 levels. In2002, exports, in terms of value, were 7 percent and imports were 15 percent below their respective peak values in 1997. The irony i s that, in contrast to the Kyrgyz Republic, both Belarus and Uzbekistan have the least reformed economic regimes among CIS countries. Table 2.3: Gross Domestic Product, Foreign Direct Investment, Exports and Imports of Goods ,andServices in 1996-2003 1996 1997 1998 1999 2000 2001 2002 2003 (in million of current US dollars) Gross Domestic Product 1,828 1,768 1,646 1,249 1,370 1,525 1,606 1,909 Foreign Direct Investment 47 83 87 38 -7 -1 5 20 Exports of goods and services 562 676 598 528 573 561 637 732 Imports o f goods and services 1,032 817 931 706 656 566 698 806 (in percentof GDP) Exports of goods and services 31 38 36 42 42 37 40 39 Imports o f goods and services 56 46 57 57 48 37 43 42 Foreign Direct Investment 2.7 2.5 5.3 3.1 -0.5 -0.1 0.3 1.O Source: Staff calculations based on the official data. Note: I/Net inflow o f investment to acquire a lasting management interest ( I O percent or more) in an enterprise operating in an economy other than that o f the investor (IFS 78bd). 2.13 Had it not been for exports of gold, which began in 1997, the contraction in total exports would have been enormous (Figure 2.1). In 1997, exports of gold accounted for 27 percent o f total exports o f goods and services, with their share growing in subsequent years to reach 40 percent in 2001. Yet, despite a 28 percent decline in the value o f gold exports in 2002 (their share fell to 26 percent o f the 33 total exports of goods and services, driven by non-gold components, increased by 12 percent in terms o f value. 2.14 The driving force behind this strong increase in non-gold exports was, in turn, an almost two-fold 2.1: Exports of Goods and Services with increase in the value of total non-CIS exports of andw/out Goldin 1995-2003 (in million of us$) services and goods in 2002-which were otherwise ~ v stagnant during 1995-2001. This i s explained mainly by re-exports to the Coalition of InternationalMilitary Base present in the Kyrgyz Republic since 2001. For ::4oo, instance, the share of the U S in total exports o f goods ; 1 Z 3oo I soared from 1.5 percent in2001 to 7.7 percent in2002. I Exports o f petroleum oils alone (or re-exports, IC 0-- .___ although they are not classified as such in official 1995 1996 1997 1998 1999 2000 2001 2002 2W3 statistic) amounted to US$35.3 million or 27 percent -X-Export o f the total increase in the value of total exports in of goods and services -Exports of goods gold excluded 2002 over 2001.60 - - .. CIS onented exports Non-CIS orientedexports goldexcluded 2.15 The Kyrgyz Republic has yet to take ! advantage o f a strong growth in import demand o f its Source: World Bank Staff calculations based on the EURASEC neighbors, Kazakhstan and Russia, which official data. 2.16 Table 2.4 sheds light on this observation, although one must readbehindthe figures. Inthe post- Russian crisis period 1999-2002, the value of Kazakh and Russian total imports increased 50 and 70 percent, respectively, indicating strong import growth. The major beneficiaries o f this growth were not other CIS economies, albeit with some exceptions. CIS countries slightly increased (1 percentage point) their presence in Kazakhstan, but they lost their share in much larger total Russian imports (5 percentagepoints). Armenia and Georgia were among top CIS performers inbothKazakh and Russian markets-the value of their sales inKazakhstan increased 151percent and 164percent, respectively, and inRussianmarkets 105percent and27 percent.6' Ukraine saw its sales almost triplinginKazakhstanand recorded a 28 percent increase in Russian markets. Kazakhstan was the most dynamic exporter among Central Asian countries in Russian markets-its exports increased 40 percent, and Russian sales in Kazakhstan went up 89 percent. With the 36 percent increase, Tajikistan recorded the largest growth among Central Asian economies in exports to Kazakhstan, followed by the Kyrgyz Republic (2 percent). Except Kazakhstan, no other Central Asian country increased exports to Russia between 1999 and 2002. However, the Kyrgyz Republic had the smallest loss (22 percent), followed by Uzbekistan (28 percent), 59This sharp decline,which was recovered since 2003, i s explainedby landslideinthe Kumtor gold mine. 6oAnother source of improvementcame in exports to China, which grew from US$19million in 2001 to US$41 million in 2002. This was still, however, less than the value of China-oriented exports in 2000 (US$44 million+not to mention USS69 million worth of exports back in 1995. Contrary to what one might expect, they did not increase from a very low base and did not display significant volatility. Armenia's exports to Russia grew at an average rate of 20 percent over 1999-03, and increasedfrom US25 million in 1998 to US$56million in 2002 andUSS70 million in 2003. Georgiahad a 10percent annual growth over this period, and its exports rose from US63 million in 1998 to USS68million in2002 and USS8l million in 2003. Exportsfrom the Kyrgyz Republicto Russia grew at a negative growth rate of 1 percent, falling from USS129 million to US74 million in 2002 and increasing to US$90million in 2003. The contractionin Kazakh markets was less dramatic, and there was a strongreboundin 2003, with the value of Kyrgyz exports increasing 21 percent to US$39 million. This is, however, still well below the 1998 level of USS53 million. 34 Tajikistan (42 percent). The share of the Kyrgyz Republic in Russian imports from Central Asia in 2002 was well below its peak level in 1998, although it rebounded in 2002. Kyrgyz performance relative to other Central Asian economies was not better in Kazakhstan: its share in Kazakhstan's imports from Central Asia fell from 47 percent in 1997 to 25 percent in 1999, and then increased only to fall down back to 26 percent in2002. Table 2.4: Kyrgyz Comparative Export Performance in Kazakhstan and Russian Markets in 1996-2002 ~~ Index,ZOOZ Kazakhstan 1996 1997 1998 1999 2000 2001 2002 1999=100 Total imports(in million of US dollars) 4,247 4,302 4,373 3,686 5,048 6,478 6,584 179 Share ofROW (%) 35 47 53 57 47 50 55 96 Share of CentralAsia in importsfrom CIS ("3) 7.1 5.9 7.5 7.6 3.9 3.6 4.1 54 Kyrgyz share intotal imports (%) 2.14 1.48 1.21 0.84 0.60 0.52 0.48 57 Kyrgyz share inimportsfrom CentralAsia (%) 46.0 46.8 34.5 25.9 28.6 28.6 26.2 101 Russia 1996 1997 1998 1999 2000 2001 2002 Total imports(in million of US dollars) 44,504 52,400 42,939 30,286 33,853 36,889 45,507 150 Share of ROW (%) 69 73 74 73 67 81 78 107 Shareof Central Asia in importsfrom CIS (%) 28 29 23 25 28 38 24 96 Kyrgyz share intotal imports("3) 1.03 1.07 1.16 1.15 0.79 0.88 0.72 63 Kyrgyz share in importsfrom CentralAsia (%) 3.66 3.71 4.98 4.60 2.77 2.36 3.05 66 Note: ROW stands for rest of the world. Source: Staff calculationsderivedfrom import data submitted by Kazakhstan to IMF, Direction of Trade database. 2.17 Furthermore, the Kyrgyz export offer has become increasingly concentrated over time, even excluding gold, although a few new exports have emerged. Gold, electricity, cotton and tobacco account for the bulk o f Kyrgyz exports. Other significant export items include metal scrap, hides and skins, vegetables and fruits, and dairy products, with the first two items being relatively strong performers in exports to China. Kyrgyz exporters have failed to capitalize on a huge increase inimport demand inboth Kazakhstan and Russia for fruits and vegetables, but as described in Box 2.1, they have made significant strides into these markets for dairy products (see Volume I1o f this Report for detailed analyses of the trade performance). 2.18 Insum, clearly, the Kyrgyz Republic's relatively free trade regime and preferential market access to most of its major trading partners have thus far not elicited supply response. Drawing on the internationalexperience, liberal trade policiesper se cannot be heldresponsible. Liberalization o f trade i s necessary though not sufficient condition for export-led growth. Other policy areas, going beyond the structure of tariffs and/or external trading environment, appear to constrain trade inand out of the Kyrgyz economy. Sections B and C below discuss external and homemade barriers. 35 Box 2.1: How Kyrgyz Exports Respondedto Growing External Demandfrom NeighboringRussia and Kazakhstan? Neither location nor market access fully explain the fall in Kyrgyz presencein two rapidly expanding markets for imports-in neighboring Kazakhstan and Russia. Both experienced fairly high GDP (6 percent and 8 percent, respectively) and import growth (17 percent and 15 percent) since late 1990s. Kyrgyz exports did not keep pace with the import growth. Its firms have lost market share to firms not only from the regionbut also from other parts of the world (e.g., EU, LAC, EA, SA, and Africa). But not all of them. Against the rather bleak overall picture, one sector (dairy) has made impressive gains, with the potentially strong spill-over effects on the Kyrgyz exports, and hence. the supply-side of the Kyrgyz economy, provided that trends continue into future (for formidable challenges on this see Volume 11, Value Chain Analyses for Dairy Industry). In other importantsectors, the performance-not unlike that ofmost CIS economies-has been mixed. Dairy products and eggs: Dairy productsand egg imports increasedby more than 60 percent in both Russia and Kazakhstan, with imports from the EU, Ukraine, and New Zealand accounting for most of this increase. Yet, the Kyrgyz Republic has shown considerable improvement in this highly competitive market with its exports quadrupling to both countries. Kyrgyz exports of dairy productsnow capture about 5 percent of Kazakhdairy importsmarket. Other CIS countries (excluding Russia and Ukraine) have performedpoorly in Kazakand Russianmarkets. Vegetablesandfruits: Vegetable and fruit imports increasedaround 45 percent in Russiaand 15 percent in Kazakhstan. They also showed growing geographical diversification (e.g., Ecuador, Uzbekistan, EU, China, Morocco). Kyrgyz exports have lost their market share in both countries, while many other CIS countries have succeeded in expanding their presence in both countries. Textileyarn: Imports of textile yarn and fabrics grew by about 30 percent in Russia and 40 percent in Kazakhstan. Kyrgyz exportsto Russia fell precipitouslyby over 60 percent, as the highly competitivegrowing exporters such as China, Korea and Turkey-which also export to Kazakhstan-penetrate into Russian market. Kyrgyz exports to Kazakhstan, however, almost doubled, resulting in aggregate gain in Kyrgyz market share for this product. Other CIS countrieslost their respective market shares in bothRussiaandKazakhstan. External Policy Barriers 2.19 To what extent are Kyrgyz exports, in particular, limited by external policies? This section begins with an assessment of conditions inaccess to foreign markets, followedby contingentprotectionist measuresand technical standards affecting Kyrgyz exports and transit issues. Market Access Barriers: Targfs 2.20 The most salient fact i s that the bulk o f Kyrgyz exports enter foreign markets unrestrained by tariffs or quotas. This i s the result of preferential arrangements with major foreign trading partners as well as the composition of the Kyrgyz export basket, which i s heavily tilted towards low-processed industrial and agricultural materials and gold (see Table 2.7 further below). As shown in Table 2.5 below, 36percent of total Kyrgyz exports went to FTA partners in 2002. Excluding gold (which is exportedto Europe and Middle East), FTA partners took 55 percent o f Kyrgyz exports in2002. Table 2.5: Share of Kyrgyz Trade with FTA Partners, 1996-2002 Partner Exports Imports Total Turnover 1996 1999 2002 1996 1999 2002 1996 1999 2002 Total EURASEC 52 29 28 39 32 42 44 30 36 Uzbekistan 23 I O 6 16 8 I O 18 9 8 Other CIS* 3 1 2 2 2 2 2 1 2 TotalFTAs 77 40 36 56 42 54 64 41 46 China 7 6 9 1 6 10 3 6 10 Rest of World 16 55 55 43 52 36 33 53 44 * "Other CIS" excludesGeorgiawith whom trade is negligible. Source; Datareportedby the Kyrgyz Republicto UNCOMTRADE database. 36 2.2 1 The Kyrgyz Republic also enjoys nonreciprocal, preferential access to major industrial country markets through the Generalized System o f Preferences (GSP). It gained quota-free access to the EU at MFNtariffrates in 1994through its Partnership and Cooperation Agreement.62 Unlike many other low- income countries, Kyrgyz textile and apparel exports are not subject to quantitative restrictions in either the United States or EU.63On other goods not covered by GSP, major industrial countries began offering MFNto Kyrgyz products even before the country joined the WTO. This is not to state that no barriers exist. Table 2.6 shows that Kyrgyz exports do in fact face non-zero tariffs on some exports (excluding gold) to major non-FTA partners. Inmost cases, however, these are relatively low. Inaddition, most Kyrgyz exports to China, which is the only neighboring country not party to an FTA as well as an increasingly important trade partner, are productson which China levies no duties.64 Table 2.6: MFNTariffs of Major Non-FTA Partners, 2001 WeightedAverage Weighted Average Coefficientof Partner Simple Average (Kyrgyz Imports) (World Trade) Variation China 15.89 5.03 14.11 75 EuropeanUnion* 5.40 0.11 3.15 115 Iran, Islamic Rep. 7.34 5.5 1 3.07 90 Japan 5.14 0.71 2.43 215 Pakistan 20.37 0 19.36 80 United States 4.53 3.65 3.10 294 * Turkish tariffs on Kyrgyz importsare the same as EUtariffs on Kyrgyz imports. Source: WITS. 2.22 As noted above and as demonstrated in Table 2.7, with the current structure o f exports almost completely dominated by low-processed materials and gold, Kyrgyz exporters would have mostly duty- free or low-tariff access to most markets with or without preferential status. Almost 40 percent of Kyrgyz exports are made up of non-monetary gold, which enters foreign markets free of duties. Among the top 12 six-digit Harmonized System items-which accounted for almost three-fourths o f total exports in 2002-there are only two manufactures-filament lamps accounting for 2.4 percent o f total exports and motor vehicles contributing 1.6percent to total exports. 2.23 Inall, access interms of tariffs does not appear to be the barrier to Kyrgyz export expansion. Neither is it a barrier to the Kyrgyz Republic's moving up the value added chain towards exporting more processed goods, with the possible exception of processed foods that are usually subject to health and safety regulations in world markets. In preferential markets, either under GSP or FTAs, likely export manufacture-candidates-such as buttons, woven carpets or residential light fixtures, just to name a few labor intensive products-would not face tariffs or quotas. They may, however, face contingent protectionmeasures(e.g., antidumping). 62Exports to Turkey are governed by the same market access policies as exports to the EU, due to Turkey's customs union agreementwith the EU. 63The EU subjects Kyrgyz exports of textiles and apparel (like those from other countries) to prior surveillance, however. (see the EC's DG-Tradedatabase at sigl.cec.eu.int.) The persistent absence of quotas in the Kyrgyz case more likely reflects the small volumeof Kyrgyz exports rather than European or American benevolence. With the terminationof quantitativerestrictions on textiles and clothing under the WTO Agreement on Textiles and Clothing as of January 1, 2005, quotas will no longer offer protectionfrom the most efficient producers in the world. 64Chineseauthoritiesreport that over halfof importsfrom the Kyrgyz Republic in 2002 were scrap metals (UNCOMTRADE). 37 Table 2.7: Principal Exports to the World, 2002 Product (6-digit level of HS) Value Share of Exports (millions of U S dollars) (percent) 710812 Non-monetarygold 162.8 35.4 520100 Cotton, not cardedor combed 43.7 9.5 271000 Petroleumoils 35.3 7.7 271600 Electrical energy 22.0 4.8 240110 Tobacco, not stemmedlstripped 19.6 4.3 410121 Other hides and skins of bovine animals 15.5 3.4 853922 Other filament lamps 11.2 2.4 870290 Other motor vehicles carrying I O or more passengers 7.2 1.6 071333 Beans(Vigna spp., Phaseolusspp.) 6.5 1.4 681110 Corrugatedsheets 5.6 1.2 170199 Other cane or beet sugar 5.3 1.1 760200 Aluminum waste and scrap 4.3 0.9 Source: 2002 trade data reportedby the Kyrgyz Government to UNCOMTRADE. Antidumping, Safeguards and Contingent Protection 2.24 WTO agreementsallow for the use of safeguards to suppress imports, i.e., contingent protection, but subject to well-defined rules. Provisions in FTAs may further limit the possibility of resorting to protectionist measures (e.g., some FTAs do not allow the use of antidumping procedures). The problem i s that EURASEC Agreements are subject to much less restrictive rules than those stipulated under the WTO (see paras. 2.108-2.1 19). Disciplines over the use of contingent protection among EURASEC countries are weak and constitute potential barriers to export expansion. The Kyrgyz Republic had been subject to Kazakh safeguard measures in a variety of sectors (including cement) after the 1998 Russia crisis, which was lifted in 2001. However, Kazakhstan introduced the same year antidumping tariff o f 67.3 percent on Kyrgyz cement, leading to a sharp decline in cement exports-in 2002 they reached only 17 percent o f their value in 1998. In 2003, Ukraine introduced antidumping measures in filament equipment, targeting Russia and the Kyrgyz Republic since the targeted producer of electric bulbs is a joint Russian-Kyrgyz enterprise. Uzbekistan also has a history o f introducing tariff and non-tariff measures against Kyrgyz exports. In violation of the FTA, Uzbekistan uses excise taxes as trade measures discriminating against imports by subjecting them to higher excise rates than on domestically produced products. Strategies for addressing contingent protection problems are discussed below in Section C. Transitproblems 2.25 The transportation profile o f Kyrgyz trade i s asymmetrical: on the export side it is the reverse o f what it i s on the import side. While 87 percent of all shipment originating in the Kyrgyz Republic go through road transport, only 25 percent o f incoming shipments enter the Kyrgyz Republic using this mode. Railroads dominate on the import side accounting for 75 percent o f the total as compared to 13 percent for exports.65 A major reason for this transport mode duality is the difference in respective compositions of imports and exports-with imports dominated interms o f tonnage by such bulkproducts as coal and grains, compared to small quantities o fproducts exported in single shipments, making the use o f railroad transport very expensive.66 Furthermore, delivery times with conventional rail transport are 65 Trade and Transport Facilitation in Central Asia: Reducing the Economic Distance to Markets, World Bank, 2004. "Trade andTransport Facilitation:Kyrgyzstan," Mimeo, World Bank, March 2003, pp. 7-8. The lack of well-developed network of freight forwarders, discussed in paras. 2.48 and 2.110-2.113, might have also contributedto it. 38 rather long. In consequence, road transport i s the main vehicle for moving goods out of the Kyrgyz Republic. 2.26 Butthe problemis that road transport is muchmore expensive than railroadtransport, even more so than freight rates alone would suggest. The most significant barriers to Kyrgyz trade involve restrictions on transportation of goods in and out of the country through neighboring countries, mainly Kazakhstan. These transit barriers are well documented elsewhere,67 although-as a result o f a transit agreement signed with Kazakhstanin December 2003-some are currently beingremoved. Barriers that the Agreement on Transit have removed include customs escort,68 discriminatory requirements conceming special insurance and guarantees by Kazakh banks on transit, and transport quotas.69 However, some measures defying the principle of national treatment-i.e., they are not applied on domestic carriers-are still inplace. The remaining official policy barriers include various road taxes and fees leviedby local authorities (oblasts) on foreign carriers. 2.27 Inaddition, informalbarriers add to the cost oftransportationeven more than the official barriers. These are related to harassment by local police and other officials, bureaucratic delays created to extract bribes, and simply weak capacity in customs administration. A recent study on transportation and trade facilitation in the CIS countries indicates that truck drivers must pay an average o f US$1,500 for transit through Kazakhstan to Siberia-in addition to official transport and insurance costs amounting to 15 percent of the value o f shipment^.^' While the recently introduced measures noted above (see para. 2.26) are likely to reduce official transport cost, payments to government officials either inthe form of bribes or other official fees account for around 70 percent o f the total costs.71 The recent trade and transit review o f Central Asian countries estimated that the full cost o f transporting agricultural goods to Russia via Kazakh roads reached as much as 50 percent o f the goods' value, mainly because of illicit payments inKa~akhstan.~~Taken together, they far exceed MFNtariff rates levied by non-FTA partners. 2.28 Since officials in transit countries "do not discriminate" between exports and imports, transport costs affect trade by raising the cost o f Kyrgyz imports and, hence, by reducing competitiveness o f exports that would have to use imported inputs.73Transport added 9 percent to the value of imports from Russia and China in2002 (Table 2.8). Simple average cost for imports from the EU stood at 14 percent. Similar costs were incurred inthe case o f imports from NAFTA-Canada, Mexico and the U.S. Simple average transportation cost on total imports was 12.6 percent. In contrast,. shipping and freight costs 67For recent quantitative assessments of transit barriers see: (i)"Trade and Transport Facilitation: Kyrgyzstan," (mimeo), World Bank, March2003; (ii) Molnar, Eva, and Lauri Ojala, "Transportation and Trade Facilitation Issues in the CIS-7, Kazakhstanand Turkmenistan," paper presented at the Luceme Conference of the CIS-7 Initiative, Luceme Switzerland, January 2003; and (iii)PragmaCorporation: "Regional Cross-BorderTradebetweenKazakhstan, KyrgyzstanandRussia," (mimeo), commissioned by USAID, July 2002. Carriers had to pay customs escort fees of around US260 for transit through Kazakhstan's territory. 69Untilthe Agreement went into effect in early 2004, Kazakhstanset limits on the number of transit permits issued to Kyrgyz truckers. Ifa Kyrgyz carrier was not able to obtain such a permit, the fee of US$150 had to be paid at the boarder. According to the Kazakh legislation for carriers from countries without permits for transit, the carrier had to pay an extra transit fee of USS60. This was on top of other fees (including customs escort fee) and illicit payments. The latter are still inplace. 'OMolnar and Ojala, 2003, "Transportation and Trade Facilitation Issues inthe CIS-7, Kazakhstanand Turkmenistan." 7'Pragma Corporation, 2002, "Regional Cross-BorderTrade between Kazakhstan, Kyrgyzstan and Russia." 72"Trade and Transport Facilitation: Kyrgyzstan," (mimeo), World Bank, March 2003. 73These costs are huge amounting, for instance, to 34 percent of the value of imports from Australia or 25 percent of imports from Ireland in 2002. Thus, it comes as no surprise that imports from these countries are negligible. The IMF's Direction of Trade Statistics show that 0.004 percent of Kyrgyz imports in 2002 came from Ireland. The same figure applies to trade with Australia. 39 average less than 3.5 percent o f the value o f goods entering the US. from all sources.74 Since imported inputs are, more ojien than not, indispensable for exports, transport costs create a signiJicant barrier to exports through this channel as well (for industry specific examples see the Value Chain Analysis in Volume I1o f this Report). Table 2.8: Transportation's Contribution to the Cost of Kyrgyz Imports (in % of the value of imports in2002) Partner Averagetransportationcosts in percentof Imports Highest Lowest EURASEC 6.1 9.6 2.4 olw Belarus 9.6 olw Kazakhstan 2.4 o/w Russia 8.8 o/w Tajikistan 3.8 Average other CIS 9.8 19.1 5.5 o/w: Uzbekistan 5.5 EU 14.2 25.3 8.0 CEFTA 13.0 23.8 8.1 NAFTA 13.5 15.4 11.6 Total imports 12.6 33.7 2.4 Source: Staff estimates based on Kyrgyz official statistics. 2.29 While some portion o f transportation costs stems from poor transportation infrastructure, a significant portion is policy-induced. Section C below address this problem, suggesting that Kyrgyz authorities need to address these policy-induced transit barriers on all fronts, i.e., multilateral, regional and bilateral, and do so more intensively. The recent agreement on transit with Kazakhstan offers hope that such efforts will pay off also inother areas. Technical Regulations on Food and Other Exports 2.30 Virtually all processed food products traded internationally are subject to some sort of regulation governing health and safety, labeling, packaging, or purity. These become more stringent with the increase in the level of processing, as there are fewer technical restrictions on bulk commodities than on packaged products ready to be sold to consumers. This often applies to non-food products as well. For instance, European governments impose fewer technical regulations on raw wool and cotton than on more highly processed fabrics and garments, which are subject to standards governing fire-resistance and toxicity o f dyes. 2.31 At the present time, high-processed products do not figure strongly inKyrgyz trade with WTO countries. But the emphasis should be that this i s true only at the present time. The Kyrgyz Republic exports very little o f these goods for reasons discussed elsewhere inthis Once Kyrgyz companies overcome marketing, packaging, quality control, and scale economy problems, they will need to concern themselves with these foreign regulatory barriers. As with transit barriers, Kyrgyz policy makers must addressregulatory barriers on a variety o f fronts, which are discussed below.76 74This was computed as difference between c i f . and customs values of all U.S. imports, divided by the total customs value, for 1996-2002. (Data were obtained from the USITC's database accessible on Internet). 75See Chapter 4 andthe Value Chain Analyses inVolume I1of this Report. 76See paras. 2.44-2.46,2.68-809, and 2.124-2.126 of this Report. 40 Summary 2.32 External barriers to the Kyrgyz Republic's integration into regional and global markets are formidable. However, they are not related to tariffs as Kyrgyz exporters face low duties, if any, partly because o f preferential arrangements and partly because o f the character o f Kyrgyz exports. Neither are they related to safeguard measures, although these do remain a potential problem. Technical barriers to trade are pervasive in CIS countries and elsewhere, but their impact on Kyrgyz exports has thus far remained negligible. 2.33 Concerning the non-tariff costs in the external trading environment, these are found intransit and transport costs, both formal and informal, which in turn choke o f f the Kyrgyz Republic's expansion of foreign trade. The combination o f bribes, harassment by local officials and inefficient customs, both domestic and in neighboring countries, exacerbates the impact o f mere geography in suppressing both imports and exports and in erecting huge barrier to the development o f higher value added commodities, requiring imported inputs. Home-Made Trade-Related Policy Issues 2.34 Trade, and trade policy, i s a two-way street: a country's own trade policies can constrain both imports and exports just as much as other countries' policies. Unlike foreign countries' policies, one's own are more easily adjusted. 2.35 Despite the Kyrgyz Republic's liberal trade regime and open foreign investment regime, its policies are not entirely foreign trade-friendly due inparticular to two factors: the customs administration and distortions induced by the tariff schedule for some sectors. Both distort investment and consumption patterns and impede specialization inline with Kyrgyz comparative advantage. Inefficient CustomsAdministration 2.36 Inefficient customs administration following out-of-date customs procedures dramatically increases the transaction costs to exporters and importers alike, thereby, further distorting competition in domestic markets and erecting barriers to export-oriented business activities. It takes at least between three and five days to release inbound consignment, largely because o f excessive bureaucratic requirements. This i s a faster release time than in most CIS economies, but it still constitutes a major impediment to Kyrgyz traders since goods are charged for each day under customs, which further exacerbates already hightransaction costs." While the well-established (and well-connected) firms seem to be less affected with this problem, it greatly complicates entry into international markets o f small and/or new firms. Further complication arises from the fact that documents needed for customs clearance are only available inBishkek and some o f them in Karakol.'* 2.37 Other problems abound imposing significant costs on traders. These include the absence of licensed customs brokers, mandatory inspection o f all shipments, and lack of electronic data interchange between traders and the Kyrgyz customs administration (KCA), between the KCA and other government agencies, and between KCA and customs bureaus o f neighboring countries. These factors result in ""Trade andTransportFacilitation: Kyrgyzstan," (mimeo), WorldBank,March2003." Incomparison,transportationauditsin Southeastem Europe measure clearance times in Balkan countries in terms o f minutes or a few hours, not days. See www.seerecon.org. '*"Trade and Transport Facilitation: Kyrgyzstan," (mimeo), World Bank, March 2003. 41 traders making high unofficial payments on top o f ad valorem customs fee of 0.15 per~ent,'~along with spending unnecessarily long times inthe clearance process. 2.38 These factors contribute to a general perception among business people that the KCA needs to be streamlined.80 The weaknesses inthe KCA are not unique: similar complaints are levied on other customs bureaus in the region and around the world. Yet, altogether they create significant barriers to international trade activities. Measures that can be considered to cut down foreign trade transaction costs will be discussedbelow.81 Distortions Triggered by Tariff Structure: Its Extent and Targets 2.39 Distortions in export incentives comes from imposing higher tariff rates on successive stages o f processing, i.e., charging relatively lower tariffs on raw materials, somewhat higher tariffs on semi- finished goods using those raw materials, and much higher tariffs on the final outputs o f an industry. Tariff escalation increases effective rates o f protection on final stages o f production.82 Its effects are clearly negative: the price incentives that could make those activities more competitive inworld markets are attenuated. Furthermore, tariff escalation diverts resources inthe economy away from other stages o f production inwhich the country may otherwise have a comparative cost advantage. 2.40 How does the Kyrgyz Republic's tariffschedule fare on these counts? Overall, the structure o f Kyrgyz applied MFN tariff rates does not create significant distortions in domestic production and consumption pattems. Its maximum tariff rate o f 15 percent is l o w by any standard. So i s the dispersion o f tariff rates. Boththe levels and the structure o fMENtariff rates inthe Kyrgyz Republic are quite close to the best international practice o f a uniform tariff rate. 2.41 Yet, the Kyrgyz tariff schedule is biased against some exports-both fully finished and primaly. An example o f the former i s the leather and textile sector; some other double-digit ISIC sectors, especially basic metal industries, are examples o f the latter. In leather and textiles, the tariff structure escalates considerably, with the average tariff rate o f 4.2 percent on the first stage o f processing, 5.6 percent for semi-finished goods, and 11.1 percent on fully processed textile and leather goods (Table 2.9). In other sectors, the Kyrgyz authorities offered higher levels o f tariff protection to producers o f primary and semi-processed goods. 79Incidentally,the ad valoremfee violates the WTO rule of chargingfor actually rendered service. This is one of the most widely shared views expressed in a recent enterprise survey about how the govemment can improve export opportunities. See "National Business Opinion Survey of the Kyrgyz Republic," (mimeo), ProjectManagement Agency, 2002. See paras. 2.81; 2.92; 2.119; and 2.127-131. 82The effective rate of protection is defined as the protection on the value-added of a particular activity rather than sales of a product. 42 Table 2.9: Tariff Escalation in Manufacturing Industries in 2002 Semi- Fullv Maximum SimDle Coefficientof Manufacturing Industry (2-digit ISIC) Primary Processed Finished tariff average variation Food, Beveragesand Tobacco 8.48 8.68 9.97 15 9.77 0.33 Textilesand Leather 4.23 5.60 11.08 15 8.34 0.64 Wood and Furniture 0.00 2.98 10 1.42 2.46 Paper, Printing and Publishing 0.00 0.00 0.00 0 0.00 0.00 Chemicals, PetroleumandRubber 2.27 2.99 1.70 10 2.62 1.07 Non-metallic Mineral Products 10.00 7.90 9.24 10 9.01 0.32 BasicMetal Industries 5.00 0.96 0.38 10 1.05 2.76 FabricatedMetals and Machinery 5.33 4.34 10 4.36 1.13 Other Manufacturing 10.00 10.00 6.88 10 6.98 0.62 Notes: Industriesare defined at the 2-digit levelof the ISIC (Rev. 2) nomenclature; the stage of processingis defined according to the GATT/WTO's classificationsystemused in the UruguayRoundnegotiations. Source: Staff calculations, usingthe 2002 tariff schedulesuppliedby the Kyrgyz CustomAdministration. 2.42 The differentiation o fprotection across sectors serves no economic purpose. First, around halfof Kyrgyz imports (55 percent in 2002) originate in CIS countries and are not subject to duties. Protecting selected industries or agricultural products, which happen to be produced in CIS countries, by affording them high MFNtariff rates, would only raise price of imports from CIS, as CISproducers would take advantage of weaker competitionfrom MFN suppliers. Second, a significant portion o f MFN imports enters Kyrgyz markets duty-free-ither because 42 percent of all tariff items are duty-free or some dutiable MFNimports enjoy tariff exemptions. Considerationof the duty collection rates provides further insights: 2.8 percent duty collection on MFN imports in 2002 was lower than the simple average tariff rate of 5.5 percent in2002 and, more importantly, than the average tariff rate, weighted by MFNimports, of 5 per~ent.'~This indicates that (i) higher tariffs do not keep imports and (ii) customs were not collected on a significant portion of MFN imports, either because of applied zero tariff rates or exemptions. Inshort, tariffs do not protect, but-as discussed earlier-transit barriers do. 2.43 Since, as shown above, MFNtariffs serve only as a government revenue raiser, the dispersion in tariff rates only complicates customs procedures and may breed corruption by offering incentives to misclassify dutiable items. Recommendation: Review the tariff schedule and average tariff rates across stages of processing including sector in which tariff rates are lower for fully finished products than earlier stages of production. CumbersomeStandardsRegime 2.44 The Kyrgyz Republic inherited the Soviet System o f Standards (GOST) of technical specifications and mandatory inspections-which was not recognized in the rest of the world-when it gained independence, as did other CIS economies. Although there has been some effort at both the national and regional level to introduce new standards in line with dominant international practice (e.g., adopting I S 0 standards or European Norms), the progress so far has been slow. The Kyrgyz standardsregime remains therefore quite different from those o f other developing countries. This has two 83 NEA Transport Research and Training (2003), "Central Asia Trade and Transport Facilitation Audit, National Report: Kyrgyzstan," p. 11. 84 That would have been the case had the weighted(by MFN imports) average tariff ratebeen much lower than the simple tariff rate, as the share of imports subject to high tariffs would have to be much lower. In other words, there would be little, if any imports subject to high tariffs capturedin a simple average. With the differenceof 10 percent or 0.5 percentagepoints, this does not appear to be the case. 43 important implications: first, the standards followed in Kyrgyz industries were written outside o f the international standards organizations that develop standards followed in advanced market economies, and they are not considered to be valid by regulatory authorities in those countries. This puts Kyrgyz firms at a competitive disadvantage in supplying processed foods (which are increasingly subject to both purity and packaging rules) and technologically sophisticated products (e.g., electronics). Second, and more significant in the short run, regulations requiring firms to demonstrate compliance with GOST standards through mandatory inspections and certifications, as opposed to market-oriented methods, significantly increase firms' production costs as they require significant payments for tests and other p r o c e d ~ r e s . ~ ~ This compulsory quality o fthe standards regimereduces competitiveness nomatter which standards local businesses follow. 2.45 Clearly, streamlining quality testing procedures and removing other unnecessary administrative barriers would dramatically increase competitiveness o f Kyrgyz firms. For instance, a recent Bank competitiveness study demonstrates that the removal o f red tape barriers, promoted by the existing standards and the certification regimes, would increase net profits o f small enterprises inthe Kyrgyz dairy industry by 140percent and those o f large enterprises by 40 percentg6 2.46 The Kyrgyz government has recently intensified its efforts to address these problems both through streamlining the certification and inspection requirements and through improving standards and technical regulations. This Report argues in favor o f a strategy o f pursuing regional and multilateral cooperation to supplement unilateral measures for introducing an effective market-oriented standards regime. Section I1and I11below discuss issues involved inmore detail. Weak Regulatory Capacity in Services Administration 2.47 The regulatory environment fostering competition in service sectors i s important for trade in services as well as for trade in goods. Services make up 10-20 percent o f the production costs and all the costs o f trading.87 Availability of high quality services lowers transaction costs, stimulates trade in goods and attracts foreign as well as domestic investors to engage inproduction activity. Incontrast to trade in goods, most barriers to trade in services stem from non-tariff measures taking the form o f regulatory restrictions or exclusivity rights. Liberalization o f trade in services requires the lowering or the removal ofregulatory barriers. 2.48 The present Kyrgyz regulatory environment underpinning such backbone services as telecommunications, transport, financial services (banking, insurance, securities trading), distribution and business services (legal, accounting, consulting) fails to enhance competition, both domestic and competition from intemational providers. The financial sector is weak, telecommunication expensive and poorly developed, and third-party logistics industry barely in statu nascendi. Kyrgyz Telecom is still owned and controlled by the government, and interconnectionrules keep out potential service providers of mobile telecommunications. As a result, costs to users are very high. There is a paucity o f freight forwarders, while express carriers, integrators, and logistics-related banking and insurance services are ~ 85 These procedures in place as recently as 2000-02 requiredbusinesses to obtain, on average, 12 certificates per year, each of which took an average of 26 days to obtain, and collectively cost 3,600 soms (aroundUSS 80, or equivalent of almost 25 percent of the GNI per capita). See ARDIChecchi (2001), "The Regulatory and Business Environment Survey: November 2000," (mimeo), Bishkek:ARDiChechhi. 86 See (i)"Barriers to Competitiveness: An Analysis of the Principal Factors Inhibiting Competitiveness of Kyrgyz Dairy Industry," (mimeo), World Bank, July 2002; and(ii) Volume I1ofthis Report, Value Chain Analyses, Dairy Industry. *'The costs of trading includepayments for such services as transport, communications,distribution services, and trade finance and insurance. See James Hodge, 2002, "Liberalization o f Trade in Services in Developing Countries," in B. Hoekman, A. Mattoo, andPh. English, eds., Development, Trade,and the WTO:A Handbook, World Bank, Washington, D.C. 44 practically non-existent. Without their presence, trade in goods is severely negatively affected (see Volume 11,Value chain Analysis for examples from several industries). 2.49 The lack of high quality intermediate services not only depresses investments and trade in goods but it also hurts exports o f services. A clear example is, tourism, which is the Kyrgyz Republic's best potential service export. Foreign currency revenues from tourism, as reported in Kyrgyz balance-of- payments statistics, amounted to 2.5 per cent o f the Kyrgyz GDP.88This i s rather l o w for a country, with unique scenic beauty along with a stable government and no violent domestic conflicts. The reasons stem from two major policy-induced barriers. First, it appears that GATS `commercial presence' o f foreign firms i s not observed. For instance, there i s perception that Uzbek and Kazakh tour operators face difficulties in doing business inthe Issyk-Kularea.89 Second, the Kyrgyz Republic's service environment supporting tourism i s weak. For instance, there are no financial services geared to the needs o f foreign tourists. These include automatic banking machines that permit withdrawals directly from foreign accounts, greater acceptance o f traveler's checks and credit cards, and micro-credits for start-up capital to permit small entrepreneurs in the sector to start businesses (e.g., mountain guides). In this context, it should be noted that the government's program to modernize the banking system needs to be fulfilled on s~hedule.'~ 2.50 As the example o f tourism clearly illustrates, various areas are critically linked with positive spill over effects. Improvements in financial services, telecommunication, and the like may not only increase tourism but also remove important barriers to trade ingoods. 2.51 In short, the Kyrgyz Republic badly needs a regulatory environment that will enhance competition and foster growth in services and, by the same token, in trade. Poor enforcement o f frequently good laws combined with corruption inhibits trade and commerce. This, in tum, deters investment ineverything from infrastructureto food processing to tourism. Other Domestic Policy Distortions: VATRefund and the Organization of Domestic Markets 2.52 A number o f domestic policies tend to raise the costs o f international trade, thereby limiting international integration. These are largely discussed in Chapter 3 o f this report, with Volume I1of the Report providing many firm level examples (see value Chain Analysis). What follows touches upon a small sub-set o fproblems: a dysfunctional VAT scheme, and the broader issue o f supply-side constraints. 2.53 As in most countries, the Kyrgyz Republic levies value-added tax (VAT) on imports and, in principle, reimburses companies for VAT paid on imported inputsused to make exported products. As in many other developing countries, these VAT reimbursements do not occur quickly enough inthe view o f the exporters, clearly not within the 30 days timeline of the existing legislation. The reasons and solutions are well known, so this Chapter simply notes that exporters frequently cite problems with VAT reimbursements as one o f their most significant obstacles to gain strength to meet foreign market demand. The elimination o f VAT exemption for imported capital inputs in 2002 has further exacerbated this problem." The strong emphasis on the problem by the Kyrgyz businesses i s not surprising: delays in VAT reimbursements amount to firms being compelled to provide interest-free loans to the govemment. This practice raises the cost to businesses, which are mostly short o f liquidity given highinterest rates and difficulties inaccess to financing inKyrgyz financial market. *'See Annex 2-B on the Kyrgyz Republic'sTrade in Services. 89 This would be incompatiblewith GATS if Uzbekistan and Kazakhstanwere WTO members. 90 See World Bank, Trade and Transport Facilitation in Central Asia: Reducing the Economic Distance to Markets (2004); and Payment System and Bank Modernization Project, (2004). 91 This issue is expectedto be addressed through the new amendmentsto the Tax Code, which are under preparation. 45 2.54 Inaddition to thisformal policybarrier, poor organization o fdomestic markets constrains Kyrgyz integration into the world economy. These supply-side deficiencies limit the ability o f local firms to respond to foreign market opportunities and render the Kyrgyz market unattractive to foreign investors. This Chapter identifies these, but leaves their discussion to Chapter 3 o fthis Report, as their solutions do not lie fully in the hands o f trade policy makers. These deficiencies stem from among other things, the lack of institutions that channel market information, few organized wholesale markets, absence o f competitive market intermediaries and, as discussed above, low quality o f backbone services. Measures that would enhance competition, transparency and supply o f backbone services would go a long way to improve business climate. Conclusion: Need For Convergence in Attacking Problems at Multilateral, Regional and Domestic Levels 2.55 The discussion above offers strong support to the conclusionthat neighbors' policies alone cannot be blamed for the Kyrgyz Republic's dismal extemal performance. While it has contributed, domestic policies are also responsible. 2.56 The extemal policy implication is that the Kyrgyz Republic needs to attack the problems simultaneously at a regional and domestic level. Furthermore, in both a regional and domestic level, it should take advantage o f opportunities offered by its WTO membership. Domestically, the push towards meeting remaining WTO commitments provides both a political shield and an anchor for undertahng challenging domestic measures. Regional and multilateral agreements are not mutually exclusive. T o the contrary, the Kyrgyz Republic should pushfor greater convergence between the two, which wouldbenefit all parties o f regional agreements. For instance, it should argue in regional fora in favor of adopting WTO-consistent disciplines in such areas as transit, antidumping, services, and customs and standards. Furthermore, since its EURASEC and other CIS trading partners seek WTO accession, the Kyrgyz Republic could use opportunities offered by its WTO membership to address trade and transit barriers that, for instance Kazakhstan, has been creating for Kyrgyz exporters and importers. 2.57 Inbrief, the development and implementationofa two-pronged strategy that involves the use of WTO membership to address domestic and regional problems is the key to reversing the Kyrgyz Republic's unsatisfactory export performance. The remainder of this Chapter elaborates key elements of such a strategy. B. TURNINGWTO MEMBERSHIPA SPRINGBOARD INTO FOR REGIONALAND GLOBAL INTEGRATION 2.58 Many complain that WTO membership (December 1998) has yielded few tangible benefits for the country over the past five years: This section o f the Chapter briefly takes stock o f the country's membership in the WTO. More importantly, it outlines ways o f using WTO membership more strategically in the future. Finally, it makes some specific policy recommendations, indicating where technical assistance i s needed to implement those recommendations. One of the points these discussions highlightis that the WTO membershiphas, infact, yieldedtangible benefits to the Kyrgyz Republic, even ifits particular circumstances have preventedit from realizing many of the gains that developing countries commonly expect when they join the WTO. What Does Kyrgyz Republic Get Out of WTO Membership? 2.59 Countries seeking to join the WTO or its predecessor, the General Agreement on Tariffs and Trade (GATT), have historically expected to benefit in four major areas from their membership: 46 0 Improved and predictable market access: WTO members grant each other binding, non- discriminatory most-favored nation access to their markets. This reduces uncertainty and transaction costs. 0 Access to binding dispute settlement: members can present a trade dispute before an impartial panel o f experts, which decides if the policy in question `nullified or impaired' WTO trade benefits for the complaining country. 0 External policy anchor: membership provides discipline to implement trade liberalization and domestic policy reforms. WTO commitments make it politically possible for the government to resist protectionistpressures and act inthe broader interest o f national economic welfare. e A seat at the table: Since the WTO i s an international institution based on consensus without independent enforcement powers, WTO members negotiate rules that govern much o f world trade.92 2.60 Kyrgyz benefits in the first two areas have been minimal to date. For reasons discussed below, there i s l i t k p o l i c y makers can do at the present time to take greater advantage o f what the WTO offers in these areas. Therefore, what follows will briefly address them and focus on the last two areas. Improvedand PredictableMarketAccess 2.61 Non-discrimination i s the core principle o f the WTO, as members commit to giving each other MFN tariff treatment-i.e., they apply the same tariffs to imports from each WTO member.93 Even before signing the GATT, the Kyrgyz Republic had already enjoyed MFNtariff access or better for most of its exports, includingmarkets o f non-WTO members. Moreover, it had already entered into FTAs with principal CIS trade partners, and the major advanced market economies began granting non-reciprocal tariff preferences through the GSP in the early to mid 1990s. Even on products not covered by the GSP, industrial countries had given MFNtreatment to the Kyrgyz Republic even before accession to the WTO. Nevertheless, they did so as a gesture o f goodwill, not as a binding commitment as under the WTO, and could have had withdrawn MFNaccess at any time. As a result, the risk to Kyrgyz exporters that WTO- member governments can arbitrarily close or restrict access to their markets for Kyrgyz products has been significantly reduced. DisputeSettlement 2.62 A second area where countries traditionally expect to benefit from WTO membership i s in bindingdispute settlement. The Kyrgyz Republic has never used the WTO dispute settlement process.94 It appears that there are no questionable trade restrictions imposed on Kyrgyz exports by WTO members.95 The absence of Kyrgyz use o f WTO dispute settlement mechanisms reflects the country's present export offer, which i s limitedto goods facing relatively few protectionist barriers. 2.63 As the country moves up the processing-ladder, however, the government will need to develop mechanisms, expertise and information channels to help it make use o f international dispute settlement 92No single country, no matter how large it is, can change the content of WTO Agreements. Any amendment changingrights or obligationsrequiresapprovalby atwo-thirds majority of all members. 93The GATT contains certainexemptionsfor preferentialagreementscreating free trade areas and customsunions. 94 The same holds true for the vast majority o f WTO members. Only 37 of the 146 WTO members (24 developing and 13 developed) are responsible for launchingthe 295 cases initiated to date. 95 The only promising candidate is a Chinese ban on trucks driving beyond Kashgar, which might be interpreted as contrary to GATT Article V compelling members to grant others transit rights. But Kyrgyz transportation officials point out that Kyrgyz exporters have no economic incentive to use Kyrgyz trucks past Kashgar-or Chinese trucks for that matter, since Kashgar is where goods are transshippedto from trucksto trains, and rail is cheaper than roadtransport. 47 procedures-both inthe WTO and, as available, underthe regionalagreements. The MinistryofExternal Trade and Industry will not be able to take disputes to Geneva without reliable information from the private sector about foreign market barriers. Inturn, private businesses and civil society cannot provide such input without reliable information from the government about other countries' WTO obligations. Information must flow in both directions. Therefore, the Ministry will need to pursue a policy o f public engagement, establishing outreach and training programs to educate the private sector and creating a consultative mechanismto solicit information. Recommendation: Developpublic engagementprogram in the Ministry of External Trade and Industry to enhance thegovernment's ability to addressforeign trade barriers. External Policy Anchor: Using Multilateral Disciplines to Effect Regulatory Reforms 2.64 Ingeneral, the economic benefits of WTO membership are determined by the extent o f one's own multilateral trade liberalization. Many developing countries look to WTO membership to provide an external anchor for domestic reforms that open the economy to competition from imports. During accession negotiations, existing members pressure candidate countries to reduce tariffs and liberalize trade-related domestic policies. After accession, membership raises the costs of reversing trade policy commitments. WTO membership helps policy makers resist domestic protectionist pressures, thereby helpingthem implement welfare-enhancing policies that benefit the economy as a whole. Moreover, it mightprovide an extra stimulus tojustify further liberalizing measures. 2.65 Tariff uolicv: WTO membership has been serving as a policy anchor for avoiding creation o f barriers to trade that would go against the broader interests o f national economic welfare. Although when the Kyrgyz Republic joined the WTO, it had already liberalized its trade regime, WTO accession greatly improved the predictability o f Kyrgyz trade policy, as applied MFN tariff rates are now bound. Furthermore, while the GATT does not specifically prohibit export tariffs, the Kyrgyz government has refrained from introducing export taxes. For instance, the government resisted effectively recent calls from wool fabric makers to use an export tax to depress the domestic price of wool. Such a measure would have helped fabric makers at the expense of wool producers and the economy as a whole. 2.66 Rezulatow uolicies: By far the greatest effect the WTO can generate as an external policy anchor, however, is on Kyrgyz regulatory policies rather than on its tariff policies. Duringthe Uruguay Round, which ended in 1994, GATT disciplines were extended to many trade-related domestic policies, such as intellectualproperty rights, technical regulations, and food safety standards. The Uruguay Round also expanded previous GATT rules on customs valuation, making them mandatory for all members rather than optional. WTO members, who do not implement these new rules, can be taken to binding dispute settlement inGeneva.96 2.67 As such, an important question to be asked inthe Kyrgyz case is: Has WTOmembership acted as an external anchor for regulatory reforms in the Kyrgyz Republic? What follows reviews implementation o f three WTO agreements deemed to have the greatest welfare-enhancing potential for a developing country: Technical Barriers to Trade (TBT); Sanitary and Phytosanitary Measures (SPS); and Customs Valuation (ACV).97 96 A large number of the dispute settlement cases brought since 1995 involve allegedviolations of TRIPS and other regulatory agreements. 97 The discussion does not include Trade Related Intellectual Property Rights (TRIPS) or Govemment Procurement Agreement (GPA). While important, they are of lesser importance for a least-developedcountry (LDC). In fact, many argue that TRIP simply redistributeeconomic rents from poor to rich countries (e.g., Global Economic Prospects and the Developing Countries 2002: Making Trade Workfor the World's Poor, World Bank, Washington, D.C. 2001). As for GPA, it is probablybetter for an 48 2.68 Standards: Among the regulatory codes, the Kyrgyz Republic faces the greatest challenges-but also greatest opportunities-by implementing the WTO TBT and SPS agreements: The administrative costs o f implementingthese agreementseffectively are the largest, both financially and politically, but the economic payoffs should also be the largest. These agreements require WTO members to apply regulations transparently and fairly. Furthermore, regulations must restrict trade as little as possible through both the use of sound procedures and international standards. International standards-codified by the International Organization for Standards (ISO), the joint FAO/WHO Codex Alimentarius, International Plant Protection Convention, and a few other institutions-are treated as defacto compliant with provisions o f WTO TBT and SPS agreements. Governments basing their technical regulations on other sources o f standards face the burden o fproving that theirs are WTO-compliant. 2.69 As noted earlier, the Kyrgyz Republic inheriteda standards regime from former Soviet central planners, which i s characterized by mandatory inspections and certifications, unique national standards, overlapping agency responsibilities for regulations, and heavy government involvement in all dimensions of the standards system: standardization, accreditation and conformity assessment. The system i s unnecessarily complex and confusing. For instance, Kyrgyzstandart and Sanitary and Epidemiological Services have overlapping mandates: both write standards or have a hand in regulation o f testing o f food imports. The excess burden on the private sector has already been noted. The current regime also places a heavy burden on the state budget as standards development, conformity assessment and enforcement i s costly. A recent analysis o f Kyrgyz and Kazakh standards regimes argues that ". . no nation, no matter . how prosperous, has sufficient resources to administer the kind o f regulatoqdcompliance regime called for by the current standardization systems o f Kazakhstan and the Kyrgyz Republic-even if it were desirable to do ~ 0 . " ~ 'One cannot overemphasize the point that the current regime-with neither transparent nor least trade restrictive attributes+onstrains Kyrgyz trade with all countries, not just with WTO members. 2.70 In a more desirable market-oriented standards regime, standards are voluntary; they are developed and enforced by private sector bodies. In addition, government regulations make use o f existing international standards and are limited to essential public health and safety requirements. The government is taking steps to move in this direction. On the institutional front, conformity assessment responsibilities of the Kyrgyzstandart have been vested in a new organization that is separate from accreditation and standardization. On the legislative front, a new Law on the Fundamentals o f Technical Regulations has been adopted, which: 0 permits manufacturer's self-declaration o f conformity assessment; 0 introduces provisions to eliminate duplicate regulations; and 0 eliminates terminological confusion inthe use of "standard" and "reg~lation"~~ 2.71 Early drafts o f the law called for heavy state involvement inthe process o f standardization, which inmostmarket economies isrelegated to the private sector (often non-profit organizations) or government bodies that act as service providers rather than regulatory authorities. The final Law eliminates most o f these provisions-Article 17 explicitly prohibits the national standards body from issuing regulations. These changes should go a long way towards preventing the reemergence o f standards as mandatory government requirements. LDC to reform the rules goveming government procurement along the GPA recommendation and opening it to external competitionin selectedareas without joining the plurilateral GPA. 98See Jane Schweiker, "A Review of Documentary Standards and the Standardization Infrastructure in the Republics of Kazakhstanand Kyrgyzstan," Mimeo. PragmaCorporation,March 2002. 99In conventional usage (including in the TBT agreement), "standard" refers to a document issuedby a consensusbody, which specifies desirable characteristicsof a product or process, compliance with which is voluntary. A "regulation" is a set of mandatoryrequirements issued by a government. What are called "standards" in many CIS countries are govemment-issued mandatoryrequirements. 49 2.72 The legislation or its regulatory framework should go further, however. First, the Law on Technical Regulations could have included language requiring the standards and regulatory bodies to notify these changes not only to the WTO, but also to the Eurasian Interstate Council for Standards, Certification and Metrology, and to other important standardization bodies to which the Kyrgyz Republic i s a member. Although the WTO TBT and SPS agreements obligate the Kyrgyz Republic to notify other WTO members o f changes in technical regulations, conformity assessment procedures, and other such measures that are potentially o f interest to other WTO members, the government has not always lived up to these commitments. Furthermore, new clauses on veterinary and sanitary inspections that were added to Article 8 ("Content of Technical Regulations") of the law run counter to the SPS Agreement: they fail to take into account disease- and pest-free areas inexporting countries; paragraph 6 explicitly calls on the government to ignore safety methods employed by manufacturers; paragraph 7 follows the SPS Agreement on introducing measures that are not based on sound science but omits the important proviso that such measuresmustbe temporary. 2.73 Second, the government should expand the scope o f recognition o f tests conducted in foreign laboratories. The current Law (Article 30) permits recognition o f conformity assessment certificates issued under intergovernmentalagreements and allows the govemment to establish alternative procedures when mutual recognition agreements are absent. But the TBT Agreement calls on WTO members to do more: members are to accept certificates whenever they are issued to comply with regulations that are equivalent to the domestic ones, and members are explicitly discouraged from relying solely on mutual recognition agreements. 2.74 The government should also redouble efforts to join international accreditation bodies. The Kyrgyz national accreditation body should participate in the regional "Central Asian Cooperation on MAS-Q" and strive to become a signatory o f the "Mutual Recognition Arrangement o f the International Laboratory Accreditation Cooperation (ILAC)" and the "Multilateral Recognition Arrangement o f the International Accreditation Forum(IAF)." This will permit Kyrgyz exportersto test their productslocally and have the certificates accepted in other countries. Under the current regime, imported products, even though they have already been certified, as meeting international standards, must undergo additional testing when they are imported into the Kyrgyz Republic.loO 2.75 Finally, while the govemment works on implementation of legislation to reform the system of technical regulations, it should refrain from passing new rules that substantially increases duplication and introduces many new testing and certification requirements.'" To the contrary, every effort should be made to strike down mandatory technical regulations, as a way of dealing with one the legacies of the Soviet system o ftechnical standards. Recommendations: 0 Standardization: Sh$t the burden of standards development out of government agencies (and other entities under substantial state control or direction) and into the hands of private sector bodies, especially those operating at the regional or international levels. 0 Accreditation: The government should promote both accreditation of Kyrgyz conformity assessment providers to international standards and the acceptance of loo For example, the Sanitary and Epidemiological Services(SES) subjects imported electronicsequipment to testingfor harmful electromagnetic emissionsevenwhen they have alreadybeen certifiedto intemationalstandards inJapan andWestem Europe. lo' For example, in June 2003 the govemment adopted Resolution No. 329, "On sanitary and epidemiological inspection providing the sanitary and epidemiological well-being of the population from the agencies and departments of the sanitary and epidemiological service of the Kyrgyz Republic" (June 6, 2003), which substantially increases the number ofproducts that require mandatory inspection or certijkation, and which undermines efforts to eliminate overlapping agency authority. 50 international accreditation of conformity assessment procedures, accelerate accession of Kyrgyz accreditation bodies to the International Laboratory Accreditation Cooperation and other multilateral arrangements, and accept as valid laboratory results of anyforeign conformity assessmentproviders that are accredited to international standards. e Conformitv Assessment: Shijt the burden of conducting testing out of the government to theprivate sector and ensurefree trade in conformity assessment services. Accept to the maximum extent feasible manufacturers' self-declaration of conformity assessment. Expand the validity of certificates so thatfewer tests are required. e Recopnition: Accept as equivalent foreign governments ' technical regulations that are based on international standards, even when thosegovernments have not entered intoformal mutual recognition treaties with the Kyrgyz Republic. 2.76 Whereas returns from regional cooperation in standards are raised inparas. 124-125 the germane question here i s whether 'going alone' in reforms outlined above may negatively affect existing and potential Kyrgyz exports. A short answer i s that the implementation of the above recommendations would notjeopardize access of Kyrgyz products to CIS markets, simplybecause CIS members recognize each other's certificates o f conformity. Simultaneously, once conformity assessment providers obtain international accreditation, Kyrgyz exports will have easier access to world markets. Furthermore, Kyrgyz recognition of laboratory results of any foreign conformity assessment providers that are accredited to international standards would not have any regional implications. This should, however, not suggest that the government withdraw from playing an active role inthe CIS-wide Council on Standards, Metrology and Certification to dismantle what remains o f the GOST and cooperate closely with EURASEC countries (see Section C). 2.77 Substantial technical and financial assistancewill be requiredto reformtechnical regulations and institutions for accreditationand conformity assessmentareas as well as to design a legal fi-amework for a market-based standards system.lo2As noted earlier, USAID, TACIS and other donors have already been working with the government on reform o f the law on technical regulation, activities of the FDI Secretariat, and reform o f Kyrgyzstandart, which has already begun the process o f reorganization. The fiscally more challenging reforms lie ahead. Several government agencies (e.g., Sanitary and Epidemiological Service and the Ministry o f Architecture and Construction) rely on testing fees to meet substantial parts of their budget. Shedding these current state functions to the private sector will, therefore, require both fiscal and institutional adjustments and i s likely to encounter bureaucratic resi~tance.''~ 2.78 An equally important issue in ongoing reform efforts is leveraging multilateral commitments in the context o f regional cooperation. Both are critical elements of a single strategy to introduce a market- oriented standards regime. To this end, the Kyrgyz Republic first needs to make fuller use of the enquiry point mechanism.'04 It has to use it not only as a source o f information for foreign companies-the TBT and SPS agreements only require the Kyrgyz Republic to notify its own regulations to other WTO members-but also as the enquiry point agency to disseminate information internally about foreign lo' The market-basedsystem of technical standards is based on decouplingstandard setting from conformity assessment and on producers' self-declarationof conformity assessmentprovided by private, accredited organizations. I O 3Some agencies involved (e.g., the Ministry of Architectureand Construction) reportedlydependheavily on testing fees. They appear to beblocking attemptsto scale back mandatorystandards. IO4 Enquirypoints mandatedby WTO agreements to help local exporters sell their goods in markets of WTO members and enlist involvement of local exporters in identifying in technical barriers in foreign countries. Kyrgyzstandart has been designated the WTO enquiry point for boththe TBT and SPS agreements. 51 regulations and to help potential exporters comply with foreign requirement^."^ The challenge i s not trivial: in the twelve months from July 2002 through June 2003, WTO members submitted over 950 notifications o f new technical regulations governed by the TBT agreement alone.lo6 The Kyrgyz enquiry point needs the capacity to sort through those notifications, identifying which hold the greatest interest to Kyrgyz traders, and then help those businesses gather the information they needto comply with new regulations. 2.79 Ina parallel fashion, the Kyrgyz government shouldwork to buildthis enquilypoint mechanism into regional standards arrangements, most notably the CIS Agreement on the Uniform Policy on Standardization, Metrology and Certi3cation. It should do so both to help coordinate technical regulations at the regional level-as development o f independent national standards i s eroding the uniformity o f standards across CIS countries since the collapse of the Soviet Union-but also because all CIS members face the common problem of adopting international standards. The two tasks, ie., the WTO enquiry point enriched with regional standards arrangements arenot contradictory. To the contrary, they complement each other provided that both are addressedcomprehensively. 2.80 What can be done to build a strong enquity point mechanism combining WTO requirements and regional standards arrangements? The first step i s to engage Kyrgyz companies, to educate them in the advantages o f producing to international standards, and to solicit their involvement inidentifying foreign technical barriers to trade that should be brought to WTO dispute settlement or to the attention o f government officials in charge o f managing the Kyrgyz Republic's bilateral and regional arrangements. Second, the principle o f transparency enshrined in WTO agreements must be extended to informing domestic companies about domestic regulations. Last but not least, it would be necessary to expand linguistic capacity in the Kyrgyz government, as notifications are published only in official WTO languages (English, French and Spanish) with member country governments distributing texts o f their regulations in their own national languages. This suggests a role for a regional translation and dissemination facility, as the Kyrgyz Republic and other CIS countries face a common linguistic barrier and can economize by sharing costs.'07 Recommendations: (0 Increase the capacity of the Kyrgyz TBT and SPS Enquily Point; (ii) train more officials in @TOlanguages; (iii) work with other CIScountries (EURASEC in particular) to establish a regional information dissemination facility; (iv) work with other CIS countries (EURASEC in particular) to simultaneously replace old Soviet standards with new international ones; and (v) establishpublic engagementmechanisms. 2.81 Customs: The Agreement on Customs Valuation i s a second important WTO agreement for the Kyrgyz Republic. The agreement requires that customs inspectors inWTO member countries rely on the transaction value-the price paid or payable inthe market-when calculating ad valorem duties instead of using reference or minimum prices that are set artificially by the government. This means relying primarily on what traders write down on their invoices.'08 Applying this valuation method in the Kyrgyz Republic,ifit is not accompaniedby reformand modernizationofthe customs administration, only opens the door to fraud and reduced collections o f tariffs, excises and VAT. To prevent such fraud, the K C A will need to allocate resources on increased training in valuation methods and enforcement, and share information about product valuation with other customs bureaus inthe region. IO5Note that this does not mean that the government should subsidize exporters' compliance with foreign regulations; that i s the responsibility of the companies' themselves! See http:lldocsoline.wto.org for these notifications. lo'Whether or not they are members of the WTO, all share a common interest in adopting international standards. 'OsThe agreement spells out procedures to follow when customs inspectors suspect that traders are misreporting. 52 2.82 Valuation i s only one dimension o f customs procedures, and it may not be the dimension that most influences international trade flows. The govemment and the K C A should intensively promote regional cooperation to advance the pace o f customs reform. In this endeavor, streamlining o f customs procedures or border controls should be complemented by administrative cooperation with neighboring countries including joint border controls, an exchange of information between customs authorities, and regulatory cooperation regarding transport equipment. A number o f foreign donors, notably USAID and the ADB, have been working with the K C A to rewrite the current customs code and improve customs administration. The revised customs code, now before the legislature, appears to be largely consistent with international best practices (including WTO rules and the revised Kyoto convention). Inparticular, it corrects problems inthe current customs code that has blocked emergenceof licensedcustoms brokers. 2.83 Yet, without simultaneously addressing bottlenecks in neighboring countries through intensive cross-border cooperation, the expected payoffs from this effort might fail to materialize. Recommendation: Use the legal obligation to comply with WTO rules to leverage comprehensive reform of customs administration, including computerization, harmonization of customs procedures among EURASEC customs union members, and promotion of entry of licensed customs brokers. 2.84 Services: The main restrictions to trade in services are `behind-the-border' laws, regulations and redtape. Thus, the task o f creatinga regulatory environment that encouragesthe development of services begins at home. Liberalization calls for reforms in a wide range o f domestic policies concerning, for instance, rules for network access in telecommunication, licensing regimes, investment rules, rules on temporary movement o f workers and competition policies. Despite the fact that the GATS/WTO commitments do not automatically provide for the regulatory environment supporting efficient provision of backbone services, WTO membership may help in the reform process,1o9as it offers a valuable mechanism to make credible commitments to reforms and shieldthem from domestic vested interests. 2.85 Nevertheless, worldwide, the use o f GATS by WTO member as a credibility enhancing mechanism has been rather limited, with one important exception-the telecommunications sector."' In this sector, the Kyrgyz Republic's reforms appear to fall within the pattern. The Kyrgyz Republic's schedule o f GATS commitments binds its telecommunications market to be open, and the Law on Electric and Postal Communications appears to be pro-competitive and up-to-date. Already several foreign- owned operators of cellular and paging services exist and the first foreign ISP (Intemet Service Provider) from South Korea was licensed in early 2003. Yet, leaving aside deficient infrastructure due to the delay in the privatization of Kyrgyz Telecom-which postpones the injection o f foreign capital and management know-how" `-the Kyrgyz Republic has yet to meet fully the non-binding GATS provisions on regulatory principles as outlined inthe GATSTelecommunication"Reference Paper." 2.86 While competitive safeguards against cross-subsidization and abuse o f information by companies appear to be in place in the telecom sector, rules on network interconnection,"* the cost-based charges and the institutional separation o f regulators and regulees raise significant concerns. Instead o f being financed by cost-based fees from licensing, the State Communications Agency collects the 0.25 percent IO9 Hoekman, Bemard, and A. Mattoo, 2000, "Services, Economic Development and the Next Round of Negotiations on Services," Journal of International Development, #12 (283-296), p. 292. `lo Aaditya Mattoo, 2000, "Shaping Future GATS Rules for Trade in Services," paper presented at an NBER Conference on Trade in Service, Seoul, June, p. 11. `I'Consequently,digital infrastructure, which users (including other telecomservice providersand ISPs) would use to offer more services, which in tum would benefit other sectorsofthe economy, such as transportation,financeandtourism is not there. `I2Ruleson network interconnectionprovide for non-discrimination,transparency, andthe cost-baseof charges. 53 charge on operators' revenues, which shouldbe more appropriately collectedby the State Budget.'I3 As a consequence, the institutional separation between regulators and service providers, a recommendation of the WTO "Reference Paper," has not been implemented. State ownership of Kyrgyz Telecom appears to be the main barrier in terms o f independent regulation. Given the state's direct involvement, potential competitors may rightly suspect that Kyrgyz Telecom will be given preferential treatment because of state interest init. 2.87 Class licensing (also known as general authorizations) would permit companies that fulfill the requirements to operate without waiting for a specific decision. This is an expeditious form o f licensing that would eliminate the time required to process applications and to reduce the cost of such processing, while removing an opportunity for unofficial payments. If such a system worked intelecommunications, it could then be tried out inother sectors (e.g., roadtransportation). Recommendation: The Kyrgyz Republic should consider moving to a class licensing system for telecommunications and to set licensing fees to cover the actual costs of processing license applications, monitoring the market, regulating prices and adjudicating disputes on a trial basis in order to observe behavior under such a regime, 2.88 Despite an all-encompassing schedule o f GATS commitments, there has been very limited progress in the development o f third party logistics industry (e.g., freight forwarders), logistics-related banking and insurance services. The Kyrgyz Republic badly needs local service providers operating in alliance with global service providers in these areas. It seems that weaknesses in the regulatory environment, combined with formal and informal barriers to entry for firms interested in establishing commercial presence in the Kyrgyz Republic, may have contributed to the present outcome (see paras. 2.121-2.123). A Seat at the Table: How to MaximizeBenefits from It? 2.89 Another major benefit that countries expect when they join the WTO is a seat at the `multilateral' table, both during infrequent, multi-year, multilateral trade negotiating rounds (such as the current Doha Round) and inthe WTO's day-to-day operations inGeneva. This includes participationor monitoring o f accession negotiations o f important trading partner^."^ The Kyrgyz Republic has much to gain from participation in accession negotiation, though not much from multilateral trade negotiations, as explained below. `I3State Communication Agency should be financed from fees covering the cost o f applications and monitoring rather than from the percentage o f a carrier's revenue. `I4 But this does not apply to cases where no current or potential future trade is at stake (e.g., Vanuatu, Seychelles, Jordan, Algeria and Oman). The Kyrgyz Republic will see little, if any, retum from any investment of its scarce time and staff resources serving on those working parties, which are mostly attended by countries having a stake in access to markets o f an acceding country. 54 2.90 Selective participation in WTO Accession Working Parties may yield direct benefits to the Table 2.10: KyrgyzMembershipinWTO Kyrgyz Republic, although it has yet to take full AccessionWorking Parties advantage o f it. Table 2.10 shows that the Kyrgyz Republic was, and currently is, a member o f several Countriesin the accessionprocess accession working parties. Its participation in the Algeria Azerbaijan Belarus accession working parties established to consider Kazakhstan RussianFederation Saudi Arabia membership o f other CIS countries, given both their Seychelles TajikiStan Ukraine proximity and economic relationships with the Uzbekistan Vanuatu Viet Nam Kyrgyz Republic and the fact that accession process Countries that have concluded accession influences rules that will affect trade inthe future, is important.li5 Albania Armenia China Croatia Estonia Georgia 2.9 1 Nevertheless, participation in working Jordan Lithuania Moldova parties should be exploited fully to effectively use Oman Taiwan the accession process for achieving trade policy Source: WTOdocuments, 1999-2003. goals. The accession process i s one o f the most important opportunities for the Kyrgyz Republic to influence the trade policies o f its trade partners. This should be pursued in tandem with efforts at the regional level, as discussed in the Section C below. If nothing else, the WTO accession forum presents the Kyrgyz Republic with the chance to solicit the participation o f China and European countries in addressing regional trade barriers, since those countries are affected by the same protectionist barriers as the Kyrgyz Republic, although they are not parties to Kyrgyz regional trade agreements.II6 2.92 Kyrgyz negotiators should focus particularly on issues where existing regional agreements provide few avenues for addressing trade problems or where the influence o f other WTO members can be brought to bear. The following actions are worth considering: 0 push for addressing transit issues-Kyrgyz exports are constrained by hightransit costs, but so are other countries' exports that needto pass through the region; 0 pushfor greater national govemment discipline onrules set by sub-central govemment; 0 press for the elimination o f indirect taxes and other fiscal policies that discriminate against imports; 0 pushfor lower access fees to use Kazakhstan's fiber optic cable; 0 pushfor greater disciplines on the use ofantidumping and other "trade remedies;" and 0 ensure that customs and other fees are based solely on actual cost o f services rendered. 2.93 Incontrast, the Kyrgyz Republic has little to gain from multilateral tariff liberalization for two reasons: First, it already has an almost duty-free access to relevant markets of WTO members. Second, since Kyrgyz tariffs are almost fully WTO-bound and relatively low, proposed tariff-cutting formulas to be used duringthe Doha Round trade negotiations on non-agricultural goods have no influence on the its MFNtariffschedule. ' The possible exception is access to China's markets, the only WTO member that shares a border with the Kyrgyz Republic. But even in this particular case, there is not much to gain. The trade-weightedaverage tariff rate of 3.7 percent is very low, relative to both the simple average (12.3 percent) and the trade-weighted average on imports into China from all sources (1 1.6 percent). Exports are highly concentrated, with the top ten products (at the four-digit level of the Harmonized System) accountingfor 89 percent of the total to China. Raw hidesand skins ofbovine or equine animals alone contributed38 percent of the total, followed by aluminumwaste and scrap contributing another 10percentto the total in2002. I" See Annex 2-A for a discussionon market access negotiations inthe Doha Round. 'I7As some observe, "...most of these (CIS) states have found the reality of the CIS to be that it hampers and constraints their actionswithout providing them with the security or assistancethey require." (Olcott, Martha Brill, Anders Aslund, and Sherman 55 Conclusion 2.94 The Kyrgyz Republic has benefited from accession in several important ways, even if it has not realized all o f the benefits that countries often expect when they join the WTO. The Kyrgyz Republic's WTO obligations have helped lock in the program o f trade liberalization initiated in 1994. WTO membership has prevented backsliding in the application o f tariffs (on trade with members and non- members alike) and other traditional trade barriers. More importantly, membership has given guidance and additional impetus to launch or continue reforms o f domestic policies, customs reform, and overhaul o f the standards regime. Unlike market access agreements (i.e., tariff liberalization), these regulatory reforms reduce barriers to the Kyrgyz Republic's trade with all counties, notjust with WTO members. 2.95 What can be done to maximizefuture benefits of the Kyrgyz Republic's WTO membership? First o f all, the government should leverage its obligations under WTO rules to accelerate reforms o f the domestic standards regime, customs administration, and telecommunications. Enterprise surveys point particularly to the first two areas as sources of substantial extra costs o f doing business (see Chapter 3). Second, the Kyrgyz Republic should make greater use o f regional bodies to economize on the costs o f implementing WTO rules. All members of the EURASEC face pressures to reform customs administration and reform domestic standards regimes, for instance. Seeking regional cooperation in customs administration and in the dissemination of information about international standards and foreign governments' technical regulations will therefore bring gains to regional partners. The same applies for taking/supporting an initiative within EURASEC and in the agenda of the CIS Interstate Council on Standards, Metrology and Certification to move away from GOST standards. Finally, the Kyrgyz government should expand its capacity to conduct commercial diplomacy. In Geneva, this will require the government to play a greater role in accessionworking parties, as the government should use its WTO membership to insist on liberalization by its neighbors in the process of admission. At home, this will require the Ministry of External Trade to actively solicit cooperation from exporters and coordinate its activities with other government agencies. c. INTEGRATIONINA REGIONALSETTINGTRANSFORMING WEAKNESSES INTO STRENGTHS 2.96 Given its location, the Kyrgyz Republic's economic performance, including international trade and investment, depends critically on relations with former Soviet republics, mainly members o f EURASEC-in addition to domestic reforms including inter alia bringing various policy areas further in line with the WTO commitments. The plethora o f bilateral and regional agreements governing Kyrgyz relations with former Soviet republics can be divided into two groups: CIS-wide agreements and other agreements with CIS members, either arranged on a bilateral or regional-CIS basis. Among the latter, the most important to the Kyrgyz Republic,interms o f economic policy dialogue, is EURASEC. 2.97 The charter of the CIS, which came into effect in January 1994, is broad in coverage. It contains provisions concerning both the development of a common economic space with a common customs policy, and issues related to protection o f human rights and fundamental freedoms as well as the coordination o f defense policy and border protection. Nevertheless, while the CIS legal and institutional infrastructure would appear to address all issues pertinent to deep regional integration, this i s not so much the case. The desire to establish sovereign statehood, especially strong among smaller CIS states, and to prevent the re-emergence o f the Soviet Union under a different guise, has been in conflict with enforcement o f CIS Agreements. Some counties would opt for deeper integration, while others would not."' W. Gamett, 1999, Getting It Wrong. Regional Cooperation and the Commonwealth of Independent States, Camegie Endowment for Intemational Peace, Washington, DC, p. 224). 'I8Fordetails, see Table 2.5 above for the top exports by value in 2002. 56 2.98 Varying national interests and the weak support for implementation of the CIS charter have ledto the emergence o f a second dimension of regional integration limitedto agreements among two or more CIS countries. These are not in conflict with the CIS charter. To the contrary, they represent efforts to implement its provisions on a selective basis. The CIS still exists providing an umbrella for more limited integration efforts. I t appears that the CIS has ceased to be a constraint on economic decisions o f individual countries, but, ithas not yet become a stimulant. 2.99 While CIS countries have a poor record o f observing commitments made under different agreements, agreements belonging to the second dimension noted above appear to have been more bindingthan provisions of the CIS charter. They have played an important role inproviding framework for economic interaction between the Kyrgyz Republic and its neighbors. Furthermore, as discussed in what follows, they can be used to improve the business environment in the Kyrgyz Republic and to address issues hampering access to other markets. This section reviews the context o f regional trade flows and then concentrates on the problem o f transforming the weaknesses of current agreements into a more effective instrument of the Kyrgyz Republic's integration into global markets. Trade Flows: Implications for Kyrgyz Foreign Economic Policy 2.100 As discussed earlier, the Kyrgyz Republic presently conducts around half o f its trade with FTA partners, of which EURASEC members form the largest share (see Table 2.5). However, these figures underestimate the importance of EURASEC countries for Kyrgyz employment and poverty alleviation. This i s because, gold, which is presently the country's single largest export product, accounting for the bulkofKyrgyz exports outside ofthe region, generateslimitedspillover into local ec~nomy."~ 2.101 This underscores the importance of other export items, and on this count EURASEC stands tall. Excluding gold, the share of EURASEC and other CIS countries in total exports increases from 36 percent to 56 percent, although it still displays the declining trend-the share o f CIS countries declined from 77 percent in 1996to 66 percent in 1999 and 56 percent in2002. Excluding electrical energy, which i s traded outside o f the market through intergovernmentalbarter arrangements, natural resource intensive and simple low-processed industrial products dominate Kyrgyz exports to the CIS (Table 2.1 1). Within this group, EURASEC members Kazakhstan and Russia provide not only important outlets for Kyrgyz products but are also both the source of foreign investment, although not a dominant one, and trade routes leading to other markets. Table 2.11: PrincipalExports to the CIS, 2002 Product(4-digit level of HS) Value ($millions) Share of CIS (YO) Cotton, not carded or combed 27.17 68 Electrical energy 22.02 55 Un-manufactured tobacco; tobacco refuse 19.01 47 Electric filament or discharge lamp 11.11 28 Petroleum oils 5.62 14 Dried leguminous vegetables 5.26 13 Articles o f asbestos-cement 5.13 13 Cane or beet sugar 4.64 12 Articles for the conveyance or packing of goods 4.07 10 Parts and accessories of motor vehicles 3.68 9 Source: 2002 trade data reported by the Kyrgyz govemment to UNCOMTRADEdatabase. These include, among others, agreements on road and rail transport. Telecommunication is subject to bilateral agreements. 57 2.102 Thus, CIS economies, or more specifically EURASEC, remain by far the most important outlet for Kyrgyz exports. Nevertheless, the Kyrgyz Republic's economic growth performance depends not only on import demand growth in EURASEC, but also on the ways that EURASEC unfolds as a project for deeper regional integration. As a member of the WTO, the Kyrgyz Republic is committed to pursuing multilateral liberalization, though it has a significant stake in seeking to actively influence the pace and scope ofregional integration and liberalization. RegionalRamification of External Economic Interaction 2.103 The Kyrgyz Republic i s a party to a plethora of various agreements under the CIS framework, both bilateral and regional,"' covering on the surface all issues pertinent to seemingly close cooperation. Nonetheless, the focus of its regional strategy should be on EURASEC. This is because EURASEC goes beyond FTAs, as it sets the goal of achieving deeper economic integration among its members. It also offers an institutional venue where issues of mutual interest can be more effectively addressed than in bilateral negotiations. The Kyrgyz Republic's weak bargaining power, because o f its small size and geographic location, is much less a problem in EURASEC organizational context than in bilateral negotiations. Furthermore, many initiatives serving economic interests of all EURASEC members stand a better chance o f being implemented on a regional, rather than bilateral, basis. The inclusion o f critical provisions omitted from FTA andor assuring their compatibility with the WTO disciplines would not only strongly serve economic interests o f the Kyrgyz Republic, but also other CIS economies. 2.104 The main questions addressed in this section concern the depth and scope o f regional integration that would best serve the Kyrgyz Republic's economic interests without jeopardizing interests o f other EURASEC members. These questions are as follows: What is the Kyrgyz Republic's participation in regional arrangements and what are their majorfeatures? How can the Kyrgyz Republic seek to address weaknesses of regional arrangements in which it participates? What areas should be addressed and encouraged in regional cooperation? Is a customs union (CU) an option worthJightingfor or resisting? Free TradeAgreements: CISFree TradeArea 2.105 Except Azerbaijan and Georgia, the Kyrgyz Republic has either signed or concluded negotiations to sign FTA (see Table 2.12). The negotiations o f FTA with Azerbaijan were concluded, and the FTA is likely to go into effect in2O04.l2l I 2 OAccording to the govemment of Kyrgyz Republic's notification to the WTO Committee on Regional Trade Agreements (WTiREG82/3, 27 September 2000), the FTA (signed on April 15, 1994) with Turkmenistan has been "provisionally applied" since December 18, 1996. Since it was an agreement among several CIS countries, it was subject to separate bilateral negotiations. I*' This is an important feature allowing for the development of the division of labor going beyond dyads o f bilateral FTAs. Inputscan be processed and enriched in any CIS countrieswithout imperiling their `local' status. Without diagonal cumulation, Russian inputs into a product imported into the Kygyz Republic from Kazakhstan would be treated as foreign content, which mightjeopardizepreferentialduty-freeaccess for this product. 58 Table 2.12: Kyrgyz Participation in Regional Trade Integration Agreementon Parties BasicFeatures ree Trade Area (signed 8 October 1992, RussianFederation FTA with exceptions andprovisionsallowing to levy 'fective as of 24 March 1993), seasonalduties and quantitativerestrictions. (Added aProtocolof Exceptionsfrom FreeTrade Regime on 711211994). Goods subject to export tariffs and licensing(mainly alcoholic beverages) are excluded ree Trade Area (22 June 1995,effectiveas of Kazakhstan A numberof protocolsof exceptionsuntil 2000. 1 November 1995) ree Trade Area (signedon 26 May 1995, Ukraine FTA on all products rfectiveas of 19 January 1998) ree Trade Agreement (signed on 4 July 1994 Armenia FTA on all products ree Trade Agreement Moldova ree Trade Area (24 December 1996,effective Uzbekistan FTA with exceptions and provisionsallowing to levy j of20 March 1998) seasonaldutiesandquantitativerestrictions. (Added aProtocolof Exceptionsfrom FreeTrade Regimeon 12/24/1996).Goods subject to exporttariffs, export andimport licensing, and quotasare excluded. conomic Union of CIS countries CIS members except Intentionto establish economic unionwith FTA !4 September 1993) Ukraine negotiatedon abilateral basis as a first step. ustomsUnion (6 January 1995) Belarus, Russia Intention to establish CET 'ustomsUnion (20 January 1995) As above plusKazakhstan As above I ustomsUnion (signed 28 March 1996, As above plus Kyrgyz As above itified by KR on 21 July 1997) Republic 'ustomsUnion (26 February1999) As above plusTajikistan As above 'ustomsUnion andCommonEconomicArea Belarus, Kazakhstan, Pledgeto set the time framework for introducing ;ignedon 26 February1999) Kyrgyz Republic, Russia, CET. Tajikistan 'ommon CustomsTariff ofthe Customs As above CET (except for sensitiveproductsas determinedby inion (17 February2000) each Part) establishedwithin five years fromthe date of entry into force of the Agreement. 08/3l/OOfor Belarus, Kyrgyz Republic and Russian Federation stablishingEurasianEconomic Community As above Establishinginternationalorganizationto administer I O October 2000) customs union and foster 'deeper' integration 2.106 The only neighboring country with which the Kyrgyz Republic has no FTA is China. Although China offered to begin FTA negotiations, this i s not an attractive option to pursue. An FTA with China, that would open the doors for the latter to larger Russian and Kazakh markets could facilitate Russia and Kazakhstan-concerned with trade deflection andor flood o f cheap Chinese import, partly processed in the Kyrgyz Republic-to introduce much tougher rules o f origin then currently in place in CIS. This would likely hurt the Kyrgyz Republic more than free access to China couldhelp. Recommendation: Do not sign new FTAs with a potential-to complicate relations with other CISpartners and that bring little, ifany, benefit to the Kyrgyz economy. 2.107 In their entirety, the existing CIS-FTA arrangements to which the Kyrgyz Republic i s a party would appear to be a full-fledged free-trade area. Customs duties, taxes and charges with equivalent effect, as well as quantitative restrictions on substantially all the trade between CIS countries have been abolished. The same rules o f origin, i.e., rules specifying whether a product qualifies for a duty-free entry, appear in all agreements. Furthermore, as rules o f origins allow for diagonal cumulation across 59 CIS countries,"' the present arrangements amount to a free trade area for agricultural and industrial goods. There are, however, three important caveats discussed in detail below. First, discretionenjoyedby customs and local authorities remains an important impediment to unfettered movement of products, as various border and non-border charges on intra-CIS trade are not contractually bound.'23 Second, administrative denials o f access and antidumping actions constitute another impediment to bilateral trade. Last but not least, Belarus and Uzbekistan have yet to introduce a market-based foreign trade regime, and-in spite o f FTAs-they impose various charges effectively suppressing imports. Kyrgyz exports have suffered in particular. In consequence, important benefits o f a free trade area encompassing CIS economies are inadvertently lost. As argued below, the best strategy would be to bringWTO disciplines to bear on CIS FTAs. CIS FTAs' Main Weaknesses:Bringing WTORules to theRescue 2.108 The FTAs signed by the Kyrgyz Republic have the same structure, commitments, coverage and escape clauses. Their features are compatible with the WTO rules, although-as discussed below-they do not always provide similarly strong disciplines. A major weakness they share is the absence of strong contractual and credible commitments to keep markets open to preferential trading partners. In consequence, they are not rule-oriented, they lack enforcement mechanisms, and, therefore, exits are relatively easy. The most important features sharedby Kyrgyz CIS-FTAs includethe following: They cover both agncultural and industrial goods, even if some FTAs contain protocols of exemption to tariff-free entry, which are subject to annual review. At present, Kyrgyz exports enjoy a mostly free trade regime throughout the CIS.'24 Most importantly, Russia does not impose an exemption from free trade regime on Kyrgyz imports, although it does so for other CIS members. Reciprocally, there are no exemptions to duty-free access to Kyrgyz markets. However, the provisions of the FTAs do not contractually guaranteethis situation to last. They all declare adherence to the principle of national treatment and non-discrimination, which guarantees the same treatment o f domestic firms and those registered in other CIS countries; They all ban the use o f quantitative restrictions or measures with similar effect, but they also specify special conditions under which these measurescan be usedas safeguards; They commit their signatories to assure cooperation and exchange o f information between respective customs administrations; They all have provisions concerning unfair competition, but they lack provisions limiting state subsidies; They all provide for free transit through respective territories, as discussed earlier, the implementation o f these provisions i s doubtful at best and ineffective at worst; `22 Economic Survey of Europe 2003, UN Economic Commission for Europe, United Nations, New York and Geneva, 2003, p. 180. See also Trade Performance and Regional Integration of the CIS Countries, (mimeo), PREM Sector Unit, Europe and CentralAsia Region, World Bank, 2003, p. 43. `23 Uzbekistanhad imposed some exemptions from free trade regime on Kyrgyz exports since 1996, in accordance with the bilateral FTA and the protocolon exemptions singed in that year. However, the exemptions have been gradually removed since then. 124 These commitments are enshrined not only in FTAs but are also stipulated under a plethora of other Agreements on: Transit through Territoriesof CIS members (1997); CommonTransport Policies inthe CIS (1997); TransportTariffs in the CIS (1997); and the Agreement on Common Railway Tariffs in EURASEC (2002). Road Transport Union of EURASEC (1998), an important agreement reaffirming the principle of national treatment to both modes of transport, rail and road, awaits ratification by the governmentof Belarus, which is the only remainingEURASEC-membernot to do so as o fFebruary2004. 60 0 They all allow for the use of antidumping measures; 0 They all provide for bilateral settlement oftrade disputes. 2.109 Several weaknesses stem from the absence of enforcement or disciplines on contracting parties resulting in de facto exits from obligations under free trade arrangements. First, while the Kyrgyz Republic's CIS partners have committed themselves to levy transit fees reflecting the cost of services rendered and while they adhere to the principle of national treatment o f transport companie~,'~' contracting governments tend to apply these rules only to railroads-not to road transport. This does not help most Kyrgyz exporters, as volumes o f Kyrgyz exports are too low to take advantage o f discounts that would make the railway transport mode competitive. 2.110 Larger use o f railroad transport may be achieved by promoting alliances o f local forwarders, who offer intimate knowledge o f their local market, with global forwarders, who hold regional and worldwide contacts. By consolidating shipments from various sources and coordinating handling and storage, which are major cost factors, freight forwarders would helpto bringdown unit costs thanks to the use of cheaper and less illicit payments-prone railroad transport. Hence, the Kyrgyz Republic needs to create an environment hospitable for freight forwarders, domestic and foreign alike. It has already bound itself open with respect to these services under the GATS. However, a key issue will be to reduce red tape preventingcommercial presence of foreign service providers inthe Kyrgyz Republic. 2.111 Greater presence o f foreign-owned service providers might have another beneficial consequence, i.e., it might create pressures from business groups on other EURASEC governments to follow transit rules generally accepted by the international community. Some firms that would start operating in the Kyrgyz Republic are likely to come from EURASEC countries. Since these firms have a stake in minimizing `harassment' from officials, they may push their governments to address transit issues. But this alone probably would not suffice to effect change+ooperation among governments i s badly needed. 2.112 As for eliciting cooperation on transit issues from neighboring countries, the Kyrgyz Republic should take advantage o f its membership inthe WTO to make its neighbor's arrangements similarly open as it has done under GATS, i.e., allow for commercial presence o f service providers and national treatment o f transport companies. The Agreement on Road Transport Union o f EURASEC, once it goes into effect, provides for national treatment, although not for commercial presence.'26 Recommendation: Makefreight forwarding a matterfor requests during WTOaccession negotiations (or in the case of China, requests in the Doha Round). Work with neighbors to reduce the corruption, as well as the unofficial fees and arbitrary fines extracted by respective officials. 2.113 A second weakness of CIS trade-related arrangements is that even the more detailed bilateral agreements often defy the letter and spirit o f broader regional agreement^.'^' A good example is the Transit Agreement with Kazakhstan, which is about to be replaced by a new Transit Agreement addressing at least some, ifnot most issues discussed below (see paras. 2.26-2.27). As soon as the Agreement goes into effect, Kyrgyz carriers will be subject to the same fees and charges as local ones. This means, for instance, that the current chargeof around USS60 will be completelyremoved. 126The Kyrgyz Republicconcludedbilateral agreements on transit and roadtransport with its neighbors-Kazakhstan (1993) and Uzbekistan(1996). But Uzbekistanhas subsequentlywithdrawn from the bilateralagreement .I2'Itshould be borne in mind that anti-dumpingis not a WTO commitment, but an option with GATT disciplines applying only insofar as the option is resortedto. 61 Recommendations: 0 The Kyrgyz Republic should lobby for the adherence of its neighbors to the free transit regime, in accordance with the EURASEC and other CISFTA agreements. In addition to bilateral efforts, the issueshould bepursued in the EURASECIntegration Committee and the CISExecutive Committee. 0 The Kyrgyz Republic should sponsor amending the EURASEC transit agreement by introducing aplurilateral institutionalframework for resolving transit disputes. It is critical to form alliances with CIS countries to bring additional impetus to resolve the issue. 0 TheKyrgvz Republic should use more aggressively opportunities offered by its WTO membership to raise practices that are in defiance of WTO disciplines on transit at the Kazakh accession negotiations with the WTO. 2.114 Third, while WTO rules allow, although not encourage,128the use of antidumping measures and countervailing duties, the CIS FTAs provide for weaker disciplines than those under WTO.I2' The Kyrgyz Republic has been on the receiving end o f antidumping duties imposed by CIS countries and knows first-hand how damaging these can be (see para. 2.24). At various regional fora, CIS governments have pledged to refrain from the use o f safeguard actions, countervailing and antidumping measures on imports from FTA partner countries, butresults are mixed. 2.115 Antidumping legislation i s a bad idea from the viewpoint of national economic interests. The alternative-a safeguard option-is a better approach to follow but it should be administered pr0per1y.l~' International trade economists almost universally condemn antidumping policies as an especially pernicious form o f protectionism on a wide range of theoretical and practical grounds.I3' Box 2.2 summarizes the fundamental reasons why antidumping rules should be removed from both national legislation and regional trade agreements. 12' The Protocol on the Mechanismof Applications of Safeguardsand Antidumping Measure in the Customs UniodEURASEC (2000), albeit largely compatible with the WTO rules, does not envision establishment of an autonomous EURASEC-wide institutional infrastructureto enforce those principles. Instead, it merely calls for bilateral consultationsas the main means to resolvedisputes. 129 In case of serious injury caused by imports, GATT Article XIX allows for safeguard actions. If protectionistmeasures are necessary to prevent injury to domestic producers, they should be price-based (i.e., expressed in terms of tariffs), precisely defined, temporary, nondiscriminatoryand introducedafter appropriateprocedures consistent with WTO rules are followed, and taking into account the costs to consumers and users. The agency responsible for conducting the injury investigationshould comprehensively addresscoststo users of investigatedimportsandbenefitsto an industryseekingcontemporary protection. I 3 OAnti-dumping rules are not transparent,discriminatory (not only by countrybut by firm), lacking in economic foundation, and highly distortionary. See for example, contributions in Finger, J. Michael, ed., 1993, Antidumping: How it Worksand Who Gets Hurt, University of Michigan Press, Ann Arbor. 62 Box 2.2: Three Reasons Why There Should be No Place for Antidumping in FTA and National Legislation First, the existence of an antidumpinglegislationalone increasesthe leverageof protectionistinterests over the government. It breeds lobbying, corruption, rent seeking, and diverts scarce entrepreneurial talent into the political process. It creates temptationto resort to antidumpingto cover whatever sort of import restrictionsseems politically expedient; Second, the standards of antidumping do not make economic sense-they do not guide government to deciding where an import restriction would harm or serve the nationaleconomic interest, while allowing for an easy exit from a liberal foreign trade regimeonce it is inplace; Third, they reduce import competition in domestic markets and raise prices as a mere opening of the investigation causes imports to fall and prices paid by users to increase; and they rarely, if at all, address cases which present a real threat to Competition. 2.116 As the first-best policy option, the Kyrgyz Republic should seek the removal o f antidumping provisions from EURASEC agreements on the grounds that a safeguard option i s a better course to follow. Strengthening competition rules, already included in EURASEC FTAs, could provide an extra bite to the use o f the WTO safeguard norms. Instead o f buildingthe case on the basis o f alleged sales below production cost, the focus i s on the assessment of its impact on competition. Inother words, the same rules are applied to domestic and other EURASEC firms. This would not only be in line with a professed goal of establishing single EURASEC market inthe future, but it would also subject all firms, domestic and other EURASEC, to the same competition rules. This would require harmonizationinLaws on Protection o f Competition among EURASEC members, which could be modeled after the EU competition rules. It would also require disciplining the use of subsidies in order to avoid unfair competition. Since the CIS FTAs do not fully control export subsidies (outlawed by the WTO), this may leadto the pressures for levying countervailing duties. 2.117 Banning antidumping entirely may, nevertheless, meet resistance among EURASEC partners, as antidumping is an attractive protectionist tool used worldwide. An alternative option would be to push EURASEC to adopt clear rules and strong disciplines on the use o f antidumping policies going beyond the current WTO agreements. A good candidate for sound rules in this area are proposals submitted during the current Doha round o f multilateral trade negotiations by "Friends of Antidumping Negotiations"-a group o f both developed and developing countries championing reforms of WTO rules on antidumping. In a nutshell, these proposals seek to eliminate significant arbitrariness by national authorities allowed under the current WTO rules. For instance, there is significant degree o f freedom in choosing a comparator (i.e., company) to assess whether a firm under antidumping investigation sells below costs. 2.118 Adopting these rules at the EURASEC-level combined with setting a regional agency responsible for antidumping investigations inaccordance with these rules will yield significant benefits to EURASEC countries. First, it would vastly improve stability and predictability of intra-EURASEC trade by subjecting it to more transparent rules-the fear o f protectionist measures kills trade. Second, it would send a strong signal to the international community o f their commitment to a sound rule-based system. Finally, it might also help inchanging EURASEC members' official status inhighly developed countries particularly incase o f antidumping investigation^.'^^ '32CIS exporters, including those from the Kyrgyz Republic, since they are former centrallyplannedeconomies, are particularly vulnerable to antidumping actions brought by other importing countries. For example, the U.S. Department of Commerce continues to classify many former Soviet republics, including Kyrgyz Republic, as a non-market economy for purposes of assessing dumping margins. U.S. examiners are given greater flexibility to disregard the prices prevailing in non-market economies in anti-dumping investigations. By default they then rely on cost information provided by companies bringing the anti-dumpinginvestigation. Kazakhstanrecently succeeded inchangingits status to "market economy." 63 Recommendations: 0 Put the issue of safeguards and antidumping on the agenda of bilateral and regional negotiation. Recommend the introduction of WTO, if not stronger, disciplines on the use of safeguards. 0 I n the meantime, do not use safeguards and do not retaliate against such measures taken by Kyrgyz FTApartners. Engaging in trade wars with largerpartners would be prohibitively costly to the Kyrgyz economy. 0 Start lobbying for the introduction of a provision that would ban the resort to antidumping actions in intra-CIS trade. 2.119 Another area where a combination of WTO rules with regional cooperation might yield significant benefit to participating countries i s that of customs. As was argued in Section A and paras. 2.81-2.83, full implementation of the WTO Agreement on Customs Valuation requires reformand modernization o f customs administration, including in other EURASEC countries in order to lower the transaction costs for Kyrgyz exporters and importers alike. It would also require establishing arrangements that will foster intensive information-sharing about product valuation and other relevant issues with customs authorities inthe region as well as applying modem techniques o f customs clearance (e.g., random inspections). Streamlining customs procedures or border controls should be complemented by administrative cooperation with neighboring countries in such areas as establishing joint border controls, regulatory cooperation regarding transport equipment, etc. These arrangements exist among NAFTA members. They also exist betweenCentral European countries on the EUaccession path. Early stages of EU integration provide illustration of good practices in that respect. South East European countries, which are part of the Stability Pact for the Balkans, have been also moving in that direction, albeit slowly. Unexplored Opportunitiesfor Regional Cooperation 2.120 One of the major weaknesses o f CIS FTA and EURASEC arrangements i s the exclusion of provisions for trade in services and the outdated approach to technical standards. Since services account for a growing share of GDP and, more importantly, are critical to trade ingoods, this i s a major omission. The existing CIS agreements related to services include-in addition to several agreements on transit, energy and transport p~licies'~~-theAgreement on Common Education Space (1997) and the Agreement on Cooperation in Cellular Mobile Communications (1997). Concerning the agreements on education and communication, they are mostly technical agreements with limitedrelevance for trade in goods and services. Finally, there are also some bilateral agreements covering electricity and telecommunications. Overall, however, these agreements are outside of CIS FTAs and EURASEC regional integration arrangements. 2.121 The absence of services in EURASEC agreements defies the trend observed inFTAs worldwide since the mid-1990s. Every major FTA now has both a service and goods dimension. Two different approaches have been taken.'34 The first may be called an integrative approach, as some FTAs have integratedboth dimensions into a full set o f disciplines for trade inboth goods and services. This stands in contrast to the WTO umbrella agreements that distinguish among three parts, with different rules applying to goods (GATT), services (GATS), and intellectual property rights (TRIPS). The second approach may be called "GATS-plus," as it reproduces the same approach adopted during the Uruguay Round o f multilateral trade negotiationthat ledto the GATS (see Box 2.3). 133As discussed earlier, deficiencies in transport and logistic arrangements significantly lower competitiveness of Kyrgyz products in international markets. 134See Sherry M. Stephenson, 2002, "Regional versus Multilateral Liberalizationof Services," World Trade Review, Vol. 1 (2): 187-209. 64 2.122 Followingthrough with these norms by addressing services intheir entirety and by bringing them under the EURASEC umbrella would be a major improvement. To infuse transparency, stability and predictability, the least controversial step would be to begin with establishing an inventory of measures restricting market access and binding them at existing levels. Nevertheless, `stand-still bindings' do not enlarge access for new providers. Hence, the next logical step would be liberalization. The Kyrgyz Republic should make the case for liberalization along its national commitments submitted under GATS. Since other EURASEC members strive to accede the WTO, and at least inthe case of Russia, the WTO- members will press for a radical reform program, as they did successfully in the case o f China's acces~ion,'~~this would appear to be a feasible strategy. But GATS does not have to be an end-point as many regional agreements not only go beyond the GATS but, "...they also rate more favorably on the objective o f achieving relatively greater liberalization of services trade."136 Gains-from improvement in `behind-the-border' laws and regulations, and limitation o f red tape-would be broad based and be significant to all EURASEC members. Recommendation: Thegovernment should start lobbyingfor the inclusion of services in EURASEC agreements and push for adopting GATS-plus approach (See Box 2.3) to liberalization of market access across service sectors. 2.123 While non-preferential liberalization usually yields larger gains, as it affords consumers access to the most competitive source, regional regulatory cooperation may be more desirable in some areas. A good example i s air transport. Inthe case of air transport, while demand for it among Kyrgyz exporters may not be significant at present,13' tourism would certainly benefit from improved regional transport. For instance, there are no direct air connections between Bishkek and Almaty. Passengers using non- regional airlines (such as KLM or Lufthansa) must terminate in Almaty and then travel overland to destinations inthe Kyrgyz Republic. It appears that there have beenrequests to permit flights to continue from Almaty to Bishkek,but that Kazakhstanhas declined them. The Kyrgyz Republic should not only press Kazakhstan to allow for these flights but it should push for `open skies' among Central Asian countries fashioned after the EU `European Civil Aviation Area' M0de1.I~' This has the following features: it makes no distinction between international and domestic services; it bans bilateral Air Service Agreements; it abolishes cross-border ownership restrictions; and it establishes a common regulatory framework for ground-handling and slot allocation. A less ambitious alternative would be the liberalization o f bilateralhegional air service agreements and the insertion o f `open skies' provisions so that airlines could serve the region more efficiently and tourists could travel more freely. 13'China's GATS commitments made upon accession to the WTO in 2001 are regarded as "the most radical services reform programnegotiatedin the WTO." (Aaditya Mattoo, 2003, "China's Accession to the WTO: The Services Dimension." Journal oflnternational Economic Law, Vol. 6, (2): 299-339, p. 299. '36SherryM. Stephenson.,2002, "Regional versus Multilateral Liberalization of Services," World Trade Review, Vol 1 (2): 187- 209, p. 193. 13'But this may be a questionof airfreight fees. Measuresto reduce their costs in the Kyrgyz Republic (e.g., airport and traffic controls fees) through competitionenhancingregulatoryframework could help reducecost andtrigger demand. The option of following the WTO track is not availableas yet. Air transportservices were virtually carved out of the WTO by the UruguayRoundGATS annex on air transport. It would, therefore, be difficult to press Kazakhstan to open its civil air market during its WTO accessionnegotiations. However, given the recent decision of the European Court of Justice granting the EU Commission authority to negotiate for all EU member states with the United States, there is a prospect of serious WTO negotiationson air transport inthe future. But this may still lie far away. 65 n Trade in services is definedin GATS (GeneralAgreement on Trade in Services) as the supplyof a servicethrough any of the four ways, known as "modes of supply": Mode 1: services supplied from one country to another (e.g., international telephone calls). officially known as "cross-border supply"; Mode 2: consumers from one country making use of a service in another country (e.g., tourism), officially known as "consumption abroad; Mode 3: a company from one country setting up subsidiaries or branches to provide services in another country (e.g. a bank from one country setting up operations in another country), officially known as "commercial presence"; and Mode 4: individuals traveling from their own country to supply services in another (e.g., an actress or construction worker), officially known as "movement of natural persons." (for the assessmentof importanceof various modesin the Kyrgyz Republic, see Annex 2-B on Trade in Services) Services entered the agenda of the Uruguay Roundof multilateral trade negotiationsfor two reasons. First, with on- going transition from industrial to service economy, trade in services has been one of the most rapidly expanding areas of international trade growing much faster than merchandise trade. Highly developed, increasingly service-based economies sought to extend rule-basedregime of internationaltrade to services. Second, electronicrevolution has made the links between services and liberalization in their trade and overall economic performance more pertinent. Liberalization of trade in services may improvethe quality and availability of servicesthroughcompetition, economiesof scale and, last but not least, incentivesto policy makers to improve regulatory environment. Benefits of services liberalization are not limited to services sectors themselves: they impact all other economicactivities. GATSframework and liberalization: GATS was deemed a success of the UruguayRoundnot becauseof the progress in liberalizationoftrade inservices but simply becauseit has lockedcountries into astandstillagainst backsliding, andto further rounds of progressiveliberalization. The GATS has failed to introduce similar disciplines in scope and depth as under the 1994 GATT. First, while it commits WTO members to meet two general obligations: transparency and the most-favored-nation (MFN) principle across-the-board, the Agreement allows for temporary exemptions to MFN. Second, unlike the 1994 GATT, the principle of national treatment (i.e., no less favorable than afforded to domestic one) and market access applies only to sectors specifiedin national schedules of GATS commitments. As a consequence, the GATS is weaker than the GATT in meeting the fundamental objectives of multilateral trading environment, that is: the promotion of transparency, stability and liberalization of trade.' The 1994 GATT scores higher on liberalization of trade. GATS Article 111 to notify changes in laws, regulations, and administrative procedures apply to all sectors thus assuring information availability, albeit with a caveat. Namely, since the barriersto market access are not price- based barriers such as tariffs but NTBs taking the form of discriminatory treatment embedded in laws, regulations and administrativeacts and procedures. these tend to be less easy to navigatethan rules relatedto trade in goods. In a similar vein, standstill rule assures stability in access, but less so than under the 1994 GATT. The problem is that GATS contains some unfinished rules on emergency safeguard measures and subsidies and with respect to domestic regulations.B'' The extent of liberalizationdepends on the sector-specific commitments, which except for financial services and telecommunication,is much more limited than that intrade in goods. For this reasonalone, 'rewards' interms of preferentialaccess may be larger for trade inservicesthanthosefor goods, simply becausethe extent of discrimination against non-preferentialsuppliers is larger. Approaches to services in FTAs: Two approaches to addressing services trade in FTA have emerged: one can be described as 'GATS-plus' another as an integrated approach. The former consists in adopting the same procedure for liberalization in trade in services, i.e., in the form of nationalschedules, as in GATS. The ASEAN Framework Agreement on Servicesprovides an example ofthe 'GATS-plus' approach. The integratedapproach, inspired by the NAFTA and followed in practically all RTAs in the Westem Hemisphere, incorporates disciplines on investment, government procurement, the movement of natural persons, competition, intellectual propertyrights, andtechnical barriersto trade in bothgoods and services.' Both approaches produce the same result: they lead to faster liberalization in services trade on a regional than multilateralbasis. What does regional liberalization in trade in services entail? It entails relaxationof restrictionson the movementof labor and capital as well as variety of domestic regulations including foreign ownership, standards, licensing and qualification requirements on a regional basis.' The scope and depth depends on the level of economic integration sought by participating countries and the instrumentsof protectioninplace. Full integrationof product and factor markets, as is the case of the EUafter the 1986 Single Market Act, is based on four freedoms of movement of goods, capital, persons and services and on very extensive regulatoryharmonization. But it is complexand takes time; even 18 years after the Single Market Act. the task is yet to be fully completed. 2.124 The last area where regional cooperation might bring quick payoffs to all participating countries i s standards discussed inthe context of the Kyrgyz Republic's obligations under the WTO TBT and SPS agreements. As discussed earlier, a standards regime inherited from the central planning era defies internationally accepted standards and procedures relevant for a market economy. On the other hand, maintaining an independent national standards regime i s costly, especially for a small developing country like the Kyrgyz Republic. Conformity assessment procedures are expensive and significantly increase transaction costs of imports. Maintaining and upgrading the capacity to conduct testing and issue 66 certificates, which are necessary for voluntary or regulatory standards mandated by a govemment, absorbs resources. Infact, the fixed costs associatedwith direct outlays for staff, training, equipment and facilities can be quite substantial, which suggests the existence o f significant economies o f scale. The opportunity costs o f retaining the necessaryhighly sophisticated equipment and technical expertise on an individual basis i s quite high. There are certainly more productive alternative uses in other sectors of the Kyrgyz economy. 2.125 The unilateral (national) and multilateral dimensions of a strategy to establish a market-oriented standards regime were discussed in paras. 67-79.13' The case for adding the regional dimension i s a straightforward one. First, the countries in the region all need the same standards to keep their mutual trade free o f technical barriers, and these standards should be harmonized with international standards in order to expand their commercial presence in global markets. Independent development o f national standards, occurring since the collapse of the Soviet Union, has eroded the uniformity o f standards across CIS countries and erected extra barriers to trade, CIS and non-CIS alike. Despite the fact that all CIS countries have signed the Agreement on the Uniform Policy on Standardization, Metrology and Certification, CIS members face the common problem of adopting international standards. Recommendation: Instead of developing technical standards on itshheir own, the Kyrgyz Republic should move jointly with its other CIS major trading partners in continuing the process of harmonizing standards with international standards within either the CIS Agreement on the Uniform Policy on Standardization, Metrology and CertiJcation or, if this is too burdensome, EURASEC. It should alsopushfor acceptance of foreign governments' technical regulations that are based on international standards, even when those governments have no formal mutual recognition treaties with Kyrgyz Republic and other CIS countries. 2.126 Second, as mentioned above, the development of institutional and technical infrastructure is expensive. Services rendered by conformity assessment providers may be supplied more cheaply at a regional, rather than on a small national, level. It would thus make sense to establish regional accreditation bodies and ensure their membership in the International Laboratory Accreditation Cooperation. Similarly, private-sector conformity assessment providers could benefit from economies o f scale ifallowed to operate inmore than one country. Recommendation: Establish market-based institutional and laboratory infrastructure jointly with its EURASECpartners-especially with Kazakhstan and Russia. Customs Union Option: I s it Worth Pursuing? 2.127 Should the Kyrgyz Republic actively participate in fulJilling one of the major objectives of EURASEC integration, that is, establishing a Customs Union (CU) and eschewing its autonomy in MFN tariffpolicy? Before addressing this question, it i s necessary to reiterate an earlier discussion on the fact that issues related to transit and deficient transportation infrastructure in the region, rather than tariffs, constitute the major external barrier to expansion o f Kyrgyz foreign trade. Transit costs add much more than duties to the cost o f traded goods. This has an importantpolicy implication: `39In a market-oriented standards regime, standards are voluntary, they are developed and enforced by private sector bodies; govemment regulations make use of existing intemational standards and are limited to essential public health and safety requirements. 67 0 As long as the EURASEC integration scheme does not address issues related to the cost of transit, the Kyrgyz Republic does not stand to gain from moving from an FTA framework to a higher stage o f regional trade integration, i.e., customs union. But entering the CU, entailing the adoption of a common external tariff (CET), may be a price worth paying, if transit and customs issues are addressed. 2.128 What is the price of a CU, i.e., of eschewing national autonomy over setting MFN rates? The answer depends on the level and structure of CET, the Kyrgyz Republic's WTO commitments and organizational arrangements concerning CU's internal economic borders. The benchmarks are as follows: (i) ifcommon externaltariffs on industrial products are set at highlevels, the Kyrgyz Republic may become a dumpingground for industrialproducts manufacturedinmuchmore developed EURASEC countries-Russia and, to a lesser extent, Belarus-and face the prospect o f complete de-industrialization; (ii) CETaresignificantly higherthantheKyrgyzRepublic's WTO `bounds', WTOmembersmay if retaliate;14' (iii) if customs duties and other charges are collected at national borders, i.e., transit costs remain unaffected, Kyrgyz producers would not benefit from a higher stage o f regional trade integration; (iv) but, Kyrgyz producers and consumers would loose if EURASEC members raise border charges and other transit fees as a penalty for notjoining the C U arrangements. 2.129 Assuming that tariff schedules of EURASEC member countries converge to Russia's, the CU option (limited solely to CET, with the border arrangements remaining intact) would not be very attractive for the Kyrgyz Republic (see benchmark (i)above). During its almost decade-long WTO accession negotiations, Russia's tariff schedule has become more uniform, international peaks removed and tariff rates lowered. But they are on average higher than those inthe Kyrgyz Republic, as shown in Table 2.13. The calculations below abstract from specific tariff^,'^' which account for 19 percent o f tariff lines of the Russian full schedule. Their `tarification', however, i s likely to increase both the variation and tariff levels. Without a more detailed analysis, it would be impossible to put a quantitative estimate on the potential shift inKyrgyz imports to less cost-efficient suppliers in EURASEC, yet it may be quite high for some products (e.g., capital and transport equipment). For instance, higher Russian tariffs for industrial products would lead, on average, to a 5 percent higher tariff on industrial products imported into the Kyrgyz Republic, thus contributing to a similar increase in their prices for Kyrgyz users o f industrial imports. 142 2.130 Customs Union i s not an attractive option for the Kyrgyz Republic as long as CET rates are higher than those in the Kyrgyz Republic. But there i s one exception: if the CET involves also the removal of economic borders among Customs Union members, benefits from the transport-and-trade facilitation effect might exceed the cost associated with trade diversion-provided that CET i s not too protectionist. Tariffs, taxes and other border charges would then be collected at the point of entry into the customs territory o f EURASEC. After the Eastern Enlargement o f EU in May 2004, shipments between the Kyrgyz Republic and the EU would then face only two customshorder controls. Nevertheless, on political economy grounds, this option i s unlikely for two reasons: first, the removal of borders would represent an even higher level o f economic integration under EURASEC, requiringa major push towards 140IfCET rates exceed the Kyrgyz Republic's WTO `bounds, WTO members might chooseto seek compensationby levying higher tariff rates on imports from the Kyrgyz Republic. Given the Kyrgyz Republic's small markets for imports from WTO countries, thisdoesnot strike one as a certainoutcome. But this possibility cannot be completelydismissed. 14'In contrast to the usual practice of limiting them to agriculturalproducts including cigarettes, specific tariffs linking charges, for instance,to the weight of a product, are also usedon imports of transportationequipment. Inthe Kyrgyz Republic's schedule there are no specific tariffs. All tariffs are ad valorem. `42 Benefitsfrom CU, especiallyamongdevelopingcountries, are problematic, especially if not accompaniedby liberalization in CET. The empirical evidence provides strong support to the finding that integration among developing countries exacerbates divergence in economic performance at the expense of least developed participants. For an extensive discussion, see Schiff, Maurice, and L. Alan Winters, 2003, Regional Integration and Development, World Bank and Oxford University Press, Washington, DC. 68 establishing a single market for goods entailing among others, harmonization o f excise and other tax rates, Second, mutual suspicions about customs revenue fraud exacerbated by weak governance in member countries would prevent an agreement to remove border contr~ls'~~-anexample is that even though the Russian-Belarus Union has a common (i.e., Russian) customs service and joint border committees, customs points still exist at the Russian-Belarus border.'44 Table 2.13: Characteristics of Structure of Tariffs in the KyrgyzRepublic and Russia Kyrgyz Republic" Russia Agricultural Products(HS Chapters0 through 24) Simple Average 8.9 10.7 StandardDeviation 4.0 4.7 Dispersion(coefficient of variation) 0.4 0.4 Maximum tariff rate 15.0 20.0 Percentof tariffs above the level of a simple average 0 27 Percentof tariffs above twice the level of a simple average 0 0 Percentof specific tariffs2' 5.5 35 Industrial Products(HS Chapters25 through 97) Simple Average 4.4 9.6 StandardDeviation 4.9 5.3 Dispersion(coefficient of variation) 1.1 0.5 Maximum tariff rate 15 20 Percentof tariffs above the level of a simple average 49.0 29.8 Percentof tariffs twice above the level of a simple average 34.4 8.2 Percentof specific tariffs 0 10.1 AN Products (HS Chapters 0 through 97) Simple Average 5.4 9.8 StandardDeviation 5.1 5.1 Dispersion (coefficient of variation) 0.9 0.5 Maximum tariff rate 65 20 Percent of tariffs above the level of a simple average 44.1 25.4 Percentof tariffs above twice the level of a simple average 5.7 7.2 Percentof specific tariffs 1.4 19.0 Number of lines 10,552 1 1,265 Number ofzero-tariff lines 4,474 Notes: "Averages do not include ad valorem statistical fee raising their values by 1.5 percent.''Specific 50 tariffs were not converted into their ad valorem equivalents. Source: Official 2002 schedules from Russianand Kyrgyz CustomsAdministrations. 2.131 All in all, establishing a customs union should not be at the top of the Kyrgyz Republic's foreign economic policy agenda. External barriers hindering Kyrgyz ability relate to border and customs procedures and conditions o f transit in countries separating the Kyrgyz Republic from non-CIS markets. The potential for welfare gains for the Kyrgyz Republic and other EURASECmemberslies inaddressing weaknesses in the current structure and coverage o f CIS FTAs. i.e., earlier discussed dimensions of regional integration, as the greatest gains have nothing to do with tariffs. 143These problems are by no means limited to CIS countries. For instance, most recently, lack of agreement among Gulf Cooperation Council countries on the distribution formula of customs revenue delayed plans for the implementation of customs from the planned January 1,2003 until 2005. 144Economic Survey ofEurope 2003, UN Economic Commission for Europe, p. 181. 69 Conclusions and Summary of Policy Recommendations 2.132 The Kyrgyz Republic's economic performance will remain closely tied to developments in EURASEC economies, the most important outlets for Kyrgyz exports. Good relations with EURASEC, as well as promoting a regional trade environment, are critical to the KyrgyzRepublic's economic welfare. 2.133 For this reason alone, the Kyrgyz Republic cannot watch from the sidelines as the EURASEC unfolds as a project for deeper integration. To the contrary, it should actively seek to influence the pace and areas of EURASEC integration. In other words, the Kyrgyz Republic needs to have a regional agenda addressing major regional barriers to its extemal economic interaction. Both the framework and practice o f regional cooperation suffer from serious weaknesses. Since they also harm other EURASEC member-economies, the Kyrgyz Republic will not necessarily be alone in its push for tuming regional trade into vehicle for prosperity. 2.134 The analysis inthis section offers insightsinto regional agenda that will maximize welfare of the Kyrgyz Republic and other EURASEC members. Its major items include: 0 Border and customsprocedures: The improvements inKyrgyz customs procedures, although highly desirable, will not do much without similar improvements in neighboring countries. Hence, there i s a need for close cooperation. The same applies to transits. 0 Conditions of transit: Although transit has been a subject of bilateral and regional discussions, the principle o f national treatment should be extended to all service providers and enshrined into EURASEC agreements. 0 Technical standards: The Kyrgyz Republic should move quickly on its own to establish a market-based system of technical standards and to replace GOST with intemational standards. This will yield higher retums if other EURASEC members move in step and cooperate closely. The Kyrgyz Republic, as a small economy, can substantially lower costs to domestic producers if for instance, conformity assessment, i s provided on a regional rather than national level. Antidumping: The Kyrgyz Republic should seek to replace antidumping provisions in EURASEC with safeguard provisions o f the GATT Article XIX or, if not successful, convince its EURASEC partners to adopt stringent rules o f their use. Services: Issues pertaining to service sectors should be addressed in their entirety and brought under the EURASEC umbrella. As a first step, measures restricting market access should be listed and bound, i.e., subject to a standstill. This i s a long-term project, as it involves regulatory overhaul o f sectors, with often-powerful vested interests (see Box 2.3). 0 Air transport: This i s an area in which `going alone' is not very productive for a small country. The Kyrgyz Republic can gain much from regional regulatory cooperation in air transport. The Kyrgyz Republic should not only press Kazakhstanto allow for continuation o f intemational flights into the Kyrgyz Republic, but it should push for `open shes' among Central Asian countries fashioned after the EU `European Civil Aviation Area' Model. 2.135 Inall, since EURASEC members arethe Kyrgyz Republic's most importanttrading partners, the Kyrgyz Republic has a huge stake inmaking sure that the pace and scope of regional integration improve its extemal environment and remove barriers to the country's integration into intemational markets, regional and global alike. 70 D. THEROAD AHEAD:THENEED A TWO-PRONGED FOR STRATEGY AND ITSORGANIZATIONALUNDERPINNINGS 2.136 The discussion in this chapter provides an answer to the puzzle why seemingly liberal foreign trade policies have failed to expand the Kyrgyz Republic's integration into regional and global economy. It shows that: (i) Kyrgyz Republic'spoor external performance cannot be blamed solely on adverse the external conditions; and (ii) reasons for unimpressive foreign trade performance are also deeply rooted in domestic policies. They relate to domestic regulatory environment and foreign trade institutions. 2.137 While it would seem that the government could address only the domestic dimension o f the Kyrgyz economic malaise, this i s not necessarily the case. External environment i s an important barrier, but steps can be taken to change it. In fact, the government i s well positioned to deal with both domestic and external conditions, thanks to its membership in both multilateral (WTO) and regional (EURASEC) arrangements. WTO membership provides a powerful tool, if a government is willing to use it, to leverage both domestic and regional reforms. The aspiration o f other EURASEC members to accede to the WTO further augments the Kyrgyz Republic's bargaining power in influencing the course of EURASEC integration. 2.138 Domestically, the need to comply with WTO commitments provides political shield and anchor for undertaking challenging domestic measures. Regionally, WTO rules can be used to provide guidelines for reforming the EURASEC framework for regional trade. Closing the gap between EURASEC current practices and those allowed under WTO rules in this way would go a long way to improve the Kyrgyz Republic's external trading environment. The adoption o f WTO-consistent disciplines in such areas as transit, antidumping, services, and customs and standards would significantly reduce transaction costs for all firms operating in EURASEC. Hence, the crux o f a recommended strategy is simultaneous focus on regional and domestic dimension set against the background o f the WTO rule-based system. 2.139 The implementation o f two-pronged strategy successfully requires changes that would enhance the government's institutional capacity to affect both regional and domestic policy outcomes. It also requires coordinated activities o f donors. The weak institutional and administrative capacity is further exacerbated the paucity o f internet connections and lack o f knowledge o f languages used in international business and organizations. These are significant shortcomings as the various trade agreements will need to be pursued as means o f helpingKyrgyz businesses integrate into the world economy. While a more detailed analysis o f indispensable organizational change i s beyond the scope of this study, the organizationalarrangements should take into account the need for: 0 Enhancement o f the government's capacity concerning its ability to assess tradeoffs and links between multilateral and regional environment simultaneously, taking into account the impact o f externalpolicies, which the government can influence, on domestic businesses; 0 Institutional setting that would deal with a full WTO agenda within one coordinating unit; and 0 Enhanced capacity of the government to carry out analysis, policy formulation and strategy, negotiations, implementation and monitoring and evaluation. 2.140 The change should not be confined to altering relationships within and across various ministries. The issue o f the government/private sector interface also needs to be addressed. Institutionalization o f a two-way communication between the government and the private sector would provide trade negotiators with the knowledge about problems exporters face inexternal markets and would offer a channel to keep domestic businesses informed about international opportunities (e.g., the benefits o f usingI S 0 standards as well as marketing opportunities). This government-business interaction needs to be transparent. It 71 needs to counterbalance inevitable efforts by import-competing industries to capture the state through outreach to import usingand export interests. 2.141 The policy matrix below summarizes major challenges and recommended policy actions discussed extensively in this Chapter. Nonetheless, the reforms at the intersection o f multilateral commitments and well-designed deeper regional integration will not produce supply response without far- reaching reforms improving the investment climate and reducing the hassle cost o f conducting business activity. The next Chapter elaborates on the status o freforms on this front and the key issues that need to be addressed. Policy Matrix: Challengesand Responses Barrier or Opportunib DomesticActions Regional Actions Redundant Reviewthe tariff scheduleand average tariff differentiation oftariff ratesacross stagesofprocessingtowards protectionin textiles streamlining. and leather. Outdated standard Establishmodem market-basedsystem; Work with other CIS (EURASEC inparticular) to system Replaceold Soviet standardswith new simultaneouslyreplaceold Soviet standardswith intemationalones; new intemationalones. Accept foreign govemments' technical Establishmarket-basedinstitutional and regulationsthat are basedon intemational laboratoryinfrastructurejointly with its standards; EURASECpartners-especially with Kazakhstan and Russia Do not introducenew mandatorytechnical regulations. Lack of information Increasethe capacityofthe TBT and SPS Work with EURASECto establisharegional easily availableto Enquiry Point disseminationfacility Kyrgyz firms about sanitary andtechnical Train more officials inWTO languages; standardsabroad Establishpublic engagement mechanisms. Deficiencies in Kyrgyz Use the legal obligation to comply with Use the legalobligationto complywith WTO customsprocedures WTO rules to leveragecomprehensive rules to leverageharmonizationof customs reform ofcustomsadministration, proceduresamong EURASECcustoms union including computerization,and members promotionof entry of licensedcustoms brokers. Poorly developed Move to a class licensingsystemfor telecommunication telecommunications; services Set licensingfees as to cover the actual costs of overview. Separate regulatorsfrom service providers,arecommendationof the WTO "Telecommunication Services" Reference Paper(April 25, 1996). New FreeTrade Do not sign new FTAs with apotential-to Agreementswith non- complicaterelationswith other CIS CIS countries partners andthat bring little, ifany, benefitto the Kyrgyz economy 72 11Barrier or Opportunity DomesticActions RegionalActions Excessivetransit cost Createenvironmenthospitablefor freight Work with neighborsto reducethe corruption, as forwarders, domestic and foreign alike. well as the unofficial fees and arbitraryfines extractedby respectiveofficials; Lobby for the free transit regime in the EURASECIntegrationCommittee; Sponsoramendingthe EURASECtransit agreementby introducing plurilateral institutional framework for resolvingtransit disputes. Continueusingmore aggressively opportunities offeredby its WTO membershipto raise transit issues at the Kazakhaccessionnegotiationswith the WTO. It shouldpoint to Kazakhstan's practices that are indefianceof WTO disciplines on transit Discretionaryuse of Refrainfrom usingsafeguardsanddo not Put the issueof safeguards and antidumpingon antidumping retaliateagainst suchmeasurestaken by the agendaof bilateral andregionalnegotiations. Kyrgyz FTA partners. Recommend(a) aprovision that would banthe resort to antidumpingactions inintra EURASEC trade or (b) recommendthe introductionof WTO, ifnot stronger, disciplineson the use of safeguards. Barriersto trade in Implementfully Kyrgyz commitments Lobby for the inclusion of services in EURASEC services, with the under GATS and improvemarket access agreements and push for adoptingGATTS rules negativeimpact on independentlyof actions taken by on transparency, national treatment andmarket regulatory EURASECpartner access. environment Poorly developed Lobby for `open skies' amongCentral Asian regionalair transport, countriesfashioned after the EU `European Civil with negativeimpact Aviation Area' Model. on trade andtourism Weak administrative (i)reorganizationtoeffectivelydealing capacityto deal with with regionalintegration,with full agenda foreign economic within one coordinatingunit; (ii) request policy donor assistance to improve internet connectionand knowledgeof advisors involved inforeign economic policy. 73 CHAPTER3. CROSS-CUTTINGISSUESFORBUSINESSDEVELOPMENT AND IMPROVEDCOMPETITIVENESS A. STRATEGYFORBUILDINGCOMPETITIVENESS 3.1 Chapters 1 and 2 highlighted the need for economic diversification and advantages that the Kyrgyz Republic has for providing opportunities for exports and future growth. The Kyrgyz Republic has relatively favorable endowments o f natural resources and a relatively well-educated, low-cost labor force. It also possesses substantial hydro resources and has relatively inexpensive electricity. Although landlocked, it i s in close enough proximity to important and fast-growing regional markets. It also still has some usable equipment and facilities inheritedfrom former Soviet era that can be put into service for export or import-substitution activities, albeit with greater attention to facilitate technology transfer. These factors augur well for the Kyrgyz Republic's active involvement in trade and future growth prospects. 3.2 Notwithstanding these advantages, however, success in stimulating and sustaining growth will depend critically on two factors: a supportive climate for investors and business managers; and ability o f entrepreneurs to "learn" and be fast, flexible, and responsive to changing market conditions. These are particularly important factors for small county success in international trade. Other key factors for competitive success, which are amenable to pro-active support form government and donors, include a range o f interventions from promoting working capital instruments, and improvingtrade support services, to upgrading infrastructure and supporting higher-value production in agriculture and manufacturing. These key elements of growth strategy are the subject matter o f this Chapter. 3.3 The Chapter is divided into three sections. The first section looks at investment climate conditions inthe Kyrgyz Republic, focusing on the so-called "second generation" policy and institutional reforms and assessing what has been accomplished, and what still needs to be done. The Chapter then turns to the findings from a series of industry studies that were conducted to assess the government and market failure constraints facing firms. These studies included interviews with companies up and down the chain of production from upstream agricultural activities to downstream processing and final goods. They assess how enterprise capabilities, industry structures, and various aspects of the business environment influence enterprise costs and competitive positions in domestic and international markets. Three such studies are undertaken as part o f the background analysis under this Report, focusing on cotton, wool, and dairy value chain.'45 In addition, the discussion draws from the recent, in-depth analysis o f the Kyrgyz h i t s and vegetables processing industry.'46 Finally, observations from discussions with businessesheld duringthe preparation o f this Report, other firm-level donor studies, and `45See Volume I1of this Report for details. 146"Fruit and Vegetable Processing Industry Analysis," the Kyrgyz Republic, November 2002-March2003, preparedby SENTI FC and commissionedby Helvetaswith assistancefrom Swiss Agency for Development Corporation. 74 findings from a recent survey on Kyrgyz business development service^'^' are included where applicable. The final section o f the Chapter looks at the road ahead for future reform efforts. B. IMPROVINGTHE INVESTMENTCLIMATE Investment Climate-Why i s it so Important? 3.4 A prerequisite for improved competitiveness and increased entry and growth o f firms is a supportive climate for investors. The term investment climate, broadly defined, includes a country's unique attributes, or "ge~graphy'~~"as well as the state o f its infrastructure, economic and social policies, institutions, and governance stability. Many definitions, however, take a narrower view that focuses on the endogenous determinants o f investment, including the economic incentives-shaped by macroeconomic policies, regulations, and public administrationprocedures-and the incentives embodied in institutional arrangements-such as security o f property rights and rule o f law, and governance stability. Institutional arrangements are considered to influence private investment decisions by shaping the "rules o f the game." These rules affect investment risk and uncertainty as well as investment safeguard^.'^' Hence, defined narrowly, the investment climate refers to the costs and risks o f doing business. As such, it determines the returns, and thus wealth creation, offered by different lines o f economic activity. 3.5 What is the evidence for the importance of these variables in determining investment? The influence o f economic incentives and institutional arrangements on investment and innovation have been subjects o f interest to researchers inrecent years. The regulatory environment and administrative barriers have been demonstrated to have a significant impact on business investment. For instance, a recent study shows that various measures o f product market regulation can influence investment in several ways:'50 First, changes inregulations can influence the markup o f prices over marginal costs-this i s because o f their affect on, e.g., entry barriers and the number o f firms in the market.I5' Second, regulations can influence the costs that firms face when expanding their productive capacity-e.g., red tape and other forms o f regulatory burden can increase firms' costs o f adjusting the capital stock and hamper their capacity to react to changes in economic or market fundamentals. Third, for sectors where regulations impose a ceiling on the rate o f return on capital that firms are allowed to eam (such as in some utilities businesses), regulation affects the demand for capital relative to labor-e.g., the study presents empirical evidence that tight regulation o f product markets over the years in Europe (Germany, Italy, France) inthe transport, communications, and utilities industries has had a large negative effect on business investment with the component o f recent regulatory reforms that has played the most important role in spurring investment inthese sectors i s entry 1iberali~ation.l~~ 14'UlrikeRoeslerandEugeneRyazanov, "Business DevelopmentServices in Kyrgyzstan: A Studyto Asses the Market for BDS Among 500 Small and Medium Enterprises inthe Kyrgyz Republic," December2002, export and investment project of GTZ and support to privateinitiatives project o f Helvetas. 14'Encompassingclimate, endowmentso f natural resources,distance from importantmarkets, andthe like. 149Investmentsafeguards broadly refer to protectionof property rights, enforcement of contracts, and maintenanceof integrity of monetarystandards. Is' Alberto Alesenia, Silvia Ardayna, Giuseppe Nicoletti, and Fabio Schiantaretti, 2003, Regulation and Investment, NBER Working Paper9560. Entry barriers are any obstructions that stop would be competitors from entering the market. Such barriers to competition generallymeanhigherprices for consumers. Is2The study shows that reductions in entry barriers have led to a reduction of markups and thus of the penalty of expanding productionin terms ofmonopolyprofits. This intum has led to greater investment. 75 3.6 Another recent study demonstrates that trade liberalization does not stimulate growth in developing countries with excessive regulations-the effect o f increased trade on growth is reduced by more than half in economies with excessive regulation^.'^^ Excessive regulations restrict growth because resources are prevented from moving into the most productive sectors and to the most efficient firms following liberalization. Finally, two other related studies-one in a panel of OECD countries and the other using the US. data-indicate that the size o f government itself, measured by spending over GDP and taxation, influences investment. A reduction in government size increases private capital accumulationmostly via its effects on reducing crowding out infinancial market^.''^ 3.7 Although theories and models o f business investment behavior do not incorporate institutional variables, there is a substantial body o f literature in the new institutional economics, which has established the importance of political and economic institutions for economic perfom~ance.'~~ Econometric efforts in this field make a strong empirical case for the relevance o f institutions. They demonstrate that: 0 Security o f property rights, credibility o f govemment commitments, rule o f law, civil liberty, and democracy matter for economic performance;'56 0 Poor countries with good policies and institutions (property rights and rule of law) grow faster than rich countries (i.e., they "converge") no matter what their initial income levels happen to be;'" 0 The institutional environment (sometimes called "social infkastructure") explains a large fraction o f the differences inproductivity (output per worker) across countries;'" 0 Endowments and policies affect development directly only through institution^;'^^ 0 Corruption has negative effects on economic growthand investment;I6' 0 Six features of the governance structure of a country "matter a great deal" for economic outcomes-voice and accountability, political instability and violence, government effectiveness and regulatory burden, rule o f law, and grafi'61-a one-standard deviation increase (decrease) inany one of these governance indicators causes between a 2.5- and 4-fold `53Bineswaree Bolaky andCarolineFreund, Trade, Regulations and Growth,World Bank, December2003 15`Alesina, Ardayna, Perotti, and Schiantarelli, "Fiscal Policy, Profits, and Investment," American Economic Review, 2002, Vol. 92 (3); and Oliver Blanchardand R. Perotti, "An Empirical Investigationof the Dynamic Effects of Changes in Govemment Spendingand revenueson Output," Quarterly Journal ofEconomics, 2002. 155These body of studies are pioneered, among others, by Olson Mancur Olson, 1982, The Rise and Decline ofNations, Yale University Press; and DouglasNorth, 1990, Institutions, Institutional Change and Economic PerSormance, Cambridge University Press. 15`StevenKnack and Philip Keefer, "Institutions and EconomicPerformance: Cross-countryTests Using Alternative Institutional Measures," Economics and Politics #7 (1995); Steven Knack and Philip Keefer, "Why Don't Poor Countries Catch Up? A Cross-Nationaltest ofan Institutional Explanation," Economic Inquiry #35 (1997). 15'Jeffrey Sacks and Andrew Wamer, Economic Convergence and Economic Policies, 1995, NBER Working Paper Series No. 5039. Robert Hall and Charles Jones, "Why Do Some Countries Produce So Much More Output Per Worker than Others?," 1999, Quarterly Journal of Economics, Vol 114 (1). 15'William Easterlyand Ross Levine, "Tropics, Germs, and Crops: How EndowmentsInfluence Economic Development," 2002, Center for Global Development and Institutefor Intemational Economics, (mimeo). I6OPablo Mauro, "Corruption and Growth," 1995, Quarterly Journal of Economics, II O (3). Daniel Kaufmann, Aart Kyrgyz Republicaay, and Pablo Zoido-Lobaton, "Governance Matters," 1999, World Bank Working Paper 2196. 76 increase (decrease) inper capita incomes (or infant mortality) and a 15 to 25 percent increase in literacy. 3.8 The remainder o f this section looks at investment climate conditions in the Kyrgyz Republic. It first focuses on the so-called "second generation" policy and institutional reforms the Government has introduced, assessing what has been accomplished. It then examines what still needs to be done to provide a better climate for investmentand innovation. MuchHas BeenDoneOver the Decadeto Improvethe InvestmentClimate 3.9 The Kyrgyz Government has made considerable progress inthe last ten years ininitiating reforms to improve the investment climate. According to a "liberalization index" developed by the World Bank and the European Bank for Reconstruction and Development to measure the extent o f economic policy reform in transition countries, the Kyrgyz Republic has made more progress reforming its economy duringthe 1990sthan the rest of the CIS.I6* Policy changeshave encompasseda set of "first-generation" reforms, needed to make markets the main mechanism for allocating resources and to stabilize the economy, and a set o f "sec~nd-generation~~reforms, needed to ensure the efficient functioning o f markets and spur investment. These achievements are briefly reviewedbelow. `&First-Generation"Macroeconomic Reforms 3.10 Macro Stabilization: As discussed in Chapter 1 of this Report, significant progress has been made in improving macroeconomic stability since inception o f the Government's structural reform program in 1993, despite several rounds of adverse external shocks to the economy. Nevertheless, economic recovery remains fragile, with slow supply-side response to otherwise stable and sound macroeconomic environment. All in all, much needs to done to develop institutions that maintain productive dynamism and generateresilienceto external shocks. 3.11 Trade liberalization: As discussed inChapter 2 o f this report, the Kyrgyz Republic has been the most aggressive reformer in the Central Asian region in liberalizing its trade regime. It was the first country in the CIS to join WTO, while at the same time actively participating in efforts to create a conducive regional environment for trade. 3.12 Foreign Investment: FollowingWTO accession in 1998, the "Law on ForeignInvestments" was amended to make the country more "investor friendly." Measures adopted included streamlining o f the registration process for joint ventures; allowing foreign insurance firms to offer brokerage and other services; and terminating the 49 percent ceiling on foreign ownership in aviation services and insurance. The Law also guarantees foreigners with protection against events such as expropriation and nationalization. Four Free Economic Zones were set up to attract FDIand investors in these areas were exempted from several taxes and duties, although, at present, only one o f them (the Bishkek FEZ) operates effe~tive1y.l~~In 2003, a new "Law On Investments" was adopted, which establishes supplementary principles o f investment policy aimed at improving the investment climate inthe country and promoting attraction o f domestic and foreign investments by providing a fair, equal legal regime to all investors and a guarantee o f protection of their investments. The State Property and Direct Investment agency has also begun the process o f establishing a "one stop shop" to help facilitate foreign investment and the Govemment has identified strengthening o f the Investment Promotion Agency as a priority. `62Transition: The First 10 Years: Analysis and Lessomfir Eastern Europe and the Former Soviet Union, 2002, World Bank, Washington, DC; Figure2.1. See para. 3.50 for further discussion. 77 3.13 Financial Sector Reforms: The National Bank o f Kyrgyz Republic (NBKR) was established in 1992193, together with the two-tier banking system. The Government has worked over the decade to strengthen the new financial system through bank consolidation and privatization, enhancement o f the supervision functions o f the NBKR and development o f the legal and regulatory framework supporting intermediation (see Box 3.1 for highlights). The Government's reform efforts over the years have begun to pay off as evidenced by a recent IMF Financial System Stability Assessment,'@ which concluded that the practices o f the NBKR in the areas o f monetary policy, banking supervision, and bank payment supervision were good in most respects. Moreover, the financial system i s beginning to show signs of stability with bothbanking sector capital adequacy and profitability i s on an improvingtrack. Box 3.1: Highlights of Financial Sector Reforms In 2001, the Government and the NBKR initiated a payments system reform programto upgrade the existing paper-based payments system, which is a serious impediment to development of private banking-these efforts are currently supported under the World Bank's Payments and Banking System Modernization Project. A comprehensive banking sector reform program was developed in 2002 to further develop the financial system, aimed at restoring depositors confidence in the financial system, deepeningbank intermediationand strengthening the culture of corporate governance inthe banking sector. Amendments to the Law on Banking and the Law on the NBKR were adopted in 2003 to introduce new bank reporting standards, improve bank inspections, change regulationsgoveming credit activity of banks, introduce additionalrequirements for bank governors and shareholdersand increase awareness of bankingsector reform in civil society. The Governmenthas also taken steps to expand credit to the poor by enacting a Law on Micro-finance in 2002. A Law on Leasing was also enacted in 2002, together with changesto the tax code in 2003: to stimulatethe development of leasingto improve lendingto SMEs. 3.14 Privatization: The Kyrgyz Republic's privatization program, initiated in 1991, has also made considerable progress, albeit less so concerning large enterprises (see Box 3.2 for highlights). The Government made rapid progress on the divestment o f medium enterprises until the late 1990s when the privatization program stalled. To date almost 70 percent o f state-owned enterprises (SOE) have been privatized, but the number o f large enterprises divested is small, and the state continues to own in excess of 200 medium and large enterprises, including SOEs in the energy, gas, communication, and aviation sectors. The Government i s now seeking to revitalize the privatization program and it has approved a state property privatization policy to the year 2005 based on a new Law on Privatization. // Box 3.2: Highlights of Privatization Program The stage-one of the privatization processes encompassed mass privatization of small enterprises in the retail trade, food processing, catering, and service sectors. In 1994, in stage two, the Government began to "corporatize," restructure, and divest a mixture of shares and coupons in medium and large businesses in other sectors of the economy, such as industry, transport and construction. Privatization consisted of transferring up to 5 percent of the shares to employees at no charge; 25 percent was auctioned to the public in exchange for coupons; and the remaining 70 percent was sold for cash, typically through auction. In most cases, the shares were purchasedby managementdue to factors such as lack of cash available to the investing public and high minimum prices. In 1996, the third stage o f the privatization program was initiated, and the Governmentbeganto divest strategic businesses in sectors such as mining and power engineeringon a case-by-casebasis to strategic investors. Progresshas beenslow since late 1990s. "Second-Generation "Reforms: Administrative Barriers and Commercial Legal Institutions 3.15 Foreign and domestic investments in the Kyrgyz Republic have been plagued by bureaucracy, administrative barriers and weak legal institutions. In the last few years, the Government has made Kyrgyz Republic, Financial System Stability Assessment: including reportson the observance of standards and codes on the following topics-monetary and financial policy transparency, banking supervision and payment systems," February 2003, InternationalMonetaryFund, Washington, DC. 78 reform in these areas a priority to improve the investment climate.16' Of particular importance was the troublesome issue o f inefficient, opaque, and unnecessary regulation. Some progress has been made in improving the quality of regulatory acts proposed by government, through reviewing their necessity and implications as well as evaluating their consistency with the existing legislation. Furthermore, in 2002, a moratorium was decreed by the President on all new regulatory acts until a system of review and impact assessment i s institutionalized. Government also took steps to remove important administrative barriers to entry and operation o f businesses and made improvements to the commercial legal framework for business investment. Nevertheless, weaknesses in implementation and enforcement o f otherwise good legislative measures remain to be the weakest element in the reform process, reducing its benefits considerably-for instance, despite the above mentioned moratorium, legislation and regulations are being introduced and/or changed frequently. 3.16 One o f the most important mechanisms set up to promote these reforms is an annual investment summit initiated by the President to elicit suggestions on needed reforms from investors and the donor community (see Box 3.3 for details). What follows presents the major achievements to date inimproving administrativebarriers and commercial legal institutions. //Box 3.3: Kyrgyz Republic'sConsultativeApproach to Strengthenthe InvestmentClimate The Govemment, for the past several years, has establisheda "best practice" mechanismto elicit input from the investors, the private sector, the central and local govemment representatives and the donor organizations to strengthen the Kyrgyz investment and business climate. The mechanism operates through the yearly investment summits, culminating in an "investment matrix" of action-oriented items for the Government to tackle. The items in the matrix are in line with priority reform areas identified in the National Poverty Reduction Strategy and the Comprehensive Development Framework in stimulatinginvestment in the privatesector. Each summit and iteration of the Matrix is expected to build upon the previous year's effort, with further areas of proposed activity added basedon feedback from Summit participants. For eachtargeted item in the Matrix (e.g., administrativebarriers, legal issues, financial sector issues. and the like) a Working Group is assigned to further the reform process and to draft necessary legislative documents. Before drafts of new normative acts or laws are submitted by a Working Group to the Government, the proposed new act must be reviewed by the InternationalBusiness Council. Implementationof the Matrix reform agenda is managed by the Government of the Kyrgyz Republic under the direction of the Prime Minister. A body called Investment Round Table (IRT-an NGO), is responsible for forming action-oriented Working Groups and for monitoring implementation progress. The IRT reports on implementation progress to the Consultative Council on Foreign /IInvestment (a group of donors and investors who meet with the President of the Kyrgyz Republic annually on investment issues). This consultative approach clearly has become a key instrument in soliciting and facilitating critical reforms over the last several years, progress on which is also being monitoredthrough donor-administratedbusinessopinion surveys. As revealed by the latter and observations of participantsto the reform process,however, implementationtrack recordof the reforms have remained weak to date. A main factor behindthis seems to be the emphasis the processputs on legislative changes, which is normally considered the "easiest fix" to a complex reform initiative. What remains largely missing in the process are the institutional changes to accommodate new legal instruments. and the mechanisms to monitor how public officials are implementingthe laws, as the current rapid-pace of legal development places great stress on government mechanisms to coordinateand track new policies and practices. Limited attentionto passthe supporting implementingregulationsto the new laws and rules further diminishes returns to legislative reforms. Action on these fronts would greatly increase the tangible benefitsof otherwise rather comprehensive effort to strengthenthe Kyrgyz investmentand businessclimate. AdministrativeBarriers 3.17 Regulations,Licenses, Certificates, and Inspections: Significant improvements have been made in simplifyingthe business registration process inthe Kyrgyz Republic, such that today businesses can be started more easily and cheaply. The registration requirements for individual entrepreneurs have been streamlined to include registration at the State Statistics Committee (at a cost o f about 220 som or See Annex 3 for a list of 5 1 legislativechanges of which 35 is adoptedjust in the year 2003. 79 approximately US$5), the State Tax Inspectorate (free o f charge) and the Social Fund (free o f charge). The registration process for legal entities, such as corporations, is much the same, but first requires registration at the Ministry o f Justice-registration i s considered a legal process in the Kyrgyz Republic, governed by the 1997 Law on Corporate Registration, rather than an administrative process. Ministry o f Justice is now legally required to accelerate the process by providing a registration certificate within ten days of receipt o f all required documents. The introduction o f the patent system has also simplified the registration and payment o f taxes for a variety o f occupations. The growth o f intermediaries to assist in the business startup process has also helped simplify the process for many firms. 3.18 Improvements inregistration and other areas have made Kyrgyz entry conditions the best among Central Asian countries and among the CIS economies. As shown inTable 3.1, the number o f procedures required to start a business and the number o f days needed for a new business to become operational are the lowest in the Kyrgyz Republic, although the cost as a fraction of GDP is still above Russia and Armenia, and substantially higher than costs incurred incountries such as Canada or New Zealand. Table 3.1: ConditionsinEntryto PrivateBusinessActivity in 1997 and 2002 Number of procedures Time to become operational Cost (as a fraction of GDP inbusinessdays per capitain 1997) 1997 2002 1997 2002 1997 2002 Armenia n.a. 11 ma. 79 n.a. 11.9% Azerbaijan n.a. 15 n.a. 104 n.a. 20.8% Belarus n.a. 20 n.a. 143 n.a. 35.6% Georgia 12 12 70 62 28.0% 38.6% Kazakhstan 12 12 31 54 12.5% 38.4% Kyrgvz Republic 9 9 23 26 20.0% 12.9% Russia 16 19 69 50 37.8% 6.9% Ukraine 11 13 20 42 19.7% 22.1% Canada 2 2 2 2 1% 1% New Zealand 3 2 17 2 0% 0% Totalsample average 10 I O 63 57 34% 55% (110 countriescovered) Source: S. Djankov, R. La Porta, F. Lopez-de-Silanes, and A. Shleifer, The Regulation of Entry, Working Paper 7892, National Bureau of Economic Research, Cambridge, Mass., September 2000; and the World Bank website. 3.19 Before legally commencing their operations many businesses are required to obtain a license to engage in chosen activities, as listed in the L a w on Licensing, which came into force in 1997. To streamline the licensing system the L a w was amended by the Government in 2001, reducing the number of activities subject to licensing from 64 to 29-since then this number has increased to 32 with some additional licenses expected as new private customs brokers are allowed to open businesses. A Government decree was also issued setting up a single procedure for issuinglicenses and incorporating all licensing requirements into a single normative act. As a result, all ministerial acts regulating licensing were abolished. Inessence, all this means that sub-licenses have been legally eliminated, however, some still exist in the areas o f telecoms, internet providers, and construction. The L a w on Licensing was also amended to incorporate tighter procedures for issuing new licenses. Finally, he Commission o f Entrepreneurship was assigned the responsibility for monitoring licenses. Unfortunately, in the three years since these new procedures were adopted, there have been new types of licenses proposed by the government violating these very procedures. This shows a lack o f awareness o f the new procedures among licensing agencies and a disregard for them in supervising legal departments and the Ministry o f Justice. 80 3.20 In addition to the Law on Licensing, a host of other laws also contain licensing provisions that may contradict or violate the Law on Licensing. Amendments to about 50 sector-specific laws have been enacted by the Government to cancel licenses not covered in the Law on Licensing or to introduce provisions in the statutes ensuring that licenses can only be imposed according to the L a w on Licensing and not under any other legislative act. To date, approximately 35 o f these amendments have been adopted by Parliament in one form or another, with the remainder either still pending or returned to the Government. Hence, there are still some laws violating the L a w on Licensing by containing additional types of licenses or provisions inconsistent with those inthe Law. 3.2 1 Product certification for ensuring health and safety, and compliance with government standards i s a requirement for doing business in the Kyrgyz Republic. Certification requirements cover a host of goods and services and are required for domestically produced products, as well as imports and exports. In2001, aresolutionofthegovemmentreducedthenumberofproducts subjecttomandatorycertification and eliminated all services that were previously subject to certification. However, there are still more than 300 product groups requiring certificationtoday.166 3.22 Recognizing the problems created by a cumbersome standards regime, the government has taken steps to reorganize Kyrgyzstandard and reform legislation related to technical regulations and standards. In2001Kyrgyzstandardissuedaninternalorder intendedtomoveitscertificationandtestingfunctions to a new-and ultimately private-entity, the "State Enterprise for Testing and Certification," although the functional separation has not yet taken place. InFebruary 2004, the president issued a decree calling for the removal o f regulatory oversight from Kyrgyzstandard. Finally, the recently passed L a w on Technical Regulations-which defines "standards" and ''technical regulation'' consistent with international norms, i.e., the former are voluntary while the latter are mandatory-prevents the national standards body from issuing regulations, separates accreditation from certification, and provides for more flexible means of conformity assessment. The challenge now i s to implement these measures in a consistent manner. To eliminate conflicts o f interest, the assets, people, and management devoted to different functions o f the standards regime must be placed in different institutions; the State Enterprise should be privatized, as called for inthe 2001 order; the national standards body must be separated completely from agencies with executive power; and the national accreditation body must be fully independent from entities that conduct certification and testing. 3.23 Besides licenses and certificates, there exist a variety of other government permitdrequirements that must be met to do business in the Kyrgyz Republic. These include health and sanitary permits, fire permits, architecture and construction permits, land use permits and a host o f other registration requirements (svidetelstvo, experts' opinions, attestations, accreditations, signatures, and unofficial permits). These permits, unlike licenses and certificates, are often not included in the published normative acts and are not controlled in any meaningful way. Ministries and agencies o f both the national and local governments have broad powers when it comes to permits and could create them without any rigorous study or approval process. 3.24 Many o f these permits are under review by the Government. With Government Decree # l o 0 a policy shift has occurred and all permits now need to be included in laws and cannot be created by normative acts. As part o f this ongoing work, a number o f ministries and agencies were required to make the permits they issue compatible with the law. Despite significant resistance, several o f them have followed the new requirements: In 2002 Ministry o f Ecology cancelled the issuance o f 96 permits, Ministry of Health cancelled 41 permits, Ministry o f Agriculture cancelled 54 permits, State Forestry 9 cancelled permits and State Commission on Architecture and Construction cancelled 40 permits. In 2003 permits inanother five ministries were revised ina similar fashion: Ministries o f Interior, Education, Products are defined at the 4-digit level of the Harmonized System. 81 and External Affairs, and State Commissions on Drug Control and Financial Reporting and Auditing Standards. Nevertheless, resistance to these changes remains strong and some ministries/agencies have already succeeded inreversing the earlier reform measuresby having their permits reinstated. A register o f all types o f charges imposed on business i s now beingprepared to guide a comprehensive approach to reform o f the permits system inthe future. 3.25 Virtually every business in the Kyrgyz Republic i s subject to some form o f government inspection and the frequency and costs o f these inspections are often cited as a major obstacle to growth and development ofbusiness. Inspections serve to protect the public when conducted properly. But over- regulation and the abuse o f public authority by inspection agencies have caused many businesses to complain that inspections are a significant administrativebarrier.I6' The government has recognized this problem and taken steps to address it. In2002, it introduceda new inspection regulation, which contains a list o f all agencies with inspection authorities. Ineach case, inspections are to be approved by the State Commission for Business Development, which then issues an inspectionpermit. Inspecting bodies were also forbidden to conduct more than one inspection per year on a single business. This rule was to be enforced by the introduction of an inspection logbook for all businesses-which each inspecting agency i s required to complete after each inspection-but the implementation to date has generally been rather irregular. Inthe most recent Investment Matrix, the Government has proposed a new law on "Protection o f Rights o f Businesses during Inspections and Auditing by Authorized Organs" to further reduce the problems and cost o f official inspections. CommercialLegalInstitutions 3.26 Property rights and investor legal protections are at the heart o f a supportive investment climate. The Kyrgyz government has worked over the decade to complete a re-formulation o f all laws that govem commercial relations, creating the foundation for improved property rights and investor protection. The most important change in the commercial legal framework was adoption of a new Civil Code in 1996, which was later modified in 1998 and currently being further modified. The Kyrgyz Civil Code adequately encompasses virtually every form o f economic relationshipproperty rights, rules o f agency and classifications of contracts. It provides the groundwork for good contracts practice. The Code i s based on the continental legal system, which uses legislative norms rather than precedent law, as in the British common law system. In the context of legal hierarchy of law in the Kyrgyz system, the Code takes precedence over all law that i s directly inconsistent with it. 3.27 Property Laws: The Civil Code governs the use o f property in the Kyrgyz Republic. Under the Code a proprietor has a right to process and dispose o f property at his or her discretion. This provides a sound legal basis for tradable property rights, but realization of this potential i s circumscribed by other changes in the law, such as the Land Code (adopted in 1999 and amended in 2001). The Land Code prevents agricultural land from being transferred to foreign ownership. It stipulates that foreign persons and foreign legal entities may receive interests in land parcels within urban land areas (cities, villages, rural localities) for up to 50 years. Also, foreign investors can lease land from Kyrgyz entities for 99 years. All transactions involving land rights are recordedunder a new land registration system, which i s just in its early stages of development and will not be fully operational until a survey and notarization o f land titles can be implemented. 3.28 Intellectual property rights are an important part of the Kyrgyz Republic's WTO accession program and crucial for investments in areas such as the information industry. The Government established the State Agency for Science and Intellectual Property (Kyrgyzpatent) in 1993 to administer intellectual property rights, such as patents, trademarks and other intellectual property. The Law on 16' For specific examples see Box 3.4, SectionC and Volume 11, Value Chain Analysis. 82 Patents (enacted in 1998) provides protection for inventions and industrial designs. Trademark protection i s controlled by the Law on Trademarks, Service Marks and Appellations of Places of Origin of Goods (enacted in 1998). The Law of the Kyrgyz Republic on Commercial Secrets (enacted in 1998) provides legal protection for commercial secrets. The Law on Copyright and Related Rights (enacted in 1998 and amended in 2001), as well as provisions o f the Civil Code govem the protection o f copynghtable works, such as computer programs and sound recordings. These new intellectual property laws are compliant with the WTO Agreement on Trade RelatedIntellectual Property Rights. 3.29 Concessions can potentially play an important role in the Kyrgyz Republic, particularly in the areas o f infrastructure development and extraction o f mineral resources, given the constraints on foreign investors' ability to own land as well as difficult global environment for utilities privatization. A Law on Concessions and Foreign Concessionaires was enacted in 1992, covering foreign private financing o f state assets, land, and mineral resources. Inaddition, sector specific laws have been enacted, such as the Mining Code in 1997, the Oil and Gas Law in 1998, and the Law on Water 1994. The State Property and Direct Investment Fund i s responsible for regulating tender offers and concessions with foreign investors. The term o f a concession can be from five to 50 years, with the Government retaining ownership o f the land, and the concessionaire gaining the right to use the asset and having title over the output and income derived from the concession. All concessions should be subject to a public tender, although direct negotiation i s permitted for concessions in the natural resources sector. Disputes can be resolved inthe courts or through local or international arbitration. Concessions can be assigned to a third party, or used as security to collateralize finance. 3.30 Investor Protections: Corporate governance and its enforcement are crucial to providinginvestor protection and an improved investment climate. Legislation needs to specify the rights o f outside investors and the obligations o f corporate insiders, primarily the board o f directors and management, and provide a set of explicit mechanisms through which outside investors and lenders can protect themselves against expropriation by insiders. Without secure transactions and corporate governance laws and procedures, insiders can expropriate company property through mechanisms such as asset stripping, below cost transfer pricing, installing unqualified family members or friends inmanagerial positions, and overpaying executives. 3.3 1 The Kyrgyz govemment has enacted a number of laws over the decade to protect investors from such problems. The Law on Pledge (enacted in 1997) as the primary legislation governing security over moveable assets, i s one of the first secured transactions laws in the CIS to provide for such modem concepts as "perfection" o f a security interest, "constructive notice" o f filed documents, and a single centralized system o f registration o f security interests. The L a w on Pledge, the Civil Code and the Law on Mortgages also determine security over immovable assets. These legislative pieces, which are currently further being strengthened as discussed in the next section, provide key elements for secured transactions inthe Kyrgyz Republic and moveable assets can be used to secure debt. 3.32 Company and securities laws are the primary legislation used to define minimum standards of corporate governance arrangements. Shareholders can introduce higher standards through company charters approved by shareholders. Inthe Kyrgyz Republic, company legislation consists of provisions in the Civil Code and the Law on Joint Stock Companies (enacted in 2003). Inaddition, the Law on the Securities Market (enacted in 1998) defines the regulations for the issuance and trading of shares, and the scope and procedures for disclosing information on a company to investors. The State Commission on the Securities Market was set up with responsibility for regulating the securities markets, and the Kyrgyz Stock Exchange was established in 1994. Publicly listed companies with more than 50 shareholders are required to register shares with an independent registrar licensed by the State Commission on the Securities Market. The most fundamental shareholder rights that must be protected under company law relate to the ability o f the board and management to amend the company charter, transfer assets out o f the company or dilute existing shareholdings. In the Kyrgyz Republic, the law 83 requires that a super majority o f shareholders must be present to amend these provisions, as in most developed countries. 3.33 The development o f a bankruptcy law i s a critical component o f any good financial intermediation system, as it supports lending by creating incentives for improved enterprise efficiency and financial management. A new Law on Bankruptcy came into force in 1997 and was amended in 2002. The L a w defines the status o f bankruptcy and identifies the grounds, terms, and procedures for the bankruptcy of commercial legal entities and individual entrepreneurs. It also establishes related procedures for special administration, sanctions, rehabilitation, preservation, and amicable agreement. Nevertheless, it continues to contain number o f deficiencies, which are the subject matter o f the next section. 3.34 One o f the most important foundations for effective corporate governance and functioning of financial markets is the ability of shareholders to obtain timely and accurate financial information on firms. The Kyrgyz Republic began introducing a market based accounting system in 1997 and enacted a new Law on Accountingin 2002, which i s based on International Accounting Standards, and provides a legal basis for private sector accounting and financial reporting. The Law on Auditing (also enacted in 2002) provides the legal basis for audits. Private sector audits must be prepared in accordance with International Standards o f Auditing. Beginning in 2007, all enterprises, with the exception o f budgetary bodies and individuals, will be required to account and report in accordance with International Accounting Standards and International Auditing Standards on an annual basis. In2003, all banks will have prepared International Auditing standards accounts, and in2004 all listedjoint stock companies and large enterprises with capital of greater than 500,000 som will be reporting in accordance with International Accounting Standards accounts. What Areas Still Needto be Improved? 3.35 Although the Kyrgyz Republic has clearly made a great deal o f progress in improving the investment climate over the decade, industry case studies as well as recent surveys o f the business community observed that signiJicant obstacles remain in the areas of governance, regulation, taxes, administrative barriers, and commercial law that continue to raise business costs and increase business risk, reducing incentives to invest. Box 3.4 below provides examples o f the actual costs imposed on firms by investment climate problems based on findings from the dairy industrycase study, which provides a cogent example (for details see Volume 11, Value Chain Analysis). 3.36 One factor that explains the persistence o f obstacles i s poor implementation. Too often important reforms have been put into operation ineptly. In many cases, new laws and regulations have not been sufficiently explicit, providing officials inthe executive and thejudiciary with a highdegree o f latitude in interpretationand discretion inimplementation. These problems are complicated by the fact that laws and changes inlaws are often not widely available to the public because o f a lack of budgeted funds to publish laws and regulations. Further complications arise because some officials simply disregard changes in laws and regulations or choose to supplant themi.e., official corruption has become a serious issue. Collectively, these weaknesses make implementation and enforcement o f laws and regulations highly unpredictable and fraught with corruption. 3.37 Obstacles also remain in the investment climate because the reform process is only partially completed. Additional reforms are required in each o f the four areas highlighted above, which is recognized by the Government's most recent Investment Matrix. The case for these reforms i s reviewed inthis section. 84 //Box 3.4: Costs Imposedon Firms by Investment Climate Problems: Dairy Industry Value Chain Analysis Beginningwith the first stage inthe value-chain,Le.,farming and deliveryof milk to processors. farmers complainthat bribesto traffic police, who stop them many times on the roadto the processingfacility inBishkek, and/or extrafuel costs to evade police checkpoints to avoid paying bribes, raise delivery costs to processors. Extra delivery costs due to these problems increase productioncost per liter of milk by an average of 26 percent (35 percentfor small farms and 18 for large farms). In the second stage of the value chain, Le., milk processing. frequent visits by the State Sanitary Epidemiological Service, the Veterinary Inspectorate, Kyrgyz Standard, and the Tax Inspectorateadd another 4 percent on average to the cost per liter of milk (7 percent for large firms and 1 percent for small firms). The problem is not that these government agencies stop vehicles or inspect firms, inspectionsare normally required to assure health and safety of products. It is that inspections are too frequent, take too much time, and often require bribes. In most instances, the laws and regulations underpinning inspections and certifications are broadly specified and allow for liberal interpretationby the implementing agency. For instance, in the case of inspections by the State Sanitary Epidemiological Service, the frequency and timing of inspections are supposed to be reflected in the inspection plan that is required to be submittedto the State Commission on Antimonopoly. However, the number of inspectionsactually conducted by this agency generallydoes not correspondwith the plan. They are far more frequent than planned. Another uncertainty is the cost of each inspectionand certification. The case study found a wide variation across companies in frequency and cost of dealing with the govemment agencies. Although costs associatedwith inspectionsand certificationsare defined by the Commission, it is not evident that these guidelinesare followed by inspection and certification agencies. Also, interviews with enterprises suggest that there is little up-to-date information available to the private sector on laws and regulationsrelatedto state inspectionsand certifications. Hence, enterprises have no reliable source of information to check on the validity of rules govemingthe scope, frequency, and costs of inspectionsand certificationsin any industry. In the third stage of the value-chain, Le., distribution of final productsto retailers. still more extra costs are imposed by tax administration problems, traffic police again, and `-sponsorship payments" to local, regional and national organizations. Concemingthe former, the recent introduction of an invoicing system to better administer VAT is viewed as an indirect tax. Concemingthe problemscreated by the traffic police, one distributor, who distributes goods to supermarketsand retail outlets within Bishkek, observed that he must pay as much as 100 som per truck each time he is stopped by a traffic police officer. These stops occur frequently each day, resulting in delays an extra costs, which can be problematic, as distributors of milk products carry time-sensitivegoods, requiring refrigeration. Finally, most mediumand largeenterprises operatinginthe Kyrgyz Republic are compelled to make "sponsorship payments" to local, regional, and nationalorganizationsand groups, such as the fire department and other government service agencies. Distributors in the dairy industry complain that these sponsorship payments can amount to as muchas 5 to 7 percent ofnet profit. Many entrepreneurs interviewed for the case studies indicated that these added costs and hassles from administrative barriers and corruption are an important reason for not expandingtheir businesses or making investmentsin new ventures. They also notethat movingtheir companiesto a more *`transparent mode of operation," interms of accountingand financial management to attract bank loans or foreign investors, would only increasethe risk of having to put up with "unwanted pressuresfrom state administrativebodies." Governance 3.38 In the area of governance, a 2002 World Bank survey shows that less than 50 percent o f firms give a satisfactory rating to the performance o f govemment organizations dealing with business.'68 Police, courts, and prosecutor services, and customs, tax, and inspection agencies of various levels o f govemment continue to come in for the strongest criticism. Half o f the firms said that they had paid bribes to officials in the last 12 months. Firms reported paying bribes to 25 different govemment or quasi-government agencies, with customs, tax and State licensing and permitting agencies cited as the most corrupt. 3.39 A 2003 UNDO survey of direct foreign investors echoes these sentiments about g0~emance.l~' Almost 90 percent o f foreign investors are dissatisfied with the transparency of decision making within Governance and Service Delivery in the Kyrgyz Republic, 2002, World Bank, Washington, DC; and Surveys of Corruption and Public Performance in Kyrgyzstan, 2001, World Bank, Washington, DC. Analysis of the Foreign Direct Investment Situation In Kyrgyzstan, United Nations Industrial Development Organization (UNIDO) 2002. 85 government. They reported that they felt the Government lacked clarity in its objectives. They were negative about the pace o f the reform process and felt that reform had stalled inthe last few years. And they were dissatisfied with the government's progress in reducing corruption. In addition, foreign investors were critical o f the number o f ministries involved in promoting foreign direct investment and their performance. There is unanimous support for the need to set up a single investment promotion organization inthe Kyrgyz Republic. 3.40 A comparative periodic survey o f firms inCentral Asia, conducted by USAID ineach year from 2000 to 2003, suggests that some o f these negative aspects of governance in the Kyrgyz Republic might be getting worse, despite increasing attention to addressing them. Official corruption appears to have increased and effectiveness o f government agencies has declined somewhat since 2000. The study also shows that compared with other countries in Central Asia, which are also shown to have high official corruption, firms in the Kyrgyz Republic pay significantly more bribes to government agen~ies.'~'This finding is corroborated by the joint EBRD/World Bank (BEEPS) survey in transition c~untries,'~' indicating that the fiequency of official bribery in the Kyrgyz Republic and the share o f firms engaged in "state capture" are significantly higher than in the rest o f the CIS.'72Finally, a 2002 World Bank Study, which evaluated six aspects of governance in the Kyrgyz Republicfor the years 1996-2002-i.e., voice and accountability, political stability, government effectiveness, regulatory quality, rule of law and control of corruption-shows that valuesfor all these variables, with the exception of regulatory quality, declined since 1996.173 Considering that these measures did not begin the study-period with highvalues, the finding indicates that serious institutionalweaknesses remain inthe Kyrgyz investment climate. 3.41 The quality of governance in the Kyrgyz Republic today, however, should, to some extent, be viewed inperspective o f the Central Asian region-where both major trade and investment partners and competition for foreign investment originates. The Kyrgyz Republic's governance, as measured by the above noted six variables, i s shown to be not very different from governance in other parts o f Central Asia (see 3.42 Table 3.2). Insome areas, the Kyrgyz Republic seems to has made faster progress than its neighbors in establishing market-based institutions (e.g., regulatory quality and control o f corruption) and inothers it has lagged (e.g., political stability). Yet puttingthings inCentral Asian perspective does not diminish the severity of the problem compared with the rest o f the world. The EBRD's "Transition Report" index ranks the Central Asian region rather low in comparison with other countries. Interms of governance quality, about 75 percent o f all countries in the world have more attractive business environment^."^ 170"Longitudinal Study of the Business Environmentin CentralAsia 2000/03," Center for Studyof Policy Opinion, 2003. 17'Business Environmentand EnterprisePerformanceSurvey(BEEPS), EBRDiWorldBank, 2002 172"State Capture" refers to the extent businesses are directly affected by private payments to influence the decisions of government institutions. 173D. Kaufmann, A Kyrgyz Republicaayand M. Mastruzzi, 2003, GovernanceMatters III:Governance Indicatorsfor 1 9 9 6 2002 (http://www.worldbank.orglwbi/govemance/pubs/govmatters3 .html). Transition Report, EBRD, 2002. 86 Table 3.2: Central Asia Governance Indicators, 2002 GovemanceIndicator PercentileRank Estimate Standard Numberof Regional Kyrgyz R. as (0-IOO),in % (-2.5 to + 2.5) Deviation surveysipolls Average, % of region Percentile average Voice and Accountability 19.7 -0.96 0.16 6 22.7 87 Political Stability 16.2 -1.21 0.28 4 31.1 52 GovemmentEffectiveness 20.6 -0.81 0.17 6 21.7 95 RegulatoryQuality 37.6 -0.46 0.22 6 25.4 148 Rule of Law 22.2 -0.83 0.16 9 20.4 109 Control of Corruption 23.7 -0.84 0.16 7 16.8 141 Source: D. Kaufmann, A. Kraay, and M. Mastruzzi, 2003, Governance Matters 111: Governance Indicators for 1996-2002, World Bank, Washington,DC. 3.43 Recommendations: 0 Develop effective procedures/sanctions to reduce official corruption and improve implementation and enforcement o f existinganti-corruption reforms; 0 Clarify functions and responsibilities of public agencies, in particular those o f inspection agencies and regulatory bodies, to avoid duplication, to economize, and to improve efficiency; and separatepolicy andregulation functions; 0 Undertake a review o f the weaknesses and the strengths of the administrative justice system and develop a results-oriented reform strategy; 0 Phase-in a program to rationalize public administration and improve standards o f pay with measurable benchmarks inthe context o f the ongoing civil service reform; 0 Eliminate off-budget funding sources of public agencies and enforce the principle that all public funds (including regulatory and user fees) are channeled through the budget; 0 Improve public accounting, auditing, and reporting procedures for principal public agencies; and strengthen Chamber of Accounts to perform efficiency and effectiveness audits in the context o f the ongoing audit/accounting reforms; 0 Develop systemic capacity-building program o f training and visits for public officials to improve policy formulation, regulatory capacity, administrativereforms, and service delivery. Taxes 3.44 The Tax Code of 1996 provided a major reform in the Kyrgyz tax system, bringing it significantly closer to meeting the requirements of a market-oriented economy. The new system was largely perceived to be capable of serving the evolving Kyrgyz economy for many years. Nevertheless, its effective implementation required similarly strong reform efforts to strengthen the tax administration along with the overall governance system, areas where reform efforts are receiving increasing attention only recently. Effective implementation of the Tax Code has been further hampered by numerous and frequent changes to it over the years, making it difficult for firms to stay current with the latest tax structure. Inaddition, the fragmented structure of the tax legislation, with tax provisions in several other parts o f legislation, raises not only compliance costs-as the firms need to examine and understand multiple pieces o f legislation to determine their tax liabilities-but also createsroom for disputes between taxpayers and tax collectors-both because o f inconsistencies between the laws and unclear guidance on which legislation takes priority. The Govemment has recently embarked on harmonizing and streamlining the Tax Code to address some of these issues. What follows first summarizes business's 87 perception o f the Kyrgyz tax regime and then provides a snapshot analysis o f its major weaknesses constraining the business activity. 3.45 The European Commission's Technical Assistance program for the CIS (TACIS) and the Center for Social and Economic Research (CASE-Kyrgyzstan) conducted a survey in 2003, to collect information about business's problems with the tax regime.'75 Respondents in the survey complained about the high tax burden, with those in the services sector reporting the highest tax burden. Specific reported tax problems included the high rates levied by the VAT and the Social Fund and the Tax Inspectorate's administrative procedures. Similar findings are consistently revealed by the recent business opinion surveys cited elsewhere in this chapter, whereby majority o f the respondents felt that combined, these problems create significant disincentives to trade and investment. As for problems with tax administration, businesses cited corruption, unprofessional behavior o f tax officials, lack o f adequate knowledge on the part o f tax inspectors (concerning particularly accounting and tax laws), difficulties in resolving tax disputes, and inability to obtain VAT refunds and credits. Corruption i s reported to be an ever-present problem with underpaid tax officials frequently exerting pressure on firms to pay bribes. Tax inspections are reported to be too frequent and to take too much valuable time. Further, conflicts in interpretationbetween normative and legal acts, and the Tax Code are reported to be a frequent problem, which, in tum, seems to promoting a negotiation mode between the taxpayer and the tax inspectorate. This i s in part explained by lack o f a single organization responsible for managing the process of clarification in case o f tax disputes. Numerous bureaucratic procedures are also reported to hamper getting VAT refunds for imports reasonably soon after the completion o f the proper documentation-a problem, which appears to particularly hurt the re-exporters. Firms also report that using credits for VAT paid earlier inthe production chain i s a problem. Tax inspectors are reported to disallow credits for many purchased inputs based on claims for improper invoices. Intoo many of these cases, honest taxpayers are forced to pay the price for dishonest taxpayers. An additional problem that many respondents noted was the difficulty o f offsetting excess payments accumulated on some taxes against other tax arrears. 3.46 Against this background, what major constraints on businesses does the Kyrgyz tax system create? Depending on their structure and the markets they serve, business firms in the formal sector o f the Kyrgyz economy pay many taxes, including the profits tax, VAT, road and emergency taxes, land tax, excise taxes, retail sales tax, real property tax, and vehicle taxes. While the specific tax burden varies by type o f firm,176 VAT, retail sales tax, and road and emergency taxes each impose fairly highburdens the on many firms and, usually impose larger liabilities than the profits tax. The last three among these set of taxes, are both somewhat uncommon and cascading taxes, increasing not only tax burden but also creating distortion.'" Nevertheless, they generate significant revenues both for local and state budget^,"^ which makes their revenue-neutral elimination a challenge. Inaddition to these tax liabilities, highsocial 175"The Tax System of the Kyrgyz Republic: Analysis and Recommendations," 2003, TACIS, Kyrgyzstan SME Development Program. 176This discussion abstracts from the incidence of the taxes. Nevertheless, respondent firms to the TACISKSER survey report the combined burden of taxes to average around 30 to 50 percent of businessgross income, depending on the sector of activity. The upper range of total payments, even though they may not be as high as 50 percent in most cases, may be above what many firms actually bear in the Kyrgyz Republic. The feedback from a recent business opinion survey (administeredby TACIS), whereby only 33 percent of businesses indicated that they believe they can pay all taxes and still develop their businesses, supportsthis perception. 177 The road and emergencytaxes are levied on nearly every transaction, and will cascade when productiongoes through more than one level in the processing chain. Concemingthe retail sales tax, the intent is to levy it on final sales, which limits the extent of cascading. Nonetheless, it is administrativelydifficult to identify when a transactionis a final sale, so there tends to be some cascadingofthe sales tax. 17'Retail sales tax revenues are directed to the local budgetsand road and emergencytax revenuesto the state budget. 88 insurance payments further increase costs, particularly for labor-intensive businesses. Furthermore, each one of these taxes i s levied on a different base,179requiring separate calculations by businesses. This combined with the much-emphasized difficulties o f dealing with tax officials, creates not only significant compliance burdens, but are also likely to discourage productive, formal sector activity. 3.47 The compliance costs that come with a high number o f taxes, weak discipline in the revenue collection agencies, the cash-flow problems businesses face, and high combined tax rates in the Kyrgyz system encourage firms to find legal means to avoid taxes or to remain in the underground economy. There are three channels in the Kyrgyz tax system, which, while aiming at broadening the tax base and easing administrative difficulties, allow firms to reduce their tax liability by remaining small or splitting into smaller firms. First channel i s the fixed patent tax"' which i s levied in lieu o f most other taxes to both simplify and ensure compliance for certain types o f firms."' Second channel i s the simplified small business tax, an instrument similar to the patent tax.'82 Third channel i s the VAT threshold (currently som 500,000), which, combined with other small business tax options, provides strong incentives for many firms to remain small (see para. 3.52 for further discussion). These tax-induced incentives are, at least partly, reflected in the growing number o f individual (micro) entrepreneurs (in terms o f number o f firms, employees, and contribution to value added) while exactly the opposite i s true for small and medium sized firms since the late 1990s (see Table 3.3). These behavioral responses to the tax system can come at a very real cost inloss inthe efficient operation o fbusiness inthe Kyrgyz economy. Table 3.3: Number and Employment of SMEs and Individual 1999 2000 2001 2002 Number of activeentities(thousandunits) 103.8 110.0 119.9 130.3 Number o f active SEs 8.0 7.6 7.6 6.9 Number o f active M E s 1.o 1.o 1.o 0.9 Individualentrepreneurs 94.8 101.4 111.3 122.5 Share in total employment (YO) 12.0 12.0 12.6 11.8 Number of people working in SEs 2.6 2.6 2.7 2.3 Number of people working inM E s 4.0 3.7 3.7 2.7 Individual entrepreneurs 5.4 5.7 6.2 6.8 Value added (as YOof GDP) 27.4 26.6 27.7 27.2 Small enterprises 10.1 9.2 8.1 7.7 M e d i u m enterprises 6.8 6.7 6.2 6.9 Individual entrepreneurs 10.5 10.7 13.4 12.6 Source: The National Statistics. For instance V A T i s levied at 20 percent on value added, the retail sales tax at 4 percent on sales to final consumers, the road and emergency taxes at 2.3 percent o f total revenue, and the profits tax at 20 percent on profits. Social insurance fees, levied on labor costs at 33 percent, are also a significant cost. I 8 OFirms are allowed or required to be in the patent system based on their type o f business, not their size. But, the selected types of business are ones often conducive to being small. Also, the patent fee can vary with factors such as the size o f a business establishment and the number o f employees. Unfortunately, determinations o f when simplified tax provisions apply are not coordinated with other features o f the tax law such as the V A T compliance threshold. 18' Revenues-to-date from the patent tax have been small, suggesting that the simplifications introduced by this tax may not be as attractive as presumed for small business and that many firms remain inthe informal sector rather than pay any taxes. 18' The system is introduced in 2002. A single tax is charged in the range o f 5 to 10 percent of gross revenues and this charge replaces such taxes as the tax on profits, tumover taxes, the tax on commercial services to consumers and the retail sales tax. The right to simplified taxation i s granted to persons with gross annual revenues of up to Som 3 million. The persons granted this rightare required to keep simplified accounting records. 89 3.48 Another common approach to avoid not only the taxes but also regulatory burdens all-together in the Kyrgyz economy i s to operate informally as demonstrated by the estimated size o f the informal economy-varying between 20 to 40 percent based on official and unofficial sources, respectively. The propensity for tax evasion is costly in many ways, but perhaps its highest costs are incurred through the higher tax rates it promotes to raise the desired tax revenues. This i s clearly the case in the Kyrgyz economy where rates for several important taxes as well as for the social insurance contributions remain fairly inflexible downwards, with fiscally-affordable tax reductions falling short o f generating the expected outcomes. For instance, the profits tax rate was recently reduced from 30 to 20 percent to limit evasion, with no tangible improvements in revenue collection to date. Inpractice, it continues to be paid by only a few large enterprises that are unable to hide their profits. 3.49 The tax advantages o f operating in the Free Economic Zones (FEZ),lE3combined with Figure 3.1: Production, Exports, and Domestic Sale limited regulatory burdens, facilitate production of Goods Produced in FEZ(mil. US$) efficiency for external markets, but create significant disadvantages for domestic producers, unless sales from FEZ into the domestic market 40 35 are subject to all required taxes. This i s because 30 firms operating in the FEZs maintain their tax 2g 2s :;; 20 advantages, when producing for local markets, both implicitly-payment of some taxes may be n5 delayed until goods are "imported into the 2000 2001 , 2002 2003 Kyrgyz Republic"-and explicitly-some taxes (such as the profits tax) are not paid. Despite Domestic sale In s --Production m o ___ ~~ ~ . improvements over the last several years, leakage Source. State Committee on State Property and Foreign fromFEZsinto domestic market continues to be a Investments. problem(see Figure 3.1). 3.50 The VAT, with a 20 percent rate, accounts for about 45 percent o f government tax receipts. The Table 3.4: Cross-country Comparison of VAT and VAT rate is significantly higher than that imposed in Collection Rates, 1999-2002 emerging market economies, while it is similar to Country VAT Average that imposed in Central Asia-except Kazakhstan. Rate 1999- On the other hand, as shown in Table 3.4, VAT 2002 collection at 5.5 percent o f GDP i s not only low CIS compared to most other countries in the region, but Kazakhstan 16.0 4.7 also compared to collection performance that Kyrgyz Republic 20.0 5.4 Moldova 5,8,20 8.5 international norms suggest for the Kyrgyz VAT Russia 10,20 6.5 rate, i.e., equivalent to about 8 percent of GDP.Is4 Tajikistan 20.0 2.2 The low collection efficiency indicates that Uzbekistan 20.0 8.1 compliance with the Kyrgyz VAT i s very weak. OECD 17.8 6.6 There are a combination o f factors accounting for the EU 19.4 7.1 VAT's failure to achieve its revenue potential, Emerging Market Countries 14.5 4.7 including its high rate, somewhat broader Source: IMFcountry data; H.Lorie, Prioritiesfor exemptions than are allowed elsewhere, and weak Further Fiscal Reforms in CIS, IMF Working Paper, tax administration. October 2003. Firms operating in the Free Economic Zones are profits tax exempt and are exempt from most other taxes including the VAT, emergency and road funds, and retail sales taxes when they export their products. Individual income tax is collected from the employees and a fee equal to two percent o f revenues is collected from the firms. The fee is used for operation o f the FEZ. Generally, collections equal to 0.4 percent o f GDP for each 1 percent VAT rate is regarded as an international norm. 90 3.5 1 Furthermore, implementation o f the VAT distorts business practices ina number o f ways: 0 The VAT structure encourages firms to keep their size below the compliance threshold in order to avoid a VAT, thereby creating an incentive for Kyrgyz firms to remain small. These disincentives would have been modest if the VAT were collected higher in the production chain, such as at retail, enabling VAT-payers to pass their credits on all o f their inputs to their purchasers. However, in some sectors, such as the agriculture, where many retailers are either too small to be required to collect VAT or are largely operating inthe informal market, the tax remains largely uncollected at higher levels as well. Therefore, the tax incidence falls primarily on firms that have become large enough to become a VAT taxpayer.'85 The incentives for staying small, on the other hand, make it harder for Kyrgyzbusiness to produce to scale, quality and standards that are becoming increasingly critical in determining their market access.186 0 The inability o f firms higher up in the production chain to obtain credits for VAT paid earlier-due to above noted breaks inthe VAT chain-implies that VAT liabilities for many products often exceed the legislated 20 percent. Clearly, the l o w collection efficiency indicates that, on average, actual VAT burdens may not be as heavy as it seems. But, a more likely outcome i s widely different effective VAT tax burdens across businesses and sectors, which results in significant distortions in resource allocations across sectors and various production lines. 0 Despite improvements over the last two years, the delays and payment-failures for VAT rebates on exported product^'^' raise costs and de-capitalize firms-which are often cash- strapped to start with, given the shallow financial markets.'" Such bureaucratic hassles appear to play a significant role in discouraging the development o f export-oriented firms in the Kyrgyz Republic. 0 The structure o f the VAT influences the way businesses are organized by providing an implicit tax subsidy. For instance, the formerly existing VAT exemption for apcultural production was being applied to companies that processed their own agricultural production, thereby encouraging vertical integration o f agricultural production and processing.lg9 Agricultural production was brought under the VAT last year, eliminating this incentive, but the forces now are likely to work inthe opposite direction. The above-described incentives to For instance, the extension of the VAT to agricultural production, as of April, 2003, appearedto have generateddisincentives for farm consolidation and formation of agricultural cooperatives, with some large farms/cooperativesalready dissolving to remainbelow the VAT compliancethreshold. See Section C, for discussion on firm level business climate issues. '" Clearlythe concem in the tax administrationis to avoid fraudulent or overstatedrefund claims, which is perceived to be high. In 2002, out of the total claims of 444.7 million soms from zero-rated suppliers, 63.2 million soms remained outstandingat the end of the year-although still large, this amount suggesteda considerable improvement compared to the previousyear when the outstandingclaims were twice as much. The total outstandingclaims in 2003 appear to remain at about 69 million som. The level of the outstandingclaims suggests that the difficulties still persist in payingrefundswithin the 30 day periodprovided for in the Tax Code. The govemment is committed to further improve the timeliness of refunds and reduce existing arrears under the ongoingIMFprogram(PRGF).. See Section C and Volume 11, TradeFinance, for further discussionon accessibilityof financing. lS9Under the previous system, agricultural producers that engaged in agricultural processingwere not only exempt for their agriculturalproductionbut were also exempt for agricultural processingor other steps in the food processing chain. On the other hand, firms that engaged in agricultural processing but not production were required to pay the VAT. Similarly, produceriprocessorswere required to pay VAT on processing associated with any purchased agricultural inputs over and above their own-produce. The VAT was also being collectedon purchased agricultural production at the processing level since there was no credit for tax paidby the producers(except for apresumed3 percent credit for purchasedproductioninputs). 91 remain small could very well discourage vertical integration, a factor that can be an important force incertain industries, such as agricultural processing. 0 The VAT exemption for imported capital goods was eliminated in 2002. Under the new system, credits for the VAT paid on imported capital goods are being allowed later in the production process.'90 Nevertheless, suppliers whose excess credit position does not result from zero-rated supplies, and whose tax arrears to the budget from other tax liabilities are insufficient to absorb the excess, are not allowed to receive refunds. This, combined with usual delays in processing o f VAT credits, clearly puts a major burden on the businesses, which needs to make large investment expenditures. Considering the formidable difficulties in access to financing, this approach clearly imposes an unbearable constraint on private investments and i s akm to providing interest-free loans to the government. 0 The Tax Code does not treat exports of services on a destination basis'" like it does products; hence exporters o f services, such as the communications industry, must pay VAT, which potentially cuts their competitiveness. 3.52 Local taxes add to the problems created by national taxes. There are 15 local taxes, which expand the compliance burden arising fiom the many taxes and increase the tax costs o f being in the formal versus the informal sector"*. Thus, local taxes compound the reasons for firms to remain small and inthe informal sector. For instance, the retail sales tax is levied at a rate o f approximately 4 percent (the rate can vary by city) on all sales to final purchasers (defined as buyers that are not registered VAT taxpayers). Given sizable informal activity, this translates into higher costs for formal sector firms (increased by 4 percent o f revenues) relative to firms inthe informal sector, with the tax burdens varying across industries and firms. Inaddition, as noted earlier, although the sales tax is supposed to be levied on final sales, limiting the extent of cascading, it i s administratively difficult to identify when a transaction i s a final sale, leading to some cascading. 3.53 Recommendations: 0 Integrate all the tax legislation into the Tax Code along with streamlining the Code, while intensifying efforts to strengthen the tax administration for proper implementation-among the priorities for the latter are strengthening information technology, providing more training, and raising wages, combined with effective sanctions for abusing official a ~ t h o r i t y . ' ~ ~ (Authorities have recently embarked on an initiative to streamline and integrate all the tax legislation into the Tax Code by spring, 2005). 0 Clarify the authority for interpreting tax laws and assign a single agency, such as MOF, for managing the process o f clarification, including in cases o f ambiguity, and contradictory application o fthe law by the tax payers andlor tax administration; 0 Reduce the tax burden and compliance costs by (i)eliminating cascading taxes and streamlining the local taxes in a way that generates the requisite revenues with low administrative and compliance costs; and (ii) strictly limiting the number o f tax inspections and shorteningthe duration o f audits; Expendituresfor investment are often lumpy and can be very large relative to the annual revenues of a company, putting a heavy burden on some firms that need to wait long to receivetheir credits fully. VAT exemptionfor imported capital goods is expectedto be reintroducedunder the new Tax Code, which is beingdeveloped. 19'Treatment on a destination basis means that the tax is rebated on exports (exports are zero-rated) and imposed on imports. Services inKyrgyzstanare mostly taxed on an origination basis, which means the sales by all Kyrgyz service providersare taxed, even when the purchaser is outside Kyrgyzstan. 192The localtaxes are expectedto be significantly streamlinedunder the new Tax Code, which is currentlybeingdrafted. 193For further discussion see Kyrgyz Republic Public Expenditure Review: Fiscal Policy for Growth and Poverty Reduction, Vol.11, pp.10-16, World Bank, March 2004. 92 0 Review the specialized small business tax regime (including the patent and the new simplified business taxes) to: (i) coordinate and harmonize it with corporate taxes, and VAT threshold for consistent tax treatment for small firms; (ii)clearly articulate exactly which taxpayers are covered by the patent system and the simplified small business tax system, respectively, while eliminating the voluntary patent system; and (iii) clearly articulate what taxes are replaced with the specialized small business tax regimes;'94 0 Improve VAT system by (i) expediting efforts to meet the legislatedtime-frame for the VAT rebates; (ii) undertaking a costbenefit analysis o f the new invoicing mechanism for providing VAT credits; (iii) exempting imports that are clearly for investment purposes, such as certain types o f industrial machinery; and (iv) identifying means for zero-rating the VAT on exported services; 0 Eliminate excise tax exemptions for firms operating in the FEZ and rationalize the profits tax exemptions while subjecting the sales into domestic market all the taxes that apply; 0 Establish a telephone hot line for allowing for unanimous reporting for (i)tax evasiodavoidance; and (ii) misuse o f official authority by customs and tax administrators. Ensure proper follow-up and media coverage for proven illegal activities for transparency. Administrative Barriers 3.54 Despite improvements over the last several years, administrative barriers to investment also continue to constrain investment. The BEEPS survey in2002 shows that administrative barriers are still a major obstacle to business activity. Among other things, they are shown to levy a significant "time tax" on enterprise managers-about 7 percent of manager's time is taken upby dealings with a~thorities.'~~ 3.55 Looking more closely at individual administrative barriers, an enterprise survey by U S A I D indicates that problems persist inbusiness registration, even though substantial improvements have been achieved.'96 Registrationcosts intime and money are shown to exceed legal limits and officials continue to demand side-payments for services rendered. Registration outside major metropolitan areas can also take much longer than mandated by law, indicating that more attention needs to be paid to implementation o f national reforms outside city centers. And there is still a great deal o f duplication among registration agencies that could be eliminated ifthey would agree to share information. 3.56 The USAID survey also shows that, although the number o f required business licenses has declined, many licenses still remain in force and the average number o f days it takes to get a license increased considerably from about 10 days in 1999 to 21 days in 2001-02. While the most current information on today's practices i s not available, poor implementation track record o f the new licensing regulations discussed earlier (see paras 15-16), reduces expectations for a tangible improvement. Nevertheless, the number of licenses is not the most important issue. The complexity and non- transparency o f the licensing process and validity o f licenses are much more problematic. Currently, the validity of licenses i s only two years, which is much too short. The rules and procedures governing licenses also needto be more transparent. The L a w on Licensing shouldbe the only legislationregulating business activity. Today there are still other laws that allow licensing. 194As a matter of principal, the simplified small business tax system and the patent system should be substitutes for business taxes (and specifically the corporate income tax) but not for personal taxes (such as the personal income tax and the social insurance taxes). Also, the simplified business tax and patent tax should not substitute for excises or customs duties. 19'See Section C, for firm level examples. "Regulatory and Business Environment Survey," 200I,USAID-ARDiChecchi, Regulatory Reform Project in the Kyrgyz Republic. Observes on the ground report that survey results continue to mimic present weaknesses. 93 3.57 Inaddition, certification requirements have not improved much and insome caseshave gotten worse. The procedures and requirements for obtaining certification and the ever-increasing number o f required certificates are the subject o f many business complaints. The cost and time involvedinobtaining certification i s particularly large in transport, construction and manufacturing, but wholesale and retail trade also has problems. Certificates are often issued for short periods o f time and require businesses to continually re-certify their goods or production processes. The list o f products requiring mandatory certification also continues to be long. A new draft Law on the Fundamentals o f Technical Regulations attempts to rectify many o f the problems in existing laws on standardization, accreditation and certification, to reduce these regulatory burdens imposed by the present regime, to ensure legal compliance with both international obligations and good pra~tices.''~A s discussed indetail inChapter 2, however, the legislative framework can go further inoverhauling the present system. 3.58 The majority o f businesses in the Kyrgyz Republic are required to obtain additional permits to start up and to continue their operations. The USAID survey shows that in some cases (n 2001-02) businesses needed more than 30 additional permits in a six-month period to legally conduct their operations. Particularly troublesome is that many o f these businesses could not obtain information about these permits, could not understand their requirements, and often were not aware o f their existence. The average time to obtain a single permit took more than two weeks, and even longer outside major metropolitan centers. The agencies singled out as the most problematic were the Sanitary and Epidemiological Stations, and organizations issuing similar permits, Kyrgyzstandard, the Ministry o f Internal Affairs and the Architecture and ConstructionInspectorate. When businesses were asked to rank the most disruptive forms of govemment administrative barriers, permits ranked second after taxes. Considering that Decree # 00 has mandated all permits to be enacted in laws and a registry o f legal and illegal permits has been completed, as noted in paras 18-19 above, the govemment is in a position to address the permits problem. An effective approach will be to cancel all the illegal permits and develop a posted price list for the remaining legal permits along with ensuring that these enforcement measures will be well communicatedto the public. 3.59 The number o f inspections and the costs they impose on business continue to be a significant business problem. This i s the case despite introduction o f an approval process by the State Commission for Business Development for both planned an unplanned inspections and o f an Inspection Logbook. According to USAID survey findings, more than 65 percent o f all respondents indicated that the number of inspections had either increased or stayed the same over the six months prior to the survey; the average number o f inspections over this six-month period was two, and there were certain sectors where firms were inspected up to six times; the average length o f these inspections was four days. There was also little awareness among firms of the new inspectionprocedures and even less awareness of the role of the Commission in controlling inspections and monitoring the activity of inspecting bodies. The recent anecdotal feedback from businesses suggests that despite some improvement in frequency o f inspections, firms continue to have n o effective means o f preventing unjustified inspections or appealing the decision o f inspecting bodies. There i s little trust in courts and most firms fear they will suffer negative consequences ifthey appeal against an inspectingagency. j9' See Chapter 2 for more detaileddiscussion. 94 3.60 To address some o f these problems, the government included among the objectives of the current round o f "investment matrix" reforms, a law on "Protection o f the Rights of Businesses during Inspections and Auditing by Authorized Organs." This effort should also include complementary set of measures to institutionalize sanctions against public official's abuse o f their position. Inaddition, there i s a needto develop and make available for public-viewing a set o f rules both spellingout what constitutes a legal inspection and establishing the rights o f business during an inspection-i.e., rules on what constitutes compliance and non-compliance with the inspectionregime. This will also helpthe judiciary, which has no formal rules to guide it when a firm complains about inspections. 3.61 Labor regulations in the Kyrgyz Republic are assessed by a recent World Bank study, "Doing Business in 2004," as among the most inflexible in the The study looks at three dimensions of possible rigidity in employment regulation -hiring, conditions o f employment and firing. The flexibility o f hiring index-which measures flexibility through availability o f part-time and fixed-term contracts- indicates how attractive it i s for businesses to hire part-time workers. The Kyrgyz index, at 36, ranks it among the world's ten least flexible countries in hiring. The conditions of employment index-which measures the legal provisions for flexibility in working time requirements, mandatory payment for nonworking days, and minimumwage legislation-similarly ranks the Kyrgyz Republic among the ten least flexible with an index o f .88. The flexibility o f firing index-which measures grounds for dismissal, procedures for dismissal, notice periods, and severance payments-places the Kyrgyz Republic in the middle rank of countries with an index of 36. Finally, the country's employment regulation index, an average o f the three previous indexes, puts it among the most regulated and inflexible labor markets inthe world. These weaknesses are expected to be addressed under the government's ongoing initiative to improve several provisions of the Labor Code in consultation with the key stakeholders. Among the major changes to be introduced are higher flexibility in hiring and firing, rationalization of social compensation and guarantees, and better conflict management procedures. 3.62 Recommendations: 0 Registration: (i)Rationalize time spent in business registration, particularly outside major metropolitan areas; (ii)eliminate duplication among registration agencies by increasing information sharing; and (iii) establish a publicly accessible register for all licenses, permits, and technical regulations, detailing the rules, procedures, timing and costs; 0 Licensing: (i) complete amendments to all sector-specific statutes to cancel licenses that are inconsistent with the Law on Licensing and to ensure that the Law i s the only legislation regulating business licensing activity; (ii) enforce rules and procedures for issuing new licenses in official agencies; and (iii) extendthe validity o f licenses from two to at least five years; 0 CertiJication: See Chapter 2, paras. 2.66231, for recommendations on standards, accreditation, conformity assessment and mutual recognition; 0 Permits: Cancel all illegal permits and create a price list for each legal permit approved by the government, registered at the Ministry of Justice and available for public viewing. Prices shouldbe based on the actual cost to administer; 0 Inspections: Broaden the current reform efforts to (i) institutionalize sanctions against abuse o f public official position; and (ii) establish and make available for public viewing formal ground rules and procedures for conducting all official inspections, specifying clearly what constitutes compliance andnon-compliance and the rights of entrepreneurs; Doing Business in 2004: Understanding Regulation, 2003, World Bank, Washington D.C. 95 0 Regulatoly Reform Process: Institutionalize the new regulatory impact assessment process by assigning monitoringand enforcement tasks to a qualifiedbodyresponsible bothfor sound oversight o f regulations/administrative procedures, and capacity development for impact assessment invarious government institutions; 0 Labor Regulations: Align employment regulations with good international practices; Commercial Legal Framework Investor Protections 3.63 High on the list o f continuing business obstacles in the Kyrgyz Republic in the 2002 BEEPS survey are rule o f law and a poorly performing judiciary. Trust in the Kyrgyz court system i s shown to be lower than average for the CIS (which is already low), as is the security of contract rights. The following highlights from the survey signal problems well: BEEPS asked firm managers the following question, "to what extent do you agree with the statement, Iam confident that the legal system will uphold my contract and property rights in business disputes"; more than 65 percent o f respondents said they disagreed with this statement. When asked, "to what extent do you agree that interpretations o f the law and regulations affecting your firm are consistent and predictable?" only 13 percent o f managers answered that they agreed or strongly agreed that interpretations were consistent and predictable. Finally, when asked, "how often do you associate the description honestluncormpted with the court system in resolving business disputes?;" 33 percent o f managers indicated "never," 31 percent " seldom," and 26 percent "sometimes," only 3 percent answered "always." These perceptions are also shared by other stakeholders, for instance the International Business Council argues that the central problem facing business inthe Kyrgyz Republic today is unpredictability and inconsistency, stemming primarily from the judicial system and other institutions involved in the enforcement o f legal rights-a view confirmed by the UNIDO survey o f foreign investors, cited above, which found a high degree o f condemnation for fairness and consistency inenforcing legal rights inthe Kyrgyz Republic. 3.64 According to the World Bank's Doing Business in 2004 study, there are 44 procedures involved inenforcinga business contract inthe KyrgyzRepublic andworking through these procedures takes an average o f 365 days. This compares to an average o f 14 procedures and 54 days in "best practice" countries. The study shows that a lower number o f procedures i s associated with more fairness and impartiality in the legal system. It is also associated with more honesty, more consistency, and more confidence. The Doing Business study also lists the Kyrgyz Republic as among the ten most expensive countries inthe world in terms o f the cost of dispute resolution-the cost o f proceedings i s shown to be more than two and a halftimes the claim amount. 3.65 One area o f the law where the Kyrgyz Republic gets relatively highmarks inthe Doing Business in 2004 report is property rights for creditors and debtors. The Law on Pledge and the Civil Code provide an ample legal foundation for creditor rights in secured transactions-the Kyrgyz Republic gets a score of three out of a possible four for the report's creditor rights index. This index, however, rates the quality o f the legal framework only, it leaves aside the question o f how well these laws are implemented inpractice. The key elements of a secured transaction framework are present inthe Kyrgyz Republic for both possessory and non-possessory charges against most types o f assets, and moveable assets can be used to secure debt. Registrationof the charges i s reasonably quick and inexpensive, and non-possessory charges can be publicized as they are registered in a single State Registry o f Pledge Transactions administered by the Ministry of Justice. The system also allows for multiple charges against property, including a fluctuating pool of assets such as inventory. Moreover, the assets can secure future fluctuating pools o fdebt, and a thirdparty can ascertain these charges. 3.66 Nevertheless, despite the sophistication of the registry system, it does not appear to be functioning properly. The registry system is paper based, and the centralized computer system provided for inthe law has not been established. Currently there i s no sign that such a system i s being established. 96 There are also some difficulties with the Law on Pledge. Legal professionals complain about conflicting provisions, lack o f clarity in the definition of assets, and the priority o f creditors' rights. Implementation i s somewhat problematic too. In practice, assets cannot be repossessed without working through the courts, which are slow and sometimes corrupt. These problems and others are now being addressed inthe new draft Collateral Law, which merges the Pledge Law and the Mortgage Law. Legal professionals in the Kyrgyz Republic observe, however, that the provisions for non-judicial foreclosure in the new draft Collateral Law are still weak to impossible to employ, with the new draft Law having a subtle, but nevertheless damaging, impact on the ability o f creditors to realize secured property after default other than through the courts. 3.67 Closely associated with the creditor rights legal framework i s bankruptcy law. As noted earlier, the Kyrgyz Law on Bankruptcy was recently amended in 2002, however, it continues to contain a number o f deficiencies inthe areas o f clearly defining creditor priorities and providing creditors with fair and predictable treatment, maximizing the value of debtors' assets, and facilitating opportunities for reorganization as an altemative to liquidation. EBRD recently described the law as "barely adequate" in its European Restructuring and Insolvency Guide 2002-03. And the Doing Business in 2004 study ranks the Kyrgyz Republic's legal framework for insolvency as good in some areas and not so good in others. The study shows that it takes as long as four years to complete bankruptcy procedures, but the cost of the bankruptcy process i s relatively low. It i s also shown that secured creditors will be paid in the Kyrgyz Republic, according to the law, before court costs, labor claims and tax claims, preserving absolute priority. However, the insolvency process in the Kyrgyz Republic seldom results in an economically efficient outcome interms of either foreclosure or liquidation with a going-concern sale; or ina successful rehabilitation maintaining the business but hiringnew management. The study's overall index, measuring the degree o f success in achieving the four goals of insolvency-cost, time, observance of absolute priority o f claims and efficiency o f outcomes achieved-places the Kyrgyz Republic in the middle category o f countries ranked. 3.68 An important problem with the current bankruptcy law is that it is based on the Russian Bankruptcy Law o f 1992, which provides for five separate types o f bankruptcy proceedings. Most of these proceedings are redundant, unnecessarily complicate the process and make it time consuming for creditors. There are thirteen instances when court decisions can be appealed, providing opportunities for frivolous appeals that can unnecessarily delay the restructuringprocess. There is a need to review Article 67 o f the law as it allows for transactions with a creditor to be rescinded if the transactions were incurred within one year of banlu-uptcy. This leads to preferential treatment of the creditor relative to other creditors. Similarly, Article 75 provides that secured credit can be invalidated within one year of bankruptcy. Both of these provisions reduce the level o f certainty and predictability for creditors and undermine the rationale for having a system of secured credit. There are also problems with the test for bankruptcy, which i s based on the "ability" of a debtor to pay, rather than failing to meet the "demands" of a creditor to pay. The latter test i s much more straightforward to apply, making it easier to initiate legitimate bankruptcy proceedings and to put in place an administrator to protect creditor interests through either restructuring or liquidation. 3.69 Company and securities law also needs further improvement. There are a number o f provisions in the new Law on Joint Stock Companies where shareholders and board members are given inappropriate rights that confuse the roles and responsibilities o f shareholders, the board of directors, and management. For example, shareholders have the right to dismiss directors without good cause, and operate without a board if there are less than 50 shareholders. Similarly, the board of directors i s made responsible for management, rather than overseeing management, but at the same time it is prevented from giving instructions to management. The degree of liability o f directors and managers i s not clearly defined, and could leadto ultra-conservativebehavior that does not promote the interests of the company. Liability should be formally evaluated in terms o f whether they have acted in good faith on the basis o f the informationthat was available. The legislation fails to provide a clear definition o f the responsibilities 97 o f the audit committee, which should be comprised of independent directors, and it i s not clear what minimumlevelof informationtheboardshouldprovide to its shareholders. 3.70 The new Law on Joint Stock Companies also createsrestrictionslimitingthe payment o f ordinary dividends to current year profits, which does not take into account the possibility o f paying dividends from reserves. Further, a company must pay out at least 25 percent of profits as dividends, which precludes opportunities for companies to reinvest profits. The law allows for subscribers o f equity to pay inkind, rather than cash, which createsrisks interms of inappropriate transfer prices. Shareholders also have the ability to only partially pay for shares for up to one year from subscription, and this makes it difficult for creditors to ascertain the true financial condition of a company. There are also a number of amendments to the Civil Code (Article 147(3) and Article 151(3)) that place restrictions on the level of dividends andnumber o f shares that can be issued by certain types ofjoint stock companies. 3.71 Accurate financial reporting continues to be a problem, notwithstanding initiatives to improve the situation. Inpart, the absence of reliable financial information has been a function of the lack of International Accounting Standards qualified accountants and International Accounting Standards qualified auditors. This situation i s now beginningto change. As of 2003, there were 42 accounting and auditing firms operating in the Kyrgyz Republic, including Deloitte Touche Tohmatsu based in Bishkek and PricewaterhouseCoopers based in Almaty. Further difficulties are caused by the difficult environment within which auditors work. Typically, SMEs maintain two sets o f accounts, many transactions are cash based, and it is difficult to get debtors to confirm transactions. These problems stem from the heavy burden imposed by the tax system, and the high levels of negotiation required with tax officials, discussed above. 3.72 There are also legislative issues that need to be addressed in the financial reporting area. The State Committee on Standards of Financial Reporting and Auditing has prepared draft legislation to make the Tax Code consistent with the Accounting Law. The Civil Code also needs to be amended to make it consistent with the Audit Law to remove the requirement for professionalindemnity insurance, as it i s not feasible at this stage. In addition, the Government should consider the introduction o f differential accounting requirements for SMEs, based on a simplified system of International Accounting Standards, to reduce compliance costs. Property Laws 3.73 Land laws continue to be problematic in the Kyrgyz Republic, as they refrain foreigners from owning land, which, in turn, creates constraint to foreign investment in the Kyrgyz Republic. In comparison, the property laws for local investors present few problems. Some difficulties arise in enforcing property rights for local investors, however, because o f the lack o f a properly functioning property register. Registration of ownership is neededto protect investments and enable assets to be used for purposes o f securing external sources o f finance. 3.74 Despite having intellectual property laws that comply with WTO regulations, enforcement of intellectual property laws by government agencies, such as customs and police, i s not adequate and the judicial system is still unable to address intellectual property right disputes effectively. As a result, illegal copying, reproduction, andbroadcasting o f intellectual property are wide spread inthe Kyrgyz Republic. 3.75 For the ten years the Concessions Law has been in effect, there has been only one concession agreement concluded, the Kumtor mine. Reasons for limited use o f concessions revolve around the type of economic activity now underway in the Kyrgyz Republic and existence o f competing laws and regulations. In the mining industry, it is useful, and technically correct, to distinguish between concessions, which are sometimes publicly bid but not always, and a normal licensing system. Concessions are generally granted for very large deposits, like Kumtor, and are normally subject to deal- specific negotiations between the government and the operator. Governments are usually advised to 98 avoid concessions on hard-rock mineral deposits, as they can open the door to corrupt practices. The more common practice inthe miningindustryi s a system of licenses (miningtitles)--exploration leading directly to exploitation-which i s provided for under the Kyrgyz Mineral Resources Act. As a result, most foreign investors in the mining sector have used licenses rather than concessions to govern their investments. 3.76 Nevertheless, as a rule it i s better to minimize the case-by-case negotiations o f concessions and conform to generally accepted tax and other laws in order to minimize the possibility o f improper dealings. The Kyrgyz Republic's Mining law is, however, provides for an unworkable mining title and license system; the tax, surface rents, bonus payments, and other fees for holding land i s also unworkable inpractice, allrequiring modifications. 3.77 A final reason why concessions have not been used is lack of a pipeline of projects open for private sector biding. In addition to mining, there are a wide range o f opportunities for added use of concessions, such as roads, water, and power. The ongoing efforts to establish private participation in electricity distribution companies through the concession route may pave the way for more such arrangements inthe future. But, this requires amending the concessions law to enable the government to give a concession of assets of joint stock companies (i.e., majority but not fully state-owned) to private investors, a work currently inprogress. A further step inthis direction would be establishment o f a Public Private Partnership Unit inthe government that can define guidelines for the use o f concessions and work with line ministries in power, roads and water to develop projects. Standard guidelines are also important, as concession agreements for public services needto be harmonized with economic regulations inthe utility sectors, where typically the projectsare large, andthe contractual arrangements are complex and relatively inflexible. 3.78 Recommendations: Contract Enforcement: (i) the time and costs to enforce business contracts through reduce judicial reforms; (ii)develop alternative, private dispute resolution mechanisms; and (iii) develop training program for judges and other members o f the judiciary in commercial law (a third party arbitrage court has recently been established, which if works effectively could address thepoint (ii); Property Rightsfor Creditors and Debtors: Improve the Law on Pledge and Mortgage Law by clarifying definition of assets and creditor rights and making provisions for non-judicial foreclosure; (ii)computerize the registry system for secured transactions (the new draft Collateral Law will address both of these issues when enacted; but it should ensure that provisionsfor nonjudicialforeclosure are strengthened not weakened); Bankruptcy: Improve the Bankruptcy Law by (i) clearing up creditor rights; (ii) simplifying procedures; (iii) eliminating potential for frivolous stays on procedures; (iv) revising the test for bankruptcy; and (v) reviewing Articles 67 and 75 to strengthen the level o f certainty and predictability for creditors; Company and Securities Legislation: (i) improve the Law on Joint Stock Companies in the areas of rights, responsibilities, and liabilities o f shareholders, directors, and managers; (ii)information disclosure; and (iii) to externally audited accounts; rights Financial Reporting: (i) as part o f the ongoing work on the Tax Code, make it consistent with Accounting Law; (ii) amend Civil Code to make it consistent with the Audit Law; and (iii)consider different accounting requirements for SMEs, based on simplified system o f International Accounting Standards; Property Legislation: (i)consider allowing for the foreign ownership of the land; (ii)computerize land registry and complete process of recording land titles; (iii) strengthen capacity o f customs, police, and other official agencies and elicit cooperation o f private sector 99 to enhance protect intellectual property rights; (iv) develop training program for judges and other members o f the judiciary in intellectualproperty law; and (v) strengthen the concession law and its consistency with other relevant legislation and establish a Public-Private Partnership body to start benefiting from the potential o f concessions in bringing-inforeign investors inminingand utilities sectors. c. CHALLENGESFORIMPROVED COMPETITIVENESS 3.79 A key element o fgrowth strategy should be to put inplace the necessary conditions for improved enterprise competitiveness and sustained growth, based on the Kyrgyz Republic's comparative advantages and the small country strategy for export success (flexible specialization in niche markets). The earlier analysis on the SAM-based sources of growth and trade barriers, the industrycase studies, and the survey findings and observations from interviews with private sector representatives, collectively, reveal five broad areas, amenable to govemment and donor initiatives that require pro-active support: 0 Strengthening enterprise capability with a focus on business strategy-making, marketing, and production efficiency; 0 Deepening financial markets and promote working capital instruments; e Improving efficiency o f trade support services; 0 Upgrading infrastructure; e Building institutions and training programs to support agriculture and meeting standards in international markets. Strengthening Enterprise Capability and Increasing Productivity 3.80 One o f the main challenges facing the Kyrgyz Republic i s enterprise competitiveness. A widely used measure to assess enterprise competitiveness across countries i s relative unit labor cost expressed in a common currency. Chapter 1 assessed Kyrgyz unit labor cost vis-a-vis CIS comparators/competitors, which revealed that the Kyrgyz Republic's low wage advantage is being eroded by its larger productivity disadvantage with all the comparator countries. The consequence i s higher unit labor cost and trouble competing at home and abroad. The industrycase studies confirm a substantial competitive gap between Kyrgyz firms and their international rivals. To address this problem, measures to improve enterprise capability and productivity must be an important part of the development agenda. 3.81 What are the major causes of the Kvrmz Republic's uroductivity problems? The industry case studies point to six factors that are mainly responsible: e Low capacity utilization: All the case studies show that many plants are plagued by excess capacity, particularly those plants established inthe Soviet era when capacity was installed to meet export quotas to other FSU countries. A lot o f large plants operate at 40 percent of capacity or less, which reduces technical efficiency o f production substantially. Firms also struggle with substantial debt burden and vintage equipment. Other problems that exacerbate the excess capacity problem are management problems, disrupted and weak channels of distribution, workmg capital shortages, difficulties getting consistent raw materials supplies and infrastructure problems, which are discussed elsewhere in this chapter. Some examples are as follows: > In the cotton industrv, production capacity in ginneries, on average, is as much as three times available raw material supplies. Small ginneries often operate at excess capacity because o f lack o f working capital to obtain raw materials; yam manufactures operate at 15 to 20 percent o f capacity; one large producer o f final products, terry cloth for furniture and towels, operates at just 6 percent o f installed capacity for lack o f working capital to purchase critical raw materials and for lack o f markets for its current product range. 100 9 In the fruits and vegetable industry, about half the processing companies average at 50 percent capacity utilization and the rest operate at much lower levels depending on regional location. Use o f available capacity i s low because o f poor product planning, inconsistency inraw material supplies, inability to get enough glass containers at critical times because o f import difficulties and working capital problems, and electricity and water problems in some places. 9 Inthe wool processing industrv,the three privatizedprocessingplantsoperate at lessthan 25 percent capacity utilization because o f dwindling raw material supplies, old and idle equipment, and dried up former markets at home and internationally. 9 Inthe dairv industry, installed capacity ofan average processing facility is about enough to produce 300 tons o f milk per day, but it operates at only 100 tons per day during the summer peak season because of difficulties and costs o f getting raw materials, lack o f working capital and transport problems. Quality of machinery: In many industries, machinery in use is vintage Soviet equipment, designed for mass production o f standard products and cheap energy. In many cases, equipment i s inefficient and i s not suitable for the flexible specialization and differentiated product strategy, which Kyrgyz firms must adopt for future competitive success. Vintage equipment i s also responsible for frequent breakdowns, which stop production and result both inproductiondelays and inincreasingcosts due to frequent repair andmaintenance as well as expensive importation of spare parts. Some examples are as follows: 9 Inthe fruits and vegetable industw, the average age ofequipmentis about 15 to 20 years old and most of it was purchased from Russia. Sixty percent o f the equipment i s assessed as in "good serviceability or better," but experts estimate that 70 percent o f the equipment o f processing companies will have to be replaced inthe future to successfully compete in target markets. Equipment investments will require new processing technologies and introduction o f information technology. P Inthe cotton industrv, nearly all ginneries operate with 1960s equipment-both local and foreign investors have done little upgrading as processors in the region are currently demanding only medium grade cotton. This old equipment in ginneries results in l o w conversionratios o f raw cotton to lint cotton-on the order o f 35 to 45 percent, about the same productivity as inefficient plants inKenya and Cambodia. 9 Inthe wool industry, the old equipment inprocessing facilities produces a wool to yarn ratio o f just 1.54 (1.54 kg of wool to 1 kg o f worsted yarn), comparable to the productivity o f some o f the world's most inefficient producers inAfiica and Central Asia. e Management capability: An important reason for low productivity i s weak management. Kyrgyz managers are not well trained and often not fully engaged inthe business. Thus, poor management results from two factors: inadequate know-how and pre-independency business style/practices that continues to cut initiative and drive about what effort, innovation, and cooperation can do. Some examples are as follows: 9 Inthe h i t s and vegetable industrv, 80 percent ofmanagers have a higher education and 46 percent have technical training. But many o f these managers got their training in Soviet management schools and got their experience as managers in the Soviet era. As a result, they put most o f their emphasis on the production process rather than on product quality and marketing and look to the government for help rather than their own initiatives. Planning and long-term development strategies are inadequate. Financial 101 management i s poor. Few firms engage in quality management. Decision making in firms i s highly centralized. Top managers make the decisions and key technical personnel are generally not involved. For instance, managers often argue that they need financing in order to produce more profits, with limited attention to finding ways to accelerate profits to obtain retained earnings for financing. Ninety-seven percent of managers cite current management practices as adequate, but blame their business problems on the external environment-administrative barriers, government's failure to help, lack of credit, energy prices andthe like. 0 Worker efficiency: Task-level efficiency of workers i s poor compared to intemational competitors. This seems to apply even in situations where equipment in use i s relatively modem and up-to-date. Insome instances, workers have good skills, but their initiative, work intensity and consistency are comparatively inadequate. Another part of the problem i s worker training. Industryspecific training institutions have closed and with them facilities to train workers. Companies do not have the resources to develop training programs for basic skill development. There is also a "brain drain" of educated and talented workers to higher wage countries inthe region. For instance, one o f the principal problems raisedby ginneries in the cotton industry is the lack of trained mechanics and engineers for operations and maintenance. Many technically trained workers are seeking jobs in higher wage countries like Northern Russia where wages in the construction or mining industry can be four to five times higherthan the Kyrgyz Republic. 0 Lack.of specialization: Kyrgyz firms often produce too many products. The reason for this lack o f focus, particularly in the case o f exporters, seems to be serving both domestic and international markets, and, in those markets, serving too many market segments. Lack o f specialization can reduce productivity, because it increases shop floor complexity and reduces throughput. Companies also find it muchmore difficult to trackjust how muchprofit each individual product provides and they often end up selling products that do not make money. Some examples are as follows: P Inthe fruits and vegetable industrv,a specializedjuice exporter have eight times higher productivity than an unspecializedexporter o f mixedproducts. Specialization inthe food processing industryi s made more difficult by the fact that producers do not have enough information to plan for future production. Farmers do not provide harvest forecasts or any other information, consequently, processors do not know exactly where particular crops will be grown, what will be grown, or who will grow them. Good information on domestic and external consumer markets i s also lacking. Better cooperation between farmers and processors and better market information will be needed to focus on particular market segments and planproduction. 0 Limited economies of scale: The Kyrgyz Republic's domestic market is small, as does its population, and incomes are low. But the market i s made even smaller by several other factors: First, a large portion o f the rural population i s isolated from the market because distribution channels, which were disruptedafter the collapse o f the Soviet Union, have not been fully re-established4ven in urban areas distribution channels for basic manufactured goods remain underdeveloped. Second, hightransport costs (because o f high fuel costs, old vehicles, poor roads, and bribes for road police) and lack o f working capital worsen the situation. As noted in Section B and Chapter 2, inadequate government standards (GOST)-- which are now beingimproved-and inadequate administration o f the standards inindustries such as building construction and others also reduce the size o f the market for companies manufacturing products like construction materials and durable goods. With small market size, it i s difficult for Kyrgyz manufactures to shift from "job-shop'' production o f a few units o f special-order products to batch production, where there are economies o f scale and 102 productivity i s much higher. Domestic firms that become exporters in many countries often begin by first producing for the domestic market and then enter world markets only after their costs are brought closer inline with international competition. Consequently, removing non- natural constraints on the size o f the home market can influence the ability to enter into export markets. Some examples are as follows: 9 Inthe cottonindustry,becauseoflackofworlung capital ginneries areunabletopurchase large volumes o f raw cotton fi-om farmers. Ginneries are forced to do contract processing and to make barter arrangements in small lots. The whole process o f consolidating purchases, producing cotton lint, and transferring it to the next stage o f value added processing o f cotton yam i s weakened. Farmers often must sell small volumes o f lint directly to cloth and yam makers or use lint cotton to barter for other goods. And, as yarn and fabric manufactures must purchase from individual farmers or through brokers, transactioncosts are higher. 9 Inthe fruits and vegetable industry,a very small group offirms have economies of scale for similar reasons-Le., lack of working capital, raw material supply inconsistencies, transport problems. Also, the market for raw material i s poorly organized and highly dependent on the weather becauseo flimitedimgation. 9 Inthe wood processing industry, door manufacturers and producers of other types of construction materials, and furniture manufactures, are hampered in producing standard products, using batch production processes, because construction standards are not well defined or properly enforced. 3.82 What stem can be taken to improve enterpriseproductiviv and enhance competitiveness? Inthe long run, the real exchange rate i s expected to converge on its equilibrium value and competitiveness becomes virtually synonymous with trendproductivity growth. So the main competitive challenge for the Kyrgyz Republic in the longer term is how to create the conditions for rapid and sustained productivity improvement. This will require firstly the support o f a sound investment climate, as the investment climate creates the potential for improving productivity growth. But a sound investment climate alone does not generate productivity improvement. Productivity i s created at the microeconomic level-in the ability of firms to design and produce valuable goods and services, using efficient production methods, andto take advantage of market opportunities. The foundations for productivity improvement rest mainly on: (i) the capability o f firms and the strength o f technology transfer mechanisms; (ii) quality o f factor the markets; and (iii) robust competitive pressure. 3.83 Several o f these elements are discussed elsewhere inthis Chapter and the Report itself, what has not been emphasized enough so far i s the importance o f developing more efficient mechanisms for technology transfer to improve the environment for enterprise learning. 3.84 Studies in many transition countries show that a key driver o f productivity improvement i s enterprise "learning." Learning takes place by way o f the transfer o f technology4efined broadly to include new ideas, equipment, management practices, marketing strategies, and the like-fi-om more advanced countries. The strength and efficiency o f the mechanisms for technology transfer ina transition country determine the enterprise-leaming rate. Depth o f financial markets, supportiveness of the investment climate, and other factors that influence investment rates are important for productivity growth too, but the efficiency o f investment will depend on the technical ability o f firms to acquire, adapt, and efficiently use new capital equipment and new ideas. 3.85 The leading source o f technical leaming in firms is by private learning mechanisms. These operate via the intemal efforts o f private firms to leam through interactions with foreign buyers and suppliers, interactions with other foreign and domestic firms in the same industry, hiring expert 103 consultants and expert foreign employees, and intemal and external training programs for managers and workers. When firms cannot meet all their leaming needs through their own efforts, there i s a demand for technical support services from govemment, NGOs, and donors. 3.86 To improve productivity in the Kyrgyz Republic, firms will need updated production technologies, technical advice to improve factory organization and product quality, and worker training programs. Productivity improvement will also require better strategy and marketing. Kyrgyz firms must do what they are doing more efficiently, but also develop new strategic approaches that make improved efficiency profitable. The latter will involve the capability to make an assessment o f the strategic positioning o f the firm. This entails making choices about: (i) what products to produce, (ii) market what segments products should be produced for and how they will be marketed, and (iii) what technology will be usedto produce the chosenproduct line. 3.87 The principal elements in building a successful strategy are to invest heavily in understanding what product attributes the buyer values, and to invest heavily in enterprise technical leaming. These, in tum, are areas where companies require govemment and donor assistance. It is observed inthe industry case studies that Kyrgyz companies too often get the strategic decision process backward-firms begin with a product they think can be producedand then try to findways to sell it, rather than starting with the market and the product attributes the market wants. 3.88 Part o f the reason for this perverse approach i s that Kyrgyz firms are isolated from the market. Most o f the mechanisms firms normally rely on to gather information about buyer's preferences are absent. Buyers are not visiting the Kyrgyz Republic in large numbers and companies often do not have the resources or do not understand how to go about visiting buyers in other countries. The attitudes o f Kyrgyz producers about how to approach the market have also been shaped by pre-independency notions inmany respects. Firms arejust beginningto understand a customer driven approach. Managers need training and they need local role models, such as direct foreign investors and joint venture partners, to leam from. They also need the advice of marketing consultants and assistance to visit foreign markets. Assistance will also be required for related and supporting industries, such as packaging, as this i s a key element in marketing and new product development. As one food-processing entrepreneur put it, "packaging i s one of the weakest points of Kyrgyz export infrastructure." Exporters injust about every industry have difficulties with packaging-it is expensive and time-consuming to import, and local packaging does not meet exporter's needs indesign, strength, and suitability as well as foreign health and safety standards. 3.89 The industry case studies illustrate that, as with strategic planning and marketing, private technology transfer mechanisms for technical leaming are also weak or missinginthe Kyrgyz Republic. Firms find it difficult to upgrade their production processes. In-firmtraining programs are few, so does interactions with buyers and suppliers, reducing the flow o f technical information; the availability o f expert technical consultants i s insufficient; and there are few foreign investors or experienced local firms to serve as role models and channels for technology transfer. Good public and private technical training resources external to the firm are also few in number. Industry-specific worker training programs collapsed with the Soviet system. Similarly, technical training in higher education institutions has deteriorated for lack o f resources. Donor, NGO, and business association training and technical advisory services do exist and are mahng an important contribution, but these programs are limited in scope and resources and cannot substitute for all the weaknesses in private technology transfer mechanisms, given their present makeup. Also, business support organizations and projects are spread unevenly across the country-the majority are concentrated in Bishkek and Osh, many rural areas receive only limited attention, if any. The deficiencies in leaming mechanisms inthe Kyrgyz Republic need more attention if firms are going to upgrade their technical capabilities and productivity to compete internationally. 3.90 Strengthening mechanisms for technology transfer depends, critically, on the quality o f the investment climate, as a sound investment climate increases the likelihood o f more foreign investment 104 and of expanding other modes o f foreign technology transfer. Clearly, FDIand the number o f buyers and suppliers traveling to the Kyrgyz Republic will not increase significantly without improvements in regulatory and administrative barriers, legal institutions, and corruption. An improved investment climate also increases incentives for local firms and investors to learn and adopt new technologies. In addition, there will also be a need for direct interventions to expand and build up mechanisms for technology transfer. 3.91 The Free Economic Zones (FEZ), with their improved investment climates, have in principle been an important intervention to increase foreign investment and technology transfer. The analysis o f the FEZ production data suggests that firms in the FEZ in Bishkek have five to seven times higher productivity than the average Kyrgyz firm because o f the improved business environment and because o f the use o f superior technology (better machines, management practices, worker training schemes, market information, and so on). The technology transfer "spillover" effects from these FEZ firms to the local economy should, however, be substantiated, by way o f the ability o f local firms to "benchmark" their operations against these higher productivity companies and by way o f Kyrgyz workers gaining experience in these FEZ firms. Some of these workers will leave over time to work for local companies or to start their own firms, taking the new technological ideas with them. Further efforts to increase FDIinthe FEZ and to increase links between FEZ firms and the local economy can help to increase these beneficial spillover effects. 3.92 Interventions to continue building up and improving institutions for management training and business advisory assistance are also needed to improve the transfer of t e ~ h n o l o g y . 'These institutions ~ ~ should be linked to advanced country sources o f expertise, and managed by the private sector entities. They will need the assistance o f government and donors until business activity grows enough to widen the market for private business development services. Helping to build up existing private business service providers, such as private business consulting firms, by assisting them to link up with foreign business consulting firms in joint-ventures and improving their skills i s another way to improve the learning environment and increase technology transfer.200 3.93 Assistance to develop technical and vocational training institutions (public and private) i s needed, too. These training institutions must cooperate closely with the private sector in developing and providing innovative programs for worker training. Inaddition, cost-sharing grant schemes are needed to assist firms in developing their own innovative, in-firm training programs, in hiring expert consultants, and in searching for new technologies and markets. Finally, as discussed in Section B above, reducing import duty and VAT on capital equipment not produced in the Kyrgyz Republic could provide another important incentive for technology transfer and upgrading o f equipment in firms. The Kyrgyz Republic's policy should be to make a supreme effort to stimulate the transfer o f new technology into the country by keeping the cost o f imported equipment as close to world market price as possible. 199 A good example of such institutions are Center for Enterprise Rehabilitation and Management Assistance (CERMA; www.CERMA.ge) in Georgia and the Agency for EnterpriseRestructuringand Assistance (ARIA; www.ARIA.md) in Moldova. Founded in 1997 to implement the post-privatization assistance to the Georgian industrial enterprises under a World Bank Project, CERMA is the largest management consultingcompany today, providing enterprisetransformation services in Georgia. It focuses on accelerating the adjustment of the enterprises to the new, market environment, improving competitiveness and financial performance of post-soviet era firms; and supplying the labor market with the qualified business consultants and incumbent managers. ARIA has been established in Moldova in 1995. It is active in management consulting, training, and investment & new business development. Companies working with ARIA have demonstrated a positive trend o f financial performance, sales positionsandreduction in the level of barter. 2oo A study, "Business Development Services in the Kyrgyz Republic," carried out by GTZ in 2002, shows that expansion of local business development services, such as managementconsulting, accounting, advertising, product development and so on, is constrained by the extent of the market, which is currently quite small, and by an unfavorablebusinessenvironment. The quality of these services, their future development, and their ability to assist in the transfer of technology are also limited by lack of contact with ideas andserviceproviders in more advancedcountries. This isolation needs to be addressed. 105 Developing More Robust Financial Systems 3.94 The industry cases studies show that access to finance i s a considerable impediment to enterprise competitiveness. Consistent with the overview in Chapter 1o f this report, the main constraints are cited to be high interest rates, high collateral requirements, and lack o f access to working capital. These conditions are a reflection o f the underdeveloped financial system; although stable, a fragile macroeconomic environment; and a nascent and struggling private sector. Volume I1 o f this Report discusses these challenges in more detail and summarizes current initiatives to strengthen the sector. What follows, will outline some o f the financial problems firms are facing as portrayed in the industry case studies. 3.95 Inall ofthe industrycase studies lackofworking capital is showntobe an important constraint on productivity improvement and industry development. Inadequate working capital is constraining capacity utilization, reducing economies o f scale inproduction, and limitingthe development o f forward and backward linkages. 3.96 The cotton industrv provides a typical example. Each stage o f value added production faces working capital constraints. Farmers cannot buy enough fertilizers, pesticides and other inputsto increase productivity. It is estimated that they are able to acquire only 40 to 50 percent o f pesticides and insecticides needed. Fertilizers often mustbe bought via a barter system, which means they pay a markup equivalent to a 62 percent price increase. A few medium to large farms with enough working capital buy plastic sheets to cover fields during the early phase o f planting. This technology has advantages o f shortening the growing season substantially, increasing yields by as much as 85 percent, and reducing labor costs for weeding and costs o f pesticide and insecticide use. In the next stage o f production, ginneries do not have enough working capital to buy raw material from farmers in large lots. Many transactions are done on an inefficient small-lot barter basis. This cuts capacity utilization and economies o f scale in distribution, reducing productivity. Y a m and cloth producers are constrained by working capital too. They often are constrained inbuying enough raw material from ginneries or must by small- lots directly from small farmers-who have usually contracted on a barter basis with ginneries to process their cotton into lint). At the higher stages o f the value chain, final goods producers are similarly constrained in buying needed inputs to upgrade the quality o f their products for export, reducing their competitiveness and market potential. 3.97 Poor access to fixed asset financing also reduces competitiveness. Trade liberalization i s putting pressure on firms to reduce costs and upgrade their technological capabilities, but lack o f credit is restricting their ability to adjust. Firms are forced to continue to use vintage, inefficient equipment, which, as noted above, constrains their ability to meet export quality standards, and raises production costs because o f increased maintenance and repair and higher energy use. The h i t s and vepetables industrv is a good example. As noted above, experts estimate that 70 percent o f the equipment o f processing companies will have to be replaced in the future to successfully compete in target markets. Interviews with firms in the industry revealed that more than 80 percent want to begin the upgrading process but most o f the companies cannot find the resources to fund these investments. Managers observe that access to credit, particularly to much-needed longer-term credit, i s limited. They also note that high interest rates and collateral requirements undercut the return to borrowed funds. Therefore, firms are reluctant to make investments unless profits from the project are highand assured. On the other side o f the equation, financial intermediaries face significant difficulties lending to processing firms. Many older firms still have substantial debt left from the transition era. Managers often lack the information and experience in preparing feasibility studies and business plans required by lenders. Finally, as discussed earlier, many firms have non-transparent financial statements, unstable financial status and poor financial and operational management. 106 ImprovingEfficiency of Trade Facilitation Services 3.98 Competitiveness requires that producers get imported inputs at world prices, on time, and final goods transported to destination markets ina timely fashion at low cost. Supply-chain costs and outward transport costs depend heavily on the efficiency of trade support services o f customs and other agencies, and the adequacy o f infrastructure. Chapter 2 of this study details problems with trade support services in the Kyrgyz Republic2" and recommends improvements inborder agencies dealing with foreign trade and transit. Inthis section, we detail some o f the problemsraisedby firms inthe industry case studies. 3.99 The most problematic trade facilitation service for business i s Customs. Firms in all the industries point to problems o f corruption, heavy burden of documentation required, and processing delays. Customs notes that inprinciple goods can be cleared when all documentation i s in order in three to four hours. According to importers, however, in practice it takes in the order o f three to five days to get consignments released, largely becauseo fbureaucratic requirements, such as translation o f documents for Customs, required certificates o f quality that entail numerous and lengthy administrative steps, a requirement that importers provide a company bank certificate and a certificate of tax registrationfor each transaction. In addition, if payments are made through a bank-compulsory for sums exceeding US$400-at least three days are required before Customs is advised o f the payment and can release goods. Furthermore, productivity of Customs administration i s significantly reduced due to procedures they follow: too many consignments are inspected when a few should be randomly selected and there is duplication in inspections, which cause delays. Customs officials also have too much discretion in determining valuations and use it to extract bribes. Delays also occur becausenumerous transit shipments are subjected to a time-consuming convoy escort system, which i s unnecessaryinmost cases. 3.100 Because o f inefficiencies in its procedures, organizational problems, and poor communications, Customs has difficulties in dealing effectively with problems of smuggling, which are large, particularly along the Kazakh and Uzbek borders. Smuggling i s having a significant affect on the ability o f local firms to grow and develop by undercutting their competitiveness. 3.101 Transportation i s cited by many firms as a costly problem, particularly in industries where agricultural raw materials are important. Equipment, fuel costs and road conditions figure in the complaints, but, as noted earlier, road police bribes and delays are part o f the problem too. In terms of infrastructure development, poor rural roads are cited as the most important problem. 3.102 Transit through Uzbekistan is difficult for Kyrgyz transporters. Same applies for transit through Kazakhstan-reportedly due to delays at police checkpoints, waiting for escorted convoys, and official corruption. These transit problems are particularly important in industries with perishable products, such as the dairy industry, an important export product-group to Kazakhstan.*02 Prior to 1998, trade regulations allowed Kyrgyz dairy processors to deliver products to markets in southem Kazakhstan. However, trade regulations and customs procedures imposed by the Kazakh government later on have increased delivery time to as much as 15 days.203 According to firms, there is constant negotiation between the dairy processor and the importer regarding, who i s responsible for costs incurred as a result. In most cases, as product delivery has not taken place, added costs must be absorbed by the dairy 20'The discussion, in addition to backgroundwork undertaken in the context of this Report, draws from a recent World Bank Study on "Trade and Transport Facilitation: Kyrgyzstan," (mimeo), World Bank, March 2003; and on Trade and Transport Facilitation in Central Asia: Reducing the Economic Distance to Markets," World Bank, 2004. 202See Box 2.1 in Chapter 2 and Volume 11, trade performanceanalysis. *03Several days are requiredto processapassport for delivery of goods, an additionalthree to four days are requiredbeforefunds arrive to the Customs office for a 16 percent VAT payment (paid by Kazakh import agents), and as many as seven to eight days are requiredto clear export documentation. During this period, dairy processors must pay for hotel accommodationfor the driver and securitypersonnel, and more important, the cargo must bekept refrigerated. 107 processor. As a consequence of these delays and added costs, Kyrgyz dairy processors have come under increasing pressure from Kazakh importers regarding delivery times and costs, are losing markets in southern Kazakhstan. As noted in Chapter 2, some of these transit/administrative barriers are currently being removed, as a result o f a transit agreement signed with Kazakhstan in December 2003. Nevertheless, among the remaining official policy barriers, various road taxes and fees levied by local authorities (oblasts) on foreign carriers, which will continue to create difficult challenges for the Kyrgyz traders. UpgradingInfrastructure 3.103 Firms in the industry case studies report that infrastructure deficiencies reduce operating efficiency andraise distribution costs. 3.104 Costs o f water and electricity in the Kyrgyz Republic are low by regional and international standards-water tariffs are half the average for OECD countries and electricity charges are much less than the regional average-but firms in the case studies report that deficiencies in water and electricity supply are reducing productivity in some industries. Electricity is reported to be the biggest problem. This, in turn is explained, among other factors, by significantly below cost-recovery charges for these services, hampering adequate maintenance and upgrade of the infrastructure. Frequent power outages and power fluctuations stop production and increase set up costs on production lines, waste raw material, damage equipment, and lower product quality. Firmsnote that electricity and water problems are uneven acrossthe country and some areas are muchworse than others. 3.105 Another infrastructureproblem i s roads, which raise transport costs, cause distribution delays and limitaccessto somemarkets. The classified inter-city roadnetwork is 9,834 kilometers longand includes 4,156 kilometers of national roads and 5,678 hlometers o f regional roads. Only 40 percent (including local roads) of the total network i s paved. At all levels roads have deteriorated. Approximately 60 percent o f the network requires urgent rehabilitation. Because o f a lack of funding, local roads, in particular, have received little maintenance. Deteriorated roads, together with bad weather conditions, make Kazakhstan-where all major international road arteries pass through-barely accessible for transit for many months of the year. Given how crucial these connections are to the Kyrgyz economy, especially when shipping out agricultural products to Russia, this i s a significant problem for Kyrgyz traders. For the same reasons, Chinese cargo enters the Kyrgyz Republic directly only in summer and must make a detour through Kazakhstan.204 3.106 Access to irrigation along with the access to roads and markets i s among the determinants o f tradable crops production and agricultural growth in general. A large part of the irrigation infrastructure has fallen into despair due to a poor operation and maintenance, though the essential parts are being rehabilitated with donor support. The irrigation fees remain low at about US$0.6 per 1,000 m3(som 30) against cost-reflective fees estimated at above US$15 per 1,000 m3. An increasing attention i s needed to develop a comprehensive rehabilitation and maintenance plan for imgation and a sound regulatory framework for water management and irrigation fees. BuildingInstitutionsand TrainingProgramsto Support Agriculture andMeet InternationalProduct Standards 3.107 The Kyrgyz Republic has excellent prospects for exports o f agncultural commodities and processed apcultural goods. For instance, a market study in the fruits and vegetable industry indicate that markets in the region and in Europe are growing fast-in Russia only consumer demand is predicted '04See "Trade and Transport Facilitation: Kyrgyzstan," (mimeo), World Bank, March 2003. 108 to grow US$30-50 million annually.*05 To take advantage o f this opportunity, the industry and government will need to work together to meet several key challenges inthe agriculture sector. 3,108 First challenge is to address weaknesses inagriculture policy and land distribution system, which have resulted in a fragmented farming community with a limited ability to respond efficiently to downstream market demands. This together with deficiencies inthe tax system encourage a proliferation o f small plots with little or no incentive to consolidate these plots into larger more economically viable commercial farms. For instance, in the cotton industry, land acquired under the land redistribution scheme i s not large enough to make cotton farming financially viable to support a minimumlivelihood for farmers. Inthe area of animal husbandry, uncertain land tenure laws constrain free movement o f animals for grazing. 3.109 Second, the long-term sustainability o f tree crops needs to be assured. Older orchards need to be replanted and any impediments to farmers getting the best plant materials from domestic or international sources must be removed. Usually, farmers buy seedlings from large growers, who produce trees and grow nursery stock. These seedling producers should be organized into an association or some other working group so that they can be trained and have access to improved genetic materials. Industry and government need to create a transparent information system that will accurately track the trends in the industry, including area planted, bearing and non-bearing area, mean plant populations, production by region and so on. Ideally, this system could also track prices at several levels in the market. 3.110 Third, market access to basic farm inputsand to new internationaltechnologies that are embodied in seeds, fertilizers, tools, and many other agricultural inputs need to be improved. In some cases (e.g.,'seeds) the state regulates production and trade in a way that suppresses the introduction of new technology and the development o f potential, while in other cases (e.g., farm machinery) the state-with foreign aid-has been the dominant if not the only formal importer and wholesaler, albeit an inefficient one. There i s also need for efficient market mechanisms to connect farmers with domestic and foreign consumers and industrial users o f agricultural products. Only a small part o f agricultural production in the Kyrgyz Republic i s formally traded or processed. 3.111 Fourth, to increase consistency in the supply o f high quality raw material, the agricultural processing industries need to develop a model by which they can deliver technical assistance to farmers. Donors and government may play a facilitating role in this, but in the end, it is in the interest o f the industry that it succeeds; therefore, it should take the lead in designing and implementing the activity. For instance, to upgrade quality in the fruits and vegetable industry, drying facilities and similar technologies need to be created in areas where the crop i s produced. Much o f the drying takes place at processing sites and by the time the crop arrives, mould growth has started. The necessary investments would not be complex or expensive; only buildings with a roof and no sides are needed to allow good airflow. Drying facilities arejust one example o f ways that quality can be improved. Another example i s developing post-harvest moisture monitoring capabilities in the rural areas. This will add to the crop quality and allow more accurate payment for the crop by processors to farmers. 3.112 Fifth,the KyrgyzRepublic could also potentially increase its export sales ifall its tree crops were certified organic. This is not likely to happen in all the Kyrgyz Republic's growing areas in the near or medium-term, but there are opportunities for groups of growers, in specific geographical areas, to work with an exporter to get the organic label. 3.113 Freshvegetable products present an excellent opportunity. It i s likely that inthe longrun, it i s the vegetable sector that will be the fastest growing horticultural export. There are several areas that need to 205"Fruit and Vegetable ProcessingIndustryAnalysis: the Kyrgyz Republic," November2002-March 2003, preparedby SENTI FC and commissionedby Helvetaswith assistancefrom Swiss Agency for DevelopmentandCorporation. 109 be addressed, however, to realize these increased exports. Farm level technical assistance and technology transfer must be improved. The government has neither the budget nor the institutions to deliver cost effective technical assistance to farmers. The farming sector's growth, to a large degree, depends on the ability of farmers to increase their knowledge and skills. The government and donors need to identify ways to help and encourage private business to increase technology transfer and learning in the agricultural sector.*06 Inaddition, donors could help further indeveloping industry-specific activities that will raise the specialized skills o f farmers, domestic traders andprocessor/exporters. 3.114 Sixth, high cost of credit and a lack o f technical and market knowledge have contributed to low investments in new equipment, as noted above. Many farmers and processors are operating with antiquated technology, resulting in low product quality, high energy costs, and, ultimately, lower sales value in the market. It i s getting to the point in many food processing plants where the equipment inherited from the former Soviet Union i s no longer serviceable and does not produce a product with quality sufficient for markets outside the country. As noted earlier, eliminating import duty and VAT on capital equipment not produced in the Kyrgyz Republic could provide an important incentive for technology transfer and upgrading o f equipment in firms. D. ROADMAP FUTURE FOR REFORM 3.115 The Kyrgyz Republic has experienced a growth acceleration-albeit with interruptions due to external shocks to the economy-since the latter half o f the 199Os, following the introduction o f a series of "first-generation'' macro reforms and an initial set o f institutional reforms that have begun to buildthe foundations o f markets. Evidence from transition and developing countries shows, however, that sustaining this growth will be more difficult than igniting it, and will require more extensive investment climate reform. Most growth accelerations across the world are shown not to be durable. Growth in the short-term does not guarantee success in the long-term. In the case o f the Kyrgyz Republic, sustaining growth in the long run is a particularly challenging task given the narrowly-based economy, which is highlyexposed to external shocks, and the expected sharp decline inthe contribution of the gold sector to the economy over the medium term. Initial reforms need to be deepened overtime with efforts aimed at both strengthening the institutional underpinning of markets and facilitating productive dynamism which, together, will generate resilience to external shocks. 3.116 It is clear from Section B that much remains to be done in the Kyrgyz investment climate to develop an environment for sustainable growth. At this point inthe transition, the focus should be on the investment climate reforms necessary to begin diversifying and deepening growth: reforms that will help to ignite investment and entrepreneurial activity in new sectors and deepen growth in others. Faster progress with ongoing reforms inthe regulatory regime, taxation, and the legal system is important inthis regard. 3.117 Intandem with these efforts, priority for Government today must be to improve predictability of the investment climate, reducing instability inthe rules o f the game. The biggest complaint o f investors is lack o f "consistency and unpredictability," stemming from deficiencies in local institutions. Attention to implementation means, first, greater emphasis on better governance. An overall governance reform strategy has already been laid out and reform efforts are ongoing. These efforts need to be intensified, notably inthe areas o fpublic finance and administrative reforms. The focus on governance i s dictated by the fact that the difficult implementation challenge that the government faces today i s not simply a question o f a hangover o f over-regulation from the command economy days. It is a perverse system of 206 There are several pilot donor initiatives providing selective assistance in this area, but a systematic government support has been limited so far. A new World Bank project on Agribusiness and Marketing, which is currently under preparation, is expected to facilitate amore focusedapproach. 110 governance resulting broadly from weak public finances, making it difficult to break from the present system o f legally mandated fees (for licenses, permits, inspections, and so on) and the abuse o f official authority. Any institutional reform effort that does not effectively address these public finance and civil service reform issues has little chance o f tangible success. Institutionalization o f sanctions against abuse o f public official position should be an integral element o f these reforms. Other areas of governance for increased attention include the judiciary and local government. 3.118 Inaddition, a greater emphasis on capacity-building is needed to increase the efficiency and effectiveness o f regulation and delivery o f public services. Clear rules on the behavior o f public officials and the rights of entrepreneurs are also necessary. Timely publication and dissemination o f documentation about regulations to the private sector are critical too. And mechanisms need to be established to monitor and evaluate implementation o f policies and regulations. This i s crucial inorder to get feedback on progress and problems with implementation. Better implementation will also require attention to frequency o f changes in legislation and rules o f the game both o f which are important for business planning. Many strong economies maintain policies for fixed periods o f at least five years and signal the private sector about upcoming changes inpolicy and legislation. It i s also essential to introduce reforms in a particular area concurrently rather then only partially; so that businesses can fully adjust to the changes at the time changes are made. Institutionalization o f the new regulatory impact assessment process shouldhelp in streamlining the regulatory reformprocess. 3.119 In the end, however, favorable national circumstances, such as supportive macroeconomic conditions, stimulating investment climates and market-expanding trade agreements, contribute to competitive success, but they do not guarantee success. It is firms not countries that are on the front line of international competition and business development. Individual firms must, therefore, develop strategies and organizational structures and improve their technical capabilities to compete at home and abroad. 3.120 Lacking large home markets, small country exporters are compelled to adopt strategies aimed at market niches and organizational structures focused on flexible production technologies rather than trying to be cost leaders in mass-produced, standardized products. Sources of growth analysis in Chapter 1 and the industry case studies, which this report draws from, provide evidence that Kyrgyz companies are already having some success with this approach in particular areas such as food processing. T o expand exports and compete more effectively at home, however, the case studies show that a wider spectrum o f producers will have to do more to remove vestiges o f the old Soviet system and many new firms will have to enter. The efficiency o f investment will, however, depend on the technical ability o f firms to acquire, adapt, and efficiently use new capital equipment, new ideas, sound management practices, marketing strategies, and the like, i.e. their leaming rate. This inturn will largely be determined by the strength and efficiency of the mechanisms for technology transfer. 3.121 The industry case studies illustrate that, as with strategic planning and marketing, private technology transfer mechanisms for technical leaming are weak or missing inthe Kyrgyz Republic. Good public and private technical training resources external to the firm are also few innumber. Donor, NGO, and business association training and technical advisory services do exist and are malung an important contribution, but these programs are limited in scope and resources, relatively concentrated in few places and cannot substitute for all the weaknesses in private technology transfer mechanisms, given their present makeup. The deficiencies in leaming mechanisms in the Kyrgyz Republic need more attention if firms are going to upgrade their technical capabilities and productivity to compete intemationally. These efforts should include government and donor support to continue building up and improving institutions. They should be managed by private sector entities and focused on management training and business advisory assistance. A key aspect o f such programs should be to assist firms to link up with advanced country sources o f expertise and improve their slulls. Assistance to develop technical and vocational training institutions (public and private) is also necessary. These training institutions must cooperate closely with the private sector in developing and providing innovative programs for worker training. In 111 addition, cost-sharing grant schemes are needed to assist firms indeveloping their own innovative, in-firm training programs, inhiringexpert consultants, and insearching for new technologies and markets. 3.122 Strengthening mechanisms for technology transfer depends, critically, on the quality o f the investment climate too, as a sound investment climate increases the likelihood o fmore foreign investment and o f expanding other modes o f foreign technology transfer. Clearly, FDIand the number o f buyers and suppliers traveling to the Kyrgyz Republic will not increase significantly without improvements in regulatory and administrative barriers, legal institutions, and corruption. An improved investment climate also increases incentives for local firms and investors to learn and adopt new technologies. Depth o f financial markets, better trade support services and adequate investments in strategic infrastructure and maintenance of networks are also among the critical factors that influence investment rates and productivity growth in the Kyrgyz Republic, requiring a more systemic approach for their improvement. Finally, the Kyrgyz Republic's policy should be to make a supreme effort to stimulate the transfer o f new technology into the country by keeping the cost o f imported equipment as close to world market price as possible. 112 Agenda for BusinessDevelopmentandImprovedCompetitiveness IConstraints Short-Term Recommendations Longer-Term Strategies Investment Strengthen both legislative and institutional Eliminate institutional Climate framework-see Sections B for details impediments to enforcement through close monitoring and evaluation. Promote FDIand increase links to economy; Promote Technology Transfer 0 Develop cost-sharing grant programs to assist through: firms inhiring consultants, developing in-firm 9 seeking donor support for training, and searching for new technologies and training and business advisory markets; institutions; Assist technical and vocational institutions to 9 developing innovative improve programs and to cooperate with private vocational and technical sector indeveloping innovative training schemes; training; Assist private business development service 9 assisting development of providers to upgrade skills and link up with privatebusiness service foreign service providers injoint-ventures; providers. 0 Eliminate Duties and VAT on imported equipment not produced inthe Kyrgyz Republic. Improve access to working capital-see Volume Furtherreformo fthe financial Markets 11, Financial Services and Trade Finance, for and banking sector focusing on: details. 9 enhancingthe technical and legal infrastructure for > intermediation; capacity building, 9 consolidation. Trade Focus on regional and domestic dimension o f 0 Focus on regional and domestic Support reforms-see Chapter 2 for details. dimension o f reforms. Continue the MediumTerm Tariff Framework Improve resource mobilization, implementation inPower and Gas Sector till the continue investments instrategic tariffs reach the cost-recovery levels; infrastructure and adequate Focus public expenditure intransport on maintenance o f networks. Operation and Maintenance o f a core set o f the road infrastructure by considering the maintenance needs for the core network; Develop a comprehensive rehabilitation and maintenance plan for irrigation and a sound regulatory framework for water management and irrigation fees. Identify ways to encourage private businesses to Further improve Land and Training increase transfer o fnew technology to farmers; Distribution and Promote to Support Increase incentives for replanting tree crops; Technology Transfer. Agriculture Assist farmers and processors to upgrade standards to meet world market demands, and, in some cases, obtain organic labels; 0 Assist inbuilding specialized infrastructure to improve quality (e.g. cold chain, local drying facilities, etc); 0 Develop property rights for range land I AmendLand Law to permit foreigners to own land for agro-processing. 113 ANNEXES 114 ANNEX1-A. PROSAND CONSOFTHE SAM-BASED MODEL 1. The S A M based model is a fixed price general equilibriummodel that traces the response of a shock across various activities, thus capturing the direct and indirect effects on the production side. It i s a demand driven model in which government, public and private investment, exports and imports to and from the rest o f the world are exogenous. A change in the demand for a good or service causes the dependent variables such as one or more of the activities, commodities, factors, and households to respond by supplyingmore or less. When demand increases, it i s assumedthat the economy can supply more without any change in prices, wages or interest rates. This implies that there are enough unused factors of production such as labor and capital in the economy to satisfy additional demand. Given the high unemployment rates, excess capacity, low use of capital in production, and the fact that relative prices in the Kyrgyz Republic-exchange rate and wages-have been relatively stable, these are reasonable assumptions at least for the medium term. But this feature o f the model can also lead to a strong supply response especially in a sector like subsistence farming where, in the absence o f technological change, it may be difficult to increase supply because o f the scarcity o f arable land. Inthis type o f a situation, one would expect supply to remain fixed and imports to adjust to the change in demand. These finer details are not captured by the model used for this report. However, to avoid erroneous conclusions from being drawn, whenever increases in subsistence farming lead to large increases inthe number of jobs in the agricultural sector, it i s noted that these jobs are likely to be low- paying and would not dent poverty. The growth impact o f shocks to agriculture are quite low, despite the strong responsiveness of subsistence farming. Because o f these limitations, the report does not recommend a growth strategy focused on grain production. 2. The model also assumes that the technology being used in the various economic activities i s not changed when a shock is applied, i.e., various inputs are always combined in the same proportion in production and there i s no substitutionbetween inputs. The model cannot tell us how certain changes in supply can be brought about; it can only indicate the types of and the quantities of the material inputs such as goods, services and factors such as labor skills, capital, etc. required to produce a certain output or achieve a specific growth rate. As an example, the model cannot tell us how policy reforms to improve agricultural production should occur, but it can tell us the magnitude of the increase in roads, water for irrigation, electricity, and labor skills inputs which will be required for agricultural growth. Similarly, as the economic behavior of agents i s not modeled, the model cannot show how specific micro reforms such as reducing bureaucratic hassles and setting up a one stop shop, or improving tenure security, property rights and so on, which are central to encouraging the private sector, can affect growth. For instance, the model has nothing to say on how participation in secondary education can be raised but it can provide estimates o f the number of skilled professionals in various occupational categories required to increase growth in a sector. From the model's output, the reader should conclude that ifraising growth ina sector i s an objective, and if there i s also a shortage of skilled professionals, then government needs to do something to increase their supply. 3. As notedinthe precedingparagraph, inmany aspects, the S A M multipliermodel is quite limited. However, its simplicity offers certain advantages: 0 First, its underlying assumptions of fixed prices and fixed technology in an economy with ample underutilized capacity like the Kyrgyz Republic seem reasonable in the medium term and possibly also the early phase o f the longer term. Simulations with a simpler model structure are also easier to understand and track. 0 Second, the model is useful to understand the nature of the backward and forward linkages in the economy, an issue that i s in general less well understood, yet critical to understandingthe 115 economy's underlying structure and examining how shocks (positive andor negative) and various development strategies may influence growth, employment poverty. 0 Third, the purpose o f the model is not to estimate exactly how much a particular sector can supply if subject to an external demand shock; rather, it is to understand the nature and quantity of inputs such as water, electricity, skills etc. that will be required to obtain a certain level of growth. If policy makers have this information, they can focus on the types of interventions required to ensure that critical material inputs will be available to meet growth targets. Inthis, the S A M model simulations provide useful information based on 2001 data, and seem to adequately depict the present economic structure. 0 Fourth, keeping the model simple permits both easy tracking of information gaps that need to be filled for improving future similar analysis that the government authorities are planning to undertake and easy transfer to them at this stage o f ongoing technical capacity building. 116 ANNEX1-B. FROM GROWTH HOUSEHOLD TO INCOMES-A CLOSER LOOK 1. Of the total national income, wage income accounts for approximately 51 percent, Table 1: Broad Distribution of HouseholdIncome, 2001 profits 44 percent-these accrue to capital Meals a Value Share in Total owners in domestic and foreign firms as well income as government-owned enterprises (Table 1). Rich Households 48198.0 74.3 The share o f income eamed by labor i s slightly PoorHouseholds 16642.2 25.7 higher than official statistics as it has been Total householdincome 64840.2 100.0 adjusted to include income from subsistence agriculture. The economy generated about 2.1 millionjobs (inclusive o f some informal employment from subsistence agriculture) in 2001 at an average annual wage o f approximately Som 15720. The absolute poverty line in2001 was definedby a per capita expenditure o f about Som 7500. This impliesthat a four person household of two working adults and two children with an average annual income o f about Som 31,000 would be placed just above the absolute poverty line (requiring an expenditure o f about Som 30,000). Together wage and profit income eamed by 2. The households account for approximately 90 percent of GDP. About 74 percent of the pie accrues to rich households while the poor households get about 26 percent. This picture suggests that (i) growthhasadirectandpositiveimpactonhouseholdincomes,asatleast90percentofitflows higher to households; (ii) both capital and labor-intensive activities increase household incomes; and (iii) rich and poor households do not benefit uniformly. 3. The distribution o f household income is not only unevenbetweenrichand poor households but it also reflects sharp inter-oblast disparities: About 87 percent of total household income i s concentrated in four oblasts: Bishkek, Jalal-Abad, Osh and Chui (Table 2). Between these four, rich households eam between two to six times the share of total household income, relative to the poor. The sources of household income are also concentrated: almost 50 percent o f the total income in rich households in the richer oblasts i s associated with labor or wage income. Profits, rents or dividends from capital assets explain the bulk o f the remainder with the exception o f transfers from government, which are significant inthe case ofrich households (Table 3). Disparities between oblasts appear to be more significant than disparities associatedwith the relative importance o f income shares from labor and capital either between richandpoorhouseholds or within an oblast. So, ifbothrich andpoor households earn income fromboth labor and capital, what explains the regional disparities? This is explained better by the distribution of skills andjobs. Table 2: Distribution of HouseholdIncome by Oblast, 2001 Region Value Share in Total Income(YO) Bishkek 23875.2 36.8 Rich 20247 31.2 Poor 3629 5.6 Issyk-kul 3645.6 5.6 Rich 2266 3.5 Poor 1379 2.1 Jalal-Abad 8152.2 12.6 Rich 5289 8.2 Poor 2863 4.4 Naryn 1606.1 2.5 Rich 696 1.1 Poor 910 1.4 117 Region Value Sharein Total Income(YO) Batken 2510.4 3.9 Rich 1689 2.6 Poor 821 1.3 Osh 11548.0 17.8 Rich 7142 11.0 Poor 4406 6.8 Talas 1028.7 1.6 Rich 403 0.6 Poor 626 1.o Chui 12474.1 19.2 Rich 10466 16.1 Poor 2008 3.1 Total HouseholdIncome . 64840.2 100.0 Source: 2001 Kyrgyz SAM, World Bank, 2004. Table 3: Sources of Household Income, 2001 Households Labor Income Income from Government Private Share o f oblast's income in Capital Transfers Transfers country's total HHIncome Bishkek 21.8 12.4 2.3 0.3 36.8 Rich 18.5 10.6 1.9 0.2 31.2 Poor 3.3 1.8 0.4 0.0 5.6 Issyk-kul 3.0 1.8 0.7 0.1 5.6 Rich 1.8 1.1 0.4 0.1 3.5 Poor 1.2 0.7 0.2 0.0 2.1 Jalal-Abad 7.3 4.2 0.9 0.2 12.6 Rich 4.8 2.7 0.5 0.1 8.2 Poor 2.5 1.5 0.3 0.1 4.4 Naryn 1.1 0.7 0.7 0.1 2.5 Rich 0.5 0.3 0.3 0.0 1.1 Poor 0.6 0.4 0.4 0.0 1.4 Batken 2.0 1.3 0.4 0.1 3.9 Rich 1.4 0.9 0.3 0.1 2.6 Poor 0.7 0.4 0.1 0.0 1.3 Osh 10.1 5.9 1.6 0.3 17.8 Rich 6.3 3.7 0.8 0.2 11.0 Poor 3.8 2.2 0.8 0.1 6.8 Talas 0.8 0.5 0.3 0.1 1.6 Rich 0.3 0.2 0.2 0.0 0.6 Poor 0.5 0.3 0.1 0.0 1.O Chui 10.9 6.4 1.7 0.3 19.2 Rich 9.1 5.3 1.4 0.3 16.1 Poor 1.8 1.0 0.3 0.0 3.1 Source: 2001 Kyrgyz SAM, World Bank, 2004. 4. The concentration o f householdincome from wage employment infour oblasts, and within them, in rich households, is explained to a large extent by the concentration of occupational skills (Table 4). For instance, the bulk o f labor income in Bishkek households i s associated with relatively high wage employment across all occupational skills, except median skilled agricultural jobs and elementary occupations, both of which fetch wages below the poverty line. In contrast, in the poorest oblast, Talas, 118 the bulk of wage income i s generated by the lowest paying occupations. The economic implications of this distribution are clear. Faster poverty reduction in the poorest oblasts requires economic diversification towards high-value agricultural and livestock production and development of high-value manufacturing and services, i.e. towards activities that pay higher wages. But these joint growth diversification andpoverty reduction objectives also require more and better skilled workers, reinforcing thepolicy implicationsfor continued efforts towards the accumulation of human capital. Table 4: Distribution of Household Income from Employment by Skills (row sums represent share of total oblast income from Table 1, by rich and poor households, %), 2001 Legislators" Professionals Technical Clerks Service Skilled Skilled Machine Elementary Total workers2'Agriculture Industry 3' operators income from labor Bishkek 4.0 2.7 1.9 0.5 5.6 0.1 3.8 2.3 0.9 21.8 Rich 4.0 2.3 1.6 0.4 4.5 0.1 3.4 1.8 0.4 18.5 Poor 0.0 0.4 0.3 0.1 1.1 0.1 0.4 0.5 0.4 3.3 Issyk-kul 0.2 0.3 0.2 0.0 0.5 1.o 0.3 0.3 0.2 3.0 Rich 0.2 0.2 0.2 0.0 0.4 0.3 0.2 0.2 0.0 1.8 Poor 0.0 0.1 0.1 0.0 0.1 0.7 0.1 0.1 0.1 1.2 Jalal-Abad 0.5 0.7 0.5 0.0 0.8 3.3 0.5 0.5 0.5 7.3 Rich 0.5 0.5 0.3 0.0 0.5 2.2 0.3 0.3 0.2 4.8 Poor 0.0 0.2 0.3 0.0 0.3 1.1 0.1 0.1 0.4 2.5 Naryn 0.1 0.1 0.1 0.0 0.1 0.5 0.1 0.1 0.0 1.1 Rich 0.1 0.1 0.0 0.0 0.0 0.1 0.0 0.1 0.0 0.5 Poor 0.0 0.1 0.0 0.0 0.1 0.4 0.0 0.0 0.0 0.6 Batken 0.3 0.2 0.2 0.0 0.2 0.3 0.2 0.2 0.5 2.0 Rich 0.3 0.2 0.1 0.0 0.2 0.1 0.2 0.1 0.1 1.4 Poor 0.0 0.0 0.0 0.0 0.0 0.2 0.0 0.0 0.3 0.7 Osh 0.9 1.o 0.9 0.2 1.7 3.0 0.9 0.6 0.8 10.1 Rich 0.9 0.7 0.4 0.1 1.o 2.1 0.5 0.3 0.2 6.3 Poor 0.0 0.3 0.4 0.1 0.7 0.9 0.4 0.4 0.6 3.8 Talas 0.0 0.1 0.1 0.0 0.1 0.4 0.0 0.0 0.0 0.8 Rich 0.0 0.0 0.0 0.0 0.0 0.1 0.0 0.0 0.0 0.3 Poor 0.0 0.0 0.0 0.0 0.0 0.3 0.0 0.0 0.0 0.5 Chui 1.2 0.7 0.6 0.1 1.4 3.0 1.6 1.5 0.9 10.9 Rich 1.2 0.7 0.5 0.1 1.2 2.5 1.4 1.2 0.3 9.1 Poor 0.0 0.1 0.1 0.0 0.1 0.4 0.2 0.3 0.6 1.8 li Includes senior officials and managers. 21 Includes shops and market sales workers. 31 Includes construction. Source: 2001 Kyrgyz SAM, World Bank, 2004. 119 ANNEXl-C. KYRGYZ REPUBLIC'SNATURAL RESOURCE ENDOWMENTS Land and Water 1. Kyrgyz territory i s mostly mountainous. About 7 percent o f land i s arable and suitable for crop production, which in per capita terms i s comparable to the EU average. Potential yields are high, thanks to extensive irrigation infrastructure, long hours o f sunlight, and clear slues. The past decade has seen substantial structural reforms that have created a positive environment for utilizing this potential, including the emergence o f private farms, a partial government withdrawal from price setting and procurement and, input market liberalization. Nevertheless, productive resources are underutilized, as shown by:207 0 existence o f arable and even irrigated land that is not cropped; 0 average rates o f fertilizer use per hectare that are 80 percent below the 1980s levels and far below the levels o f use inEUcountries; 0 yields for most crops that are far below EUyields; 0 highlyqualified labor that i s hardly remunerated; and 0 farm profitability and revenues that are extremely low. 2. About 48 percent o f the land i s comprised of permanent pastures with rich potential for livestock farming and related industries such as milk, meat and dairy and processed products. The prevailing tradition o f carting goods primarily over land routes raises the cost o f shipping, thereby making logistics and transportation integral to growth o f the very important livestock sector. Equally critical i s sustainable pasture management for preventing degradation o f pastures, which requires improving the division o f responsibility for pasture management among different levels o f government.208 3. The Kyrgyz Republic is fortunate to have substantial hydro resources, which were developed during the Soviet era, making it a large hydroelectricity provider to the Central Asian grid. Water in the Kyrgyz Republic has competing uses: efficient irrigation can lead to higher agricultural yields, while a reliable supply o f water i s an essential ingredient for energy that is needed in industry and demanded in the region. At present, partially due to the poor management o f water resources, the Kyrgyz Republic i s locked in an inefficient trading arrangement o f electricity with coal and gas supplies from Kazakhstan and Uzbekistan. The poor state o f the power supply infrastructure, low domestic electricity tariffs and the fact that the main customers-Kazakhstan and Uzbekistan-settle the payment for electricity and water inthe form o f energy swaps all hinder the effective use o f the country's water resources for industrial, agricultural and domestic uses. Mineralsand Precious Metals 4. Gold, antimony and coal production dominated the Kyrgyz Republic's mining sector before independence. The country also has some deposits o f mercury, tin, tungsten and polymetallic ores. Currently, nearly all growth in the mining sector is associated with gold, which, together with the processing, accounts for about 10 percent o f GDP. Antimony output has been depressed as a result o f large supplies from China, the world's main producer o f antimony since 1998. Coal output too has 207See Kyrgvz Republic Agriculture and Agribusiness: Growth Opportunities and Obstacles," World Bank, June 2002, and Volume I1ofthis Report, "Value Chain Analysis," for cotton, wool anddairy industry. 208For instance, at the local governments level with Aiyl Okmotus responsibleonly for the close-in pastures, these areas are increasinglyoverusedanddegraded becauselocal herderscannot easily obtain grazingpermitsfor more distant summer pastures. 121 dropped to less than 25 percent o f pre-independence levels in the absence of new investment^.'^^ Over the medium term, with the depletion o f gold reserves, the potential contribution o f the mining sector to the economy is expected to fall substantially. Development o f the mining sector in the Kyrgyz Republic i s also impeded by natural disadvantages such as the location o f most of the mineral deposits at high altitude inroughterrain, the poor condition o f the domestic road network and the landlockednature o f the country. Collectively, this raises the costs of transporting bulk minerals, as well as critical mining equipment and consumables for miningoperations. People 5. The Kyrgyz Republic i s also fortunate to have a relatively young population. Today, 91 percent o f the total population i s comprised o f worlung age adults and children. According to the Kyrgyz Living Standards Survey (KPMS), the unemployment rate was estimated to be over 20 percent compared to official estimates of 8.6 percent in 2002. Notwithstanding the FSU-legacy o f high literacy rates and a technically qualified labor force, the Kyrgyz Republic's human capital risks depletion with the decline in education expenditures since independence. However, higher spending in education may do little to enhance human capital of the Kyrgyz population, unless structural issues are addressed. The public education system-which largely maintains pre-independence structure and remains oriented towards narrowly specialized occupations and programs-has not adapted to current labor market needs, resulting in a considerable skill gap. Employer surveys that could inform the policy makers on the skill requirements and possible vacancies o f the employers are weak in the Kyrgyz Republic. Many individuals are not adequately equipped with skills demanded by the labor market, and the vocational education programs are not able to provide relevant training and retraining to match workers to labor market needs.*" 209 Kyrgyz coal mines are too small and lacking requisite infrastructure to be competitive internationally. For further discussion, see Kyrgyz Repub1ic:Updateon the Mining Sector, World Bank, September 2002. See Kyrgyz Republic: Enhancing Pro-Poor Growth, World Bank, September 2003, and Chapter 111o f this Report. 122 ANNEX1-D. NON-GOLDEXPORTSDIVERSIFICATIONINDICATORS - Share o f Linkage Induced Share of Employ Value Name of Sector Share in Shareinof Exports Share in share in Exports i n with household GDP Product, GDP Exports Non-Gold other income m. per 1 Added in Exports Sectors multipliersmln. Som Labor at f r ~ Grain 9.4 63.3 0.I 0.2 0.3 2.5 1.3 78.9 54.1 Potatos 2.8 75.9 0.0 0.0 0.i 2.8 I.3 81.7 50.9 Vegetables 3.8 75.1 0.I 0.2 0.4 2.7 1.3 83.1 54.0 Cotton 2.5 95.6 2.3 6.2 10.4 2 7 I.3 103.0 78.7 Tobacco 0.8 94.4 1.2 3.0 5.I 2.2 1.1 104.0 77.0 Sugar beet 0.2 84 3 0.1 0.1 0.2 2.8 I.3 93. I 37.4 Fruits, berries 1.9 91.0 0.1 0.4 0.6 2 6 1.3 101.1 72. I Nuts 0.I 97.0 0.0 0.0 0 0 2.6 1.3 105.4 83.9 Feeding stuff 2.0 80.9 0.0 0.0 0.0 2.8 1.3 88.5 53.8 Other crops 1.8 93.4 0.5 1.3 2. I 2.0 1.o 103.0 77.0 Meat (live weight) 6.0 28.8 0.0 0.0 0.0 3.3 1.3 47.8 41.8 Milk 3.2 29.1 0.0 0.0 0.0 3.5 I.3 48.3 38.3 Eggs 0.6 62.5 0.0 0.0 0.0 3.I 1 3 101.0 63.9 Wool 0.1 41.4 0.1 0.2 0.3 3.2 1.3 67. I 17.2 Other animal 0.2 53.8 0.0 0.0 0.0 3.2 1.3 97.5 48.4 Coal 0.1 36.7 0.0 0. I 0.1 0.6 0.2 38.2 36.2 Crude Oil 0.3 49.9 0.0 0.0 0 0 3.5 1.o 36 5 57 2 Gold ores 9.2 64.9 0.0 0.0 0.0 2.6 I.2 2.2 21.2 Flour milling 1.6 20.0 0.0 0.1 0. I 3.8 I.2 39.6 71.9 Sugar refining 0.2 62.4 0.1 0.3 0.5 1.8 0.6 39.6 70.8 Meat processing 0.0 16.1 0.0 0.0 0.0 2.8 0.8 40.0 61.4 Dairy industry 0.5 49.8 0.I 0.3 0.6 3.9 1.1 39.2 82.2 Juices, fruits& veg. Proces&canning 0.0 18.2 0.1 0.2 0.3 2.3 0.7 40.2 72.3 Beer and Vodka production 0.1 13 5 0.0 0.0 0.0 2.2 0.8 47.4 26.1 Miniral water 0.1 58.9 0.0 0.1 0.2 2.6 0.8 40.0 60.5 Other food industly 0.3 6.2 0.9 2.4 4.1 2.7 0.8 46.9 30.9 Tobacco proc. & products 0.I 17.4 0.I 0.2 0.3 1 7 0.7 54.5 I2 6 Cotton ginning 0.3 10.2 0.0 0.1 0.2 3.3 1.2 44.6 17.0 Cotton yarn 0.0 32.8 0.0 0.1 0.I 3. I 0.9 42.4 31.1 Cotton fabric 0.1 56.3 0.0 0.1 0.2 3.9 1.1 39.7 37.0 Wool yam 0.0 48.8 0.0 0.1 0.I 3.4 1.1 40. I 32.6 Wool facric 0.0 65.7 0.0 0.0 0.0 3.8 1.1 40.5 38.3 Knitted items production 0.0 48.5 0.1 0.I 0.2 0.5 0.1 40.8 38.4 Clothing 0.5 59.0 0.0 0.I 0.2 3.8 1.1 39.2 48.5 Hides and skins processing 0.0 17.3 0.2 0.4 0.7 4.0 1.1 40.6 32.5 Final leather cloths 0.0 72.5 0.0 0.0 0.0 3.3 0.9 41.6 41.8 Other textile industry 0.1 19.8 0.2 0.5 0.9 2.2 0.7 40.1 31.8 Timber proces. & woodwork 0.0 32.5 0.2 0.6 1.1 1.2 0.3 39.8 52.0 Paper, cardboard. publish.& printing 0.2 34.4 0.1 0.2 0.4 0.9 0.3 39.8 84.5 Oil refining 0.3 18.4 0.5 1.3 2 1 1.4 0.4 39 8 58.7 Other chemicals 0.0 15.6 I.3 3.3 5.6 0. i 0.0 41.7 56 3 Rubber and plastic prod. 0.1 15.9 0.7 1.9 3.2 1.0 0.3 39.9 55.0 Glass sheets 0.0 15.2 0.0 0.0 0.0 2.2 0.7 42.3 54.1 Other construction materials 0.6 27.4 0.4 1.1 1.9 2.9 0.9 39.8 79 1 Gold 1.8 11.5 15.5 40.8 3.5 1.2 1.o 82. I Other metallurgy 0.1 57.3 0.5 1.4 2.4 0.6 0.3 39.7 84.2 Metal fabrics production 0.1 40.2 0.9 2 3 3.8 0.6 0.2 39.8 62.3 Machinery and equipment 0.2 37.0 0.7 1.9 3.2 1.2 0.3 39.8 62.2 Bulbs 0.4 37.6 0.8 2.1 3.5 3.4 1.0 39.8 63.2 Other machinery and equipment 0.5 36.6 1.8 4.9 8.2 I.4 0.4 39.8 63. I Power 4.6 55.5 3.0 7.9 13.4 2.1 0.9 48.4 24.4 Hotels and restaurants 0.9 45.0 0.9 2.5 4.2 2.2 0.8 50.9 88.5 Total 58.8 33.8 89.1 81.6 ITotal non-gold 47.8 18.3 48.3 Total non-gold non-power 43.2 15.3 40.4 Total (exc. gold, power, colton&tobacco) _ll.l 79 9 11.8 31.2 Source: 2001 Kyrgyz SAM, The World Bank, 2004. 123 ANNEX2-A. THEKYRGYZ REPUBLICAND MARKET ACCESS NEGOTIATIONS INTHE DOHAROUND 1. A number of WTO members have proposed tariff cutting formulas to be used during the Doha Round trade negotiations on non-agricultural goods.*" All attempt to eliminate tariff peaks (tariff lines extremely high rates) and lower average tariff rates. In addition to the particular formulas, these proposals differ in two other important dimensions: the choice o f base tariff (current bound rate, applied rate in a given year, mix o f the two, etc.), and the degree o f reciprocity expected o f developing countries.*'* At one extreme, India and China propose requiring smaller cuts by developing countries than developed. Korea and India propose usingbase tariffrates that often lead to smaller reductions. The U.S. proposal calls for the most aggressive tariff reductions, including eliminating all "nuisance rates" (those below 5 percent). The Chairman of the WTO Trade Negotiating Committee (TNC) has introduced a proposal that aims for middle ground between country proposals. 2. How would these differentformulas change Kyrgyzstan's tarifstructure? Which makes the most sense for the Kyrgyz Republic? Table 1below contrasts the effects o f different tariff cutting formulas on bound tariff rates for non-agricultural products. The choice o f proposal makes little difference along most dimensions: the share of tariff lines with bound rates remains the same (100 percent), as do the share that are not ad valorem and the prevalence o f tariff peaks. These remain the same because o f the tariff reductions the Kyrgyz Republic already made in the past decade. With the exception o f the U.S. proposal, none of the proposals makes significant changes to tariff dispersion (measured by the coefficient o f variation)213or the share of duty-free lines, and these proposals leave Kyrgyzstan with an average boundrate on manufactured goods o f between 2.5 and 5.5 percent. 3. WTO members negotiate the levels o f tariff bindings, but what influences trade flows directly i s the level o f applied tariffs. In some cases these are the same. Most developing countries have bound their tariff rates substantially above their statutory, applied rates, but the Kyrgyz Republic and other recently acceding countries came under pressure to bind at, or close to, their applied rates. Table 2 contrasts the effects o f different tariff cutting formulas on applied MFN tariff rates214(the applied rates change only if the negotiations result in a bound rate lower than the current applied rate). There is virtually no difference across tariff cutting formulas in the share o f duty-free lines, tariff dispersion, prevalence o f tariff peaks, and share of tariff lines subject to compound or specific tariffs. Differences in average tariffs (simple or trade-weighted) are small across the various proposals: simple averages range from 1.7 to 3.4 per cent; trade-weighted averages range from 2.0 to 3.9 percent. BothTable 1and Table 2 suggest that the competing proposals therefore would have little effect on the Kyrgyz Republic's own tariff schedule. *I1During the first several rounds of the GATT, countries made requests and offers on individual tariff lines. This proved too cumbersome in recent rounds, so countriesswitched to cutting tariffs across the board using a formula, initially a simple linear formula (i.e., cut all tariff ratesby apredeterminedpercentage),and subsequentlyusingmorecomplex formulas. 212The WTO Secretariatpresents formulas proposedas of March 2003 in TNIMNS3IRev. 2 (April 11,2003). For an analysis of how tariff formulas work in general see Francois, Joseph, and William J. Martin, Formula Approaches for Market Access Negotiations,CEPR DiscussionPaper 3720, January 2003. This i s measured here by the coefficient of variation, which is computed by dividing the standard deviation by the mean and multiplying by 100. *I4The table uses the 2001 tariff code submitted by the Kyrgyz govemment to the WTO, which i s presently the most recent information the govemment has provided the WTO Secretariat (GIMNTAW3IRev.8, March 17, 2003). As noted earlier, the government has subsequentlyreducedmaximumtariff rates. 125 Table 1: DohaTariffCutting Formulas: Effect on KyrgyzBoundRates Pre-Doha Chairman's BoundTariffs (2001) Proposal EC India Korea PRC us Binding Coverage 99.91 100.00 100.00 100.00 100.00 100.00 100.00 Share not ad valorem 0.29 0.29 0.29 0.29 0.29 0.29 0.29 Simple average tariff 6.68 2.86 3.56 4.47 5.34 2.48 1.78 Coefficient of variation 62.90 56.30 60.70 63.30 62.90 62.50 123.00 Min 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Max 20.00 5.60 8.60 13.40 12.00 5.30 5.50 Share of lines where tariff = 0% 22.50 22.50 22.80 22.50 22.70 21.70 60.20 Share of lines > 15% 0.02 0.00 0.00 0.00 0.00 0.00 0.00 Share of lines >triple the national average 0.00 0.00 0.00 0.27 0.00 0.00 0.02 Note: Data are aggregatedfrom the tariff line to the 6-digit level of the HarmonizedSystembefore cuts are applied. Source: Calculationsmadewith WITS usingofficial Kyrgyz tariff data suppliedto the WTO. Table2: Doha Tariff CuttingFormulas: Effects on Kyrgyz Applied MFNRates Pre-Doha Chairman's Applied MFNTariffs (2001) Proposal EC India Korea PRC U S Share not ad valorem 0.05 0.05 0.05 0.05 0.05 0.05 0.05 Simple average tariff 4.62 1.69 2.23 2.84 3.39 1.70 1.69 Coefficient of variation (unweighted) 131.OO 118.00 119.00 119.00 19.00 16.00 118.00 Trade-weighted average tariff 5.66 1.97 2.59 3.29 3.94 1.97 1.97 Coefficient of variation (weighted) 139.00 102.00 103.00 104.00 04.00 02.00 102.00 Min 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Max 20.00 5.60 8.60 13.40 11.10 5.30 5.60 Share of lines where tariff = 0% 56.70 57.70 57.70 57.70 57.70 56.80 57.70 Share of lines > 15% 4.76 0.00 0.00 0.00 0.00 0.00 0.00 Share of lines >triple the national average 4.78 0.02 0.50 0.54 0.02 0.18 0.02 Note: All calculationsare madeusingtariff andtrade information at the 6-digit level ofthe HarmonizedSystemratherthan tariff line level Source: Calculationsmadewith WITS usingofficial Kyrgyz tariff and trade data suppliedto the WTO. 4. How might the Doha Round affect tariffs imposed on Kyrgvz exports? It goes without saying that they will have no effect on exports to other CIS countries: those countries already grant duty-free access. The principal export to WTO members i s gold, which also enters duty-fiee. Most other exports to WTO members are constrained by hightransportation costs rather than border tariffs. The notable exception i s China, the only WTO members that shares a border with the Kyrgyz Republic. Table 3 profiles China's 2001 tariff schedule and contrasts the effects o f different proposals on Chinese applied duties (which, unlike bound rates, are the ones faced by traders).*I5 215 One should be aware that the simulations are conducted on 2001 data and that China has subsequently lowered some of its tariffs to comply with commitmentsmade at accession. The maximum rate in 2002 was 71 percent (on wheat and other field grains), for example. 126 Table 3. Doha Tariff CuttingFormulas:Effect on ChineseApplied MFNRates Pre-Doha Chairman's Applied MFNTariffs (2001) Proposal EC India Korea PRC us Share not ad valorem 0.54 0.54 0.54 0.54 0.54 0.54 0.54 Simple average tariff 14.53 12.40 6.50 9.58 11.33 6.89 4.57 Coefficient o f variation (unweighted) 167.00 239.00 243.00 179.00 190.00 298.00 275.00 Trade-weighted average tariff 11.62 10.32 5.42 7.54 8.89 5.87 3.97 Coefficient o f variation (weighted) 131.00 206.00 210.00 159.00 174.00 253.00 232.00 Min 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Max 90.00 25.10 15.00 29.00 26.50 13.10 7.30 Share o f lines where tariff = 0% 2.06 2.06 2.45 2.06 2.06 2.06 9.13 Share of lines > 15% 39.67 39.58 0.00 17.37 28.01 0.00 0.00 Share o f lines > triple the national average 0.72 0.00 0.00 0.72 0.00 0.00 0.00 Note: Data for simulations are first aggregated to the 6-digit level o f the HS. Source: Calculations made with WITS using official Chinese 2001 tariff data supplied to the WTO. 5. Which proposals are best for Kyrgyz exporters? The Korean, Indian and TNC Chairman's proposals do the least to cut high tariff rates and remove tariff peaks (as measured by the share of lines with tariff rates greater than 15 percent), which is the main feature o f the tariff schedule that deters imports from the Kyrgyz Republic, and their resulting average tariff rates are higher than under the European, Chinese and American proposals. Interestingly, the Chinese proposal manages to cut tariff peaks and reduce the overall average rate while at the same time increasing the dispersion o f tariffs, suggesting that the Chinese formula was designed with an eye towards preserving protection of certain sensitive industries. None o f the proposals generates a serious increase in the share of duty-free tariff lines. 6. This simulation shows results o fcuts applied to all non-agriculturaltariff lines. Kyrgyz exporters do not trade in all lines o f China's full tariff schedule, however, but rather only a very small subset o f tariff lines. Table 4 examines the portion o f China's 2002 tariff schedule applied to imports from the Kyrgyz Republic. What do these data tell us? The striking feature o f Table 4 i s the exceptionally low trade-weighted average tariff rate (3.70 percent), relative to the simple average (12.25 percent) and the trade-weighted average on imports into China from all sources (11.62 percent). What this reveals i s that the Kyrgyz Republic presently concentrates its exports to China in those product lines that enjoy exceptionally low protection from the Chinese government: scrap metals account for over half o f all imports from the Kyrgyz Republic in 2002, as reported by Chinese authorities. What this statistic obscures, by definition, is information on tariffs affecting goods that the Kyrgyz Republic does not export at this time. China continues to impose very high tariffs on certain goods (though some o f these are falling as a consequence o f liberalization commitments made at accession). Some o f these fall on goods that Kyrgyz might be able to export inthe future.216 2'6One informant reported that a Russian investor had expressed interest in establishing motor vehicle assembly operations in the Kyrgyz Republic, intending to export vehicles to China-until he discovered the high levels o f Chinese protection. Customs duties on motor vehicles are among the highest in China's tariff schedule. In addition there are extensive licensing, inspection and other non-tariff barriers. 127 Recommendation: Support tariffcutting proposals that most reduce tariffpeak. At this time these are the proposals made by the European Commission, China, and the United States. Table 4. Chinese Tariffs Applied to Imports from Kyrgyzstan Number of tariff lineswith imports 48.00 There are over 7,300 tariff lines in the full schedule Simpleaveragetariff rate 12.25 slightly lower than infull schedule Trade-weightedaverage tariff 3.70 much lowerthan infull schedule Coefficient of variation 82.00 less dispersion than full schedule Minimum rate 0.00 Maximumrate 38.00 on shom wool Shareof lines that are duty-free 8.30 higherthan full schedule Share of lines with rates > 15% 33.00 high, though lower than inthe full schedule Source: Staffcalculationsusing2002 data supplied by China to the WTO. 128 ANNEX2-B. GATSAND KYRGYZSTAN'S INSERVICES" TRADE 1. The Kyrgyz Republic's WTO membership includes extensive commitments made under the General Agreement on Trade in Services (GATS) to maintain open borders to cross-border trade and foreign investment in services. Virtually all sectors are included inits schedule o f commitments, covering liberalization inall modes o f delivery o f services. Inmost sectors there are no limits on foreigners' share of equity. These policies are also "bound," i.e., irreversible, in most cases. A Liberal Law on Foreign Investment implements WTO/GATS commitments allowing for commercial presence o f foreign firms to provide services (e.g., establishing bank branches) and for presence o f natural persons (temporary labor mobility). A. GATS Regime: Salient Features and their Relevance for RegionalAgreements 2. Trade in services i s defined in GATS (General Agreement on Trade in Services) as the supply o f a service through any o f the four ways, known as "modes o f supply": Mode 1: services supplied from one country to another (e.g., international telephone calls), officially known as "cross-border supply"; Mode 2: consumers from one country making use o f a service in another country (e.g. tourism), officially known as "consumption abroad"; Mode 3: a company from one country setting up subsidiaries or branches to provide services in another country (e.g., a bank from one country setting up operations in another country), officially known as "commercial presence"; and Mode 4: individuals traveling from their own country to supply services in another (e.g., an actress or construction worker), officially known as "movement o f naturalpersons." 3. Services entered the agenda o f the Uruguay Round o f multilateral trade negotiations for two reasons. First, with on-going transition from industrial to service economy, trade in services has been one of the most rapidly expanding areas o f international trade growing much faster than merchandise trade. Highly developed, increasingly service-based economies sought to extend rule-based regime o f international trade to services. Second, electronic revolution has made the links between services and liberalization in their trade and overall economic performance more pertinent. Liberalization of trade in services may improve the quality and availability of services through competition, economies o f scale and, last but not least, incentives to policy makers to improve regulatory environment. Benefits o f services liberalization are not limited to services sectors themselves: they impact all other economic activities. 4. GATS was deemed a success of the Uruguay Round not because of the progress in liberalization o f trade in services but simply because it has locked countries into a standstill against backsliding, i.e., erecting new protectionist measures and to further rounds o f progressive liberalization. The GATS has failed to introduce similar disciplines in scope and depth as under the 1994 GATT. First, while it commits WTO members to meet two general obligations: transparency and the most-favored-nation (MFN) principle across-the-board, the Agreement allows for temporary exemptions to MFN. Second, unlike the 1994 GATT, the principle o f national treatment (i.e., no less favorable than afforded to domestic one) and market access applies only to sectors specified in national schedules of GATS commitments. 5. In consequence, the GATS is weaker than the GATT in meeting the fundamental objectives of multilateral trading environment, that is, the promotion o f transparency, stability and liberalization o f trade. The 1994 GATT scores higher on liberalization o f trade. GATS Article 111to notify changes in laws, regulations, and administrative procedures apply to all sectors thus assuring information availability, albeit with a caveat. Namely, since the barriers to market access are not price-based barriers such as tariffs but NTBs taking the form o f discriminatory treatment embedded in laws, regulations and administrative acts and procedures, these tend to be less easy to navigate than rules related to trade in 129 goods. Ina similar vein, standstill rule assures stability in access, but less so than under the 1994 GATT. The problem is that GATS contains some unfinished rules on emergency safeguard measures and subsidies and with respect to domestic regulations. The extent o f liberalization depends on the sector- specific commitments, which except for financial services and telecommunication, i s much more limited than that in trade ingoods. For this reason alone, `rewards' in terms o f preferential access may be larger for trade in services than those for goods, simply because the extent o f discrimination against non- preferential suppliers i s larger. 6. Two approaches to addressing services trade in FTA have emerged: one can be described as `GATS-plus' another as an integrated approach. The former consists in adopting the same procedure for liberalization in trade in services, i.e., in the form o f national schedules, as in GATS. The ASEAN Framework Agreement on Services provides an example o f the `GATS-plus' approach. 7. The integrated approach, inspired by the NAFTA and followed in practically all RTAs in the Western Hemisphere, incorporates disciplines on investment, government procurement, the movement o f natural persons, competition, intellectual property rights, and technical barriers to trade inboth goods and services. 8. Both approaches produce the same result: they lead to faster liberalization in services trade on a regional than multilateral basis. 9. What does regional liberalization intrade in services entail? It entails relaxation o f restrictions on the movement o f labor and capital as well as variety o f domestic regulations including foreign ownership, standards, licensing and qualification requirements on a regional basis. The scope and depth depends on the level o f economic integration sought by participating countries and the instruments o f protection in place. Full integration of product and factor markets, as i s the case o f the EU after the 1986 Single Market Act, is based on four freedoms o f movement o f goods, capital, persons and services and on very extensive regulatory harmonization. But it i s complex and takes time, as even 18 years after the Single Market Act the task i s yet to be fully completed. B. Performance of Trade inServices 10. Services play an increasingly important role not only in the domestic economy but also in Kyrgyzstan's foreign trade. Trade in services in terms o f the GDP amounted to 18 percent in 2003, up from 14 percent in 1998. Among Central Asian members o f the Commonwealth of Independent States (CIS), only Kazakhstan had a higher share o f 21 percent in 2003, but almost exclusively due to the dramatic expansion in imports o f services (Table 1). While imports have driven Kazakh trade in services, a spectacular increase in exports in2000-03, with the average annual growth rate o f 38 percent over 2001 - 03, has been behind the growth in significance o f this trade for the Kyrgyz economy. The share o f services in total exports o f goods and services doubled between 1998-2000 and 2003 from 11percent to 22 percent, which i s the highest among Central Asian economies. Although the share o f imports o f services in total imports increased, this was only the result of a one-time surge of 18 percent in 2001, In other years, imports o f services were either stagnant or falling. 130 Table 1: Significance of Trade in Services in Central Asian CIS, 1998-2003 Share o f services Index, Share o f Index, Trade in Index, intotal exports 2002 services in 2003 services in 2003 imports GDP 1998 2003 1998=100 1998 2003 1998=100 1998 2003 1998=100 Kazakhstan 13 14 103 15 32 218 9 21 230 KYWYZ 11 22 207 19 21 111 14 18 122 Republic Tajikistan 8 1 16 4 5 126 6 4 73 Uzbekistan 10 16 166 14 20 140 7 13 170 Source: National balance-of-payments statistics. 11. The bulk of the increase in exports of commercial services occurred in 2002, with the value o f exports growing from US$80 million in 2001 (up from the average o f around US$60 millionin 1998-00) to US$140 million and US157 million in 2002 and 2003 respectively. This spectacular increase coincided with the establishment o f a NATO military base following the US-led invasion of Afghanistan inthe Fall of2001. 12. But not the whole increase inreceipts (or exports) from the sale o f commercial services can be explained by the `military base-induced' surge in demand for locally provided services. In fact, Kyrgyz commercial service providers have also increased their sales to customers in CIS economies, albeit-not surprisingly-their growth was weaker. Although the share o f CIS countries fell from 59 percent in2000 to 41 percent o f total exports of commercial services, the value o f sales in current prices increasedUS$25 million, from US$35 million in 2000 to US$60 million in 2003 (Table 2). The difference accounted for 32 percent o f the increase in the value o f total exports o f commercial services o f US$79 million between 2000 and 2003. Hence, the `military base' has overall contributed up to o f 68 percent o f the total increase over this period-potentially a huge chunk, but not all the increa~e.''~ 13. Against the background o f a strong overall performance, three developments are worth noting. The first concerns the growth in tourism from both CIS and other countries. The `travel' balance-of- payments category registered the largest absolute increase over 2000-03 for both total and CIS countries indicating that Kyrgyzstan has succeeded in both retaining its old clientele and adding a new one, albeit some of this new one may be associatedwith travel related to presence at the military base. 14. Second, there has been hefty increase in sales o f transport-related services, mainly air and railways. Kyrgyzstan's receipts from the provision o f railroad services doubled in2000-03, mainly thanks to receipts from CIS customers. The increase in exports o f air transport services has been even more impressive, with 75 percent related to non-CIS customers. The sources, including a significant contraction in 1999-01, o f this growth in2002-03 are not clear. 15. Third, the balance-of-payments statistics do not allow identify sources o f the strong increase in receipts by Kyrgyz firms from provision o f other business services.'" This may be due to merchanting, i.e., resale o f goods imported by Kyrgyz firms to foreign entities in Kyrgyz Republic (the difference 217 Without more detailed data, it is impossible to distinguish between base-related services and services sold to other nonresidents. Since there are no reasons to suspect that there has been a decline in exports to other than CIS and `base-related' customers, 68 percent o f the total would seem to be a maximum estimate. *Is One should emphasize that this is not the statistical weakness peculiar to Kyrgyz balance-of-payments statistics, which follows the IMF-set format. The task o f designing a system o f monitoring service activities in line with definitions used in GATS is yet to be completed. 131 between respective prices is a merchanting service), but other explanations are possible. Since most o f the increase occurred in CIS exports, the crux o f the matter i s that that this i s not related to leasing services associated with the `base.' Table 2: Exports of Total and to CIS of Commercial Services in 1998-2003, the change between 2000 and 2003 (both in million ofUS dollars) and the share of CIS inchange (in percent) Change Change (inmillion (inmillion Share of Total (inmillion ofU S dollars) ofUS$) Exports to CIS of US$) CIS in 2003 over 2003 over 1998 1999 2000 2001 2002 2003 2000 2000 2003 2000 change Exports of commercial services 58 60 57 73 118 136 79 35 60 25 32% Transport, of which 19 20 17 20 37 42 25 10 19 10 37% Railway 2 3 5 7 9 1 0 6 4 8 4 72% Air 15 9 8 9 23 26 18 2 7 5 25% Travel 8 14 15 24 36 48 32 9 28 19 59% Other business 4 4 5 7 1 8 1 8 13 2 9 7 59% Power sector services 2 3 3 4 6 8 4 3 8 4 100% Memorandum: Government services 5 5 5 7 2 2 2 1 16 25 20 -5 -29% Source; Derived from Kyrgyzstan's official balance of payments statistics. C. Provision of Commercial Services andModes of Supply 16. Although specific commitments under GATS are defined in terms o f the four standard modes o f supply (mode I:trans-border supply, mode 2: consumption abroad, mode 3: commercial presence, and mode 4; presence o f natural persons), the available services trade statistics are not reported according to a mode o f supply and do not allow to take full account of trade in services.219 Even if some transactions can be captured in the IMF format of the balance o f payments statistics, the latter suffer from two major deficiencies: 0 They do not distinguish between various modes o f supply as defined inGATS. As a result, it i s impossible to allocate balance-of-payments categories to mode 1or 4 without extra detailed information. For instance, information on transactions incomputer and information, personal, cultural and recreational services, and other business services do not say how a service has been delivered;220 0 Both the definition of a resident and non-resident and the breakdown o f services in GATS and the balance o f payments statistics differ. In the balance of payments, non-resident becomes a resident after more than 12 months o f residency and, as such disappears from the balance o f payments statistics as transactions are no longer before a resident and a non- resident. 2'9 For details, see Manual on Statistic of International Trade in Services, Statistical Papers Series M No. 68, Department of Economic and Social Affairs, Statistics Department, United Nations, Geneva, Luxembourg, N e w York, Paris, Washington, D.C., 2002. 220This is due to the fact that a supplier of these services may actually go to the territory of the consumer. 132 17. In consequence, balance-of-payments statistics, not only in the Kyrgyz Republic but also in all other countries, provide only proxies for allocating services to different modes o f delivery. Hence, the data tabulated in Table 3 only approximates real flows and testify to the difficulty in allocating services between cross border supply (mode 1) and presence of natural persons (mode4). In order to avoid guessing, we have simply allocated computer and information and other business services to mode 1. 18. The composition of both exported and imported commercial services according to mode o f delivery does not diverge significantly from the average for developing countries.22' Cross-border supply i s a dominant mode there accounting for 60 percent of total trade in services. The most important "service" on bothreceipts (export) and expenditure to a foreign provider (import) relates to transportation. Exports o f transport services doubled over 2001-03, while the value of payments to foreign providers slightly contracted during that period. It is not clear whether this was due to the improved competitiveness o f services offered or the shift towards cheaper mode o f transportation by rail on the import side. Whatever the reasons are this sector is no longer such a drain on foreign exchange revenues as it was in the past. On the import side, this share is higher for Kyrgyz imports reflecting its land-locked location. Transportation accounted for 40 percent of total expenditures for commercial services, albeit its share was falling from 70 percent in 1998. Table 3: Modes of Supply of Services in 1998-2003 (in million of US dollars and percent) Cross-bordersupply(mode1) 1998 1999 2000 2001 2002 2003 1998 1999 2000 2001 2002 2003 fin million of USdollars) (share in Dement) Total Exports, of which 35 35 33 37 69 72 67.7 62.5 60.0 53.4 59.7 54.0 Transport 19.1 19.9 16.6 20.4 37.5 42.1 36.6 35.1 30.6 29.1 32.3 31.7 Communication 9.8 10.3 9.3 8.7 8.9 8.7 18.8 18.2 17.0 12.4 7.6 6.5 Computer and information 0.2 0.2 0.5 0.5 0.7 1.5 0.3 0.3 0.9 0.7 0.6 1.1 Other business 3.9 4.0 4.8 7.1 18.4 17.6 7.5 7.0 8.7 10.1 15.9 13.3 Insurance 0.9 0.7 0.5 0.2 0.3 1.3 1.8 1.3 0.9 0.3 0.2 0.9 Financial (other than insurance) 1.4 0.3 1.0 0.6 3.6 0.6 2.7 0.6 1.9 0.8 3.1 0.5 Total Imports, of which 134 110 99 78 104 97 87.3 83.0 78.8 77.2 82.4 80.4 Transport 93.2 77.7 69.9 49.8 55.9 47.8 69.5 58.5 55.8 49.2 44.4 39.6 Communication 8.3 8.2 7.0 7.9 7.0 8.2 6.2 6.1 5.5 7.9 5.5 6.8 Computer and information 2.4 0.7 0.9 1.0 1.8 3.5 1.8 0.5 0.7 1.0 1.5 2.9 Other business 11.9 8.3 8.8 8.7 17.7 18.7 8.9 6.3 7.1 8.6 14.1 15.5 Insurance 11.6 10.1 8.0 7.4 8.9 14.4 8.6 7.6 6.4 7.3 7.0 12.0 Financial(0therthaninsurance) 6.8 5.2 4.2 3.2 12.5 4.4 5.1 3.9 3.3 3.2 9.9 3.7 Consumptionabroad(mode2) 1998 1999 2000 2001 2002 2003 1998 1999 2000 2001 2002 2003 Exports (travel) 8.4 14.1 15.3 24.4 35.7 47.8 16.0 24.9 28.0 34.9 30.7 36.0 Imports (travel) 3.5 10.7 15.6 11.9 9.9 16.6 2.3 8.1 12.5 11.8 7.8 13.7 Commercialpresence(mode3) 1998 1999 2000 2001 2002 2003 1998 1999 2000 2001 2002 2003 Exports 8.5 7.1 6.5 8.2 11.2 13.3 16.2 12.6 12.0 11.8 9.6 10.0 Construction 6.7 3.9 3.1 4.5 4.9 5.7 12.8 6.9 5.8 6.5 4.2 4.3 Power sector services 1.8 3.2 3.4 3.7 6.3 7.6 3.4 5.7 6.2 5.3 5.4 5.7 Imports 10.8 5.9 7.0 7.8 8.8 4.5 20.7 10.4 12.9 11.1 7.6 3.4 Construction 9.7 3.2 6.0 6.7 8.5 4.0 6.3 2.4 4.7 6.6 6.8 3.3 Power sector services 1.1 2.7 1.1 1.1 0.3 0.5 0.7 2.1 0.9 1.1 0.2 0.5 Source: Derived from Kyrgyzstan's official balance o f payments statistics. 22' Maurer, A,, and P. Chauvet, 2002, "The Magnitudeof Flows of Global Trade in Services," in B. Haekman, A. Mattoo, and Ph. English, eds., Development, Trade, and the WTO:A Handbook, World Bank, Washington, DC. 133 19. The service item that suddenly emerged as a very important item o f trade in the cross-border o f delivery i s "other business services." The value o f their exports increased 2.6 times in 2002 over 2001. Since this balance of payment statistics category covers a wide range o f various services, without additional information it i s impossible to identifythe source or sources o f this growth. 20. Another noteworthy development is growing significance o f the mode 2 o f delivery o f services, almost exclusively related to tourism and business visits. Receipts from travel (tourism) have more than tripled over 2000-03, and their share in total commercial services increased 30 percent to 36 percent o f total receipts from commercial services. By intemational standards, these are respectable levels. For instance, this share was also 36 percent inArmenian exports o f services. 21. The development in trade in services under mode 3, commercial presence, point to the relative increase o f Kyrgyz firms rendering services outside o f Kyrgyzstan and absolute decrease o f the significance o f foreign firms providing services in the territory o f the Kyrgyz Republic. The supply o f construction and energy-related services to customers abroad has significantly expanded. Simultaneously, the provision o f construction services to Kyrgyz residents inKyrgyzstan varied over time but was lower in2003 than inany other year over 1998-2003. D. ConcludingComments 22. A s mentioned earlier, intemational transactions as defined inthe national accounts and balance o f payments statistics diverge from the GATS definition o f services. Factors of production staying longer than a year in a country are treated as having acquired the status o f resident. By the same token, local sales of foreign entities are no longer treated as transactions between resident and non-residents, and as such captured by balance o f payments statistics. Inconsequence, transactions falling into such modes o f supply as commercial presence and movement of natural persons are not reported in these statistics. Balance o f payments statistics do not distinguish between modes o f supply, i.e., cross-border supply, consumption abroad, commercial presence or presence o f natural persons for less than a year. Furthermore, within WTO definitions, all services except transport and travel are identified as "other commercial services" and services exercised by governments are excluded. 23. Hence, as long as a new reference framework for measuring trade in services according to GATS i s not inplace, proxies derived from the balance of payments statistics and information from other sources are the only way to estimate services trade. The current practice i s to use balance o f payments statistics categories other than "travel" as a proxy for cross-border supply (mode 1);222"travel" as an indicator of consumption abroad of a service (mode 2); and "compensation o f employees" together with balance o f payments labor-related statistics as a proxy for presence o f natural persons (mode 4). The balance o f payments statistics do not allow capture activities falling under commercial with the exception o f construction services (mode 3). Some estimates o f the mode 3 can be derived from FAT (foreign affiliate transfers) statistics, if available, data on FDI stocks together with production statistics such as value added (share o f foreign firms inthe total in a market) or turnover o f foreign firms with their share inrespective markets for services. 24. Proxies are what they are-nly surrogates for the absence of statistical concepts and methodologies that would allow to gauge trade inline with the GATS classification. The major problems stem from the two following weaknesses o f balance o f payments statistics from the point of view o f the 222 Balance o f payments categories, such as transportation, communication services, computer and information services, other business services, personal, cultural, and recreational services, insurance services, financial services, royalties and license fees belong to mode 1. 223 The presence exceeding one year leads to the change o f status from that o f a non-resident to that o f a resident. 134 task at hand: First, the balance o f payments category "travel" tends to overestimate trade in mode 1, as it includes also consumption o f goods. The statistics do not provide one with information allowing for distinguishingwhat tourists and business travelers spend on hotels, transportation, service in restaurants and on foods and other goods.224 Second, some balance o f payments components may fall to more than one mode o f delivery, that is, it i s impossible to assess how a service has been provided. For instance, the transaction between a resident and nonresident o f a country concerning the provision of a computer- related service may take place over Internet (cross-border, mode 1) or on site o f a resident-firm by an expert dispatched by a foreign firm (commercial presence, mode 4). 25. Although much remains to be done in establishing a reliable system o f monitoring international trade in services, the improvement in terms of details covered in Kyrgyz balance o f payments statistics should be addressed now. For instance, there i s a clear needto distinguishbetween various types o ftravel inorder to understandpatterns inmovement o f goods and services. This is also important for any policy discussion on the choice of transportation issues to be addressed inbilateral and regional negotiations. 224Although it would be temptingto draw the conclusionthat services trade is overestimatedvis-&vis trade in goods, this is not necessarilyso as the inclusionof re-exportsinflatesthe latter. 135 ANNEX3. KYRGYZ REPUBLIC'S 2003 LEGISLATIVE REFORMS TO IMPROVE INVESTMENT AND BUSINESS CLIMATE # Lawsamended Status Comments 1. On amendingthe Law On Passed, June 24,2003 Protectionof Atmospheric Air 2 On amendingthe Law On Drugs The Govemment Resolution# 414 Amendmentswere withdrawn as anew approvingthe amendments. law On drugswas drafted. Withdrawn by the Govemment The Law "On drugs" was Passedof Resolution# 668 of October 20, April 30,2003. 2003 Note: it is not in full compliance with the Law On Licensing. 3 On amendingthe Law On Passed, June 11,2003 EnvironmentProtection 4. On amendingthe Law On Tax Passed, July 15,2003 Consultants 5. On amendingthe Law On Passed, April 12,2003 PopulationEmployment Facilitating 6. On amendingthe Tax Code Passed, July 28,2003 7. On amendingthe Law On Fire Passed, February28,2003 Security On amendingthe Law On Initial The Govemment Resolution#420 Vocational Education approvingthe amendments. Withdrawn by the Govemment Resolution# 668 of October 20, 2003. The Law has not been amended On amendingthe Law On Passed, August 01,2003 Transport I O . On amending the LandCode Passed, December 05,2003 11. On amending the Labor Code The GovemmentResolution#423 The Code has not beenamended. The approvingthe amendments. new Labor Code is begindrafted. Withdrawn by the Govemment Note: Expectedto be infull Resolution# 668 of October 20, compliancewith the Law on 2003. Licensing. 12. On amendingthe Air Code Passed,June 24, 2003 13. On amendingthe Law On Passed,March 06,2003 MandatoryCopy of documents 14. On amending the Law On Basis Passed, April 12,2003 of Social Services 15. On amendingthe law On Oil and Passed, March 09,2004 Gas 16. On amendingthe Law On Passed, April 21,2003 Medical Insurance 17. On amendingthe Law On Passed, March 06,2003 Weapons 18. On amendingthe Law On Power PassedFebruary26,2003 Industry 19. On amendingthe Wildlife Law PassedJune 24.2003 20. On amendingthe Law On Taxes PassedJuly 28, 2003 from enterprisesand organizations 21. On amendingthe Law On The govemmentResolution#433 Notary Activity approvingthe amendments. Pending. 137 # Laws amended Status Comments 22. On amendingthe Law On PassedJune 24,2003 Protectionand Use ofPlants 23. On amendingthe ForestCode PassedJune 28,2003 24. On amendingthe Law On PassedApril 21,2003 ReproductiveRightsof Citizens 25. On amendingthe Law On Passed,April 09,2003 Commodity Exchangeand Commodity ExchangeBusiness 26. On amendingthe Law On PassedJune 11,2003 Ecological Expertise 27. On amendingthe Law On Basis PassedJune 1I,2003 ofTown BuildingLegislation 28. On amendingthe Law On Passed24,2003 Traffic 29. On preciousmetals and stones PassedApril 09,2003 30. On amendingthe Law On PassedAugust 01,2003 RadiationSecurity 31. On amendingthe Law On State Passed,March 06,2003 Registrationof Rights On ImmovableProperty 32. On amendingthe Custom Code The Government Resolution #444 LegislativeAssemblyadoptedthe new approvingthe amendments.These CustomCode (CC) ofApril 13,2004 amendmentswere no longer andnow it is waiting for Peoples' relevantas anew CustomCode had RepresentativeAssemblyand been drafted. President approval.Along with CC, Amendmentsto the Law on Licensing were drafted in order to bring CC in compliancewith the Law on Licensing.The Parliamentdeclined these Amendments; therefore Custom Code contradictsthe Law on Licensing. 33. On amendingthe Law On Water The Govemment Resolution#450 Note: Reportedly,amendmentswere approvingthe amendments.The declinedby the L A of the Parliament. law has not beenamended 34. On amendingthe Law On seeds Passed,March 05,2004 35. On amendingthe law On The GovernmentResolution #452 Livestock Breeding approvingthe amendments. The law has not been amended 36. On amendingthe Law On The GovernmentResolution #453 Potable (Drinking) Water approvingthe amendments.The law has not beenamended yet. 37. On amendingthe Law On The GovemmentResolution#752 Note: A new law On Veterinaryis veterinary approvingthe amendments.The drafting by the Ministry of law has not been amended yet. Agriculture. 38. On amendingthe Law On Passed, October 21,2003 Tourism 39. On amendingthe Law On unity Passed, of November 18,2003 ofMeasurementSystem 40. On amendingthe Law On Passed, June 24,2003 Informatization 41. On amendingthe Law On The GovernmentResolution #768 InsuranceArrangement approvingthe amendments.The law has not beenamended 42. On amendingthe Law On Passed,July 15,2003 Sanitary and Epidemiological Well-beingof Population On amendingthe Law On Passed, June 28,2003 ChemicalixationandPlants Protection 138 ~~ # Laws amended Status Comments 44. On amendingthe Law On Passed,June 11,2003 Electrical and Postal Service 45. On amendingthe Law On Passed,November 18, 2003 Certification of Goods and Services 46. On amending the Law On The GovernmentResolution#SO6 Natural HealingResourcesand approvingthe amendments.The Health Resorts law has not been amended yet. 47. On amending the Law on Coal To be approved by the Government. 48. On withdrawal of Draft Law on To be approvedby the The Govemment Resolution# amendingthe Law on Licensing. Govemment. 197approvingthe amendments This Draft withdrawn by the on new types of Licenses, which GovemmentResolution# 197 contradictedthe Moratorium. 49. On amending the Law on Passed,March 10,2003 Education 50. On amending the Law on To be approvedby the InvestmentFunds Government. 5 I. On amendingthe Law On To be approvedby the Systemof Scientific Technical Government. Information Source: USAID Trade Facilitation and InvestmentProject,PragmaCorporation. 139 REFERENCES ADB (Asian DevelopmentBank). 2000. Small and MediumEnterprise Development.FirstDraft. Alesenia, Alberto, Silvia Ardayna, Giuseppe Nicoletti, and Fabio Schiantaretti. 2002. "Fiscal Policy, Profits, and Investment." American Economic Review 92 (3). Alesenia, Alberto, Silvia Ardayna, Giuseppe Nicoletti, and Fabio Schiantaretti. 2003. Regulation and Investment. M E R Working Paper 9560. ARD/Chechhi. 2000. "The Regulatory and Business Environment Survey." November. Bishkek.Mimeo. 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