Report No. 12410-KG Kyrgyz Republic External Trade Policy April 27, 1994 Country Operations Division I (EC3C1) Country Department Ill Europe and Central Asia Region FOR OFFICIAL USE ONLY MI CROGRAPH I CS Report No: 12410 KG Document of the World Bank Type: SEC This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization CURRENCY EQU!VALENTS Until May 10, 1993 Currency Unit = Ruble 1 Ruble = 100 kopecks After May 10, 1993 Currency Uiit = Som I Som = 100 tiyins Period Averaw End o£ eriod (Rubles/Som per US Dollar) Rubles Quarter I 102.4 100.0 Quarter II 94.6 100.0 Quarter Im 177.7 254.4 Quarter IV 396.4 414.5 1223 Quarter I 580.1 684.0 SQm Quarter II" 4.1 4.3 Quarter m 5.6 6.5 Quarter IV 7.8 8.0 1994 Quarter I 10.1 11.7 1/ May 10June 30, 1993. WEIGHTS AND MEASURES Metric System GOVERNMENT FISCAL YEAR January 1 - December 31 FOR OFFICIAL USE ONLY GLOSSARY OF ABBREVIATIONS AMC - Antimonopoly Commiffee BOP - Balance of Payments CBR - Central Bank of Russia CG - Consultative Group CIS - Commonwealth of Independent States CMEA - Council for Mutual Economic Assistance CPI - Consumer Price Index ECO - Economic Cooperation Organization EC/EU - Economic Community/European Union FDI - Foreign Direct Investment FSU - Former Soviet Union GATT - General Agreement on Trade and Tariffs GDP - Gross Domestic Product GNP - Gross National Product GSP - General System of Preferences IMF - Intemational Monetary Fund MEF - Ministry of Economy and Finance MFN - Most Favorable Nation Status MOA - Ministry of Agriculture MITMR - Ministry of Industry, Trade and Material Resources MTMR - Ministry of Trade and Material Resources NBK - National Bank of Kyrgyzstan NTB - Non-tariff Barriers OECD - Organization for Economic Cooperation and Development QR - Quantitative Restrictions SOE - State-Owned Enterprise SPF - State Property fund VAT - Value-Added Tax WPI - Wholesale Price Index This domt has a resticted distibon and may be used by recipients only in the pa afthdI oficial dudes Its contents my not othewise be disclosed without World Ban atoraton ACKNOWLEDGEMENTS This report is based on the work of a mission which visited the Kyrgyz Republic in June and July 1993. The mission wishes to thank the Kyrgyz authorities for their support and cooperation in providing information and facilitating analysis. The report was prepared by a team led by Kathie Krumm (World Bank) and including Alex Duncan, Chris Jones, Dani Rodrik (consultants), Tom Daves and Pedro Rodriguez (World Bank). Anita Kochkorbaeva (World Bank local office) joined the mission and supported the work. Kadyrbek Kaliev, Director, Foreign Trade Association provided consultant support in Kyrgyz Republic. Guidance was provided by Lant Pritchett (World Bank). The study was carried out under the general supervision of Kadir Tanju Yurukoglu, Division Chief, Costas Michalopoulos, Senior Adviser and Russell J. Cheetham, Director. KYRGYZ REPUBLIC EXTERNAL TRADE POLICY --TECHNICAL REPORT Table of Contents Pages POSTSCRIPT ...... ...... . ......... (1) EXECUTIVE SUMMARY. ....... (i-ix) t. Introduction - Trade and Trade Policy for the Transition . . I A. Magnitude of the Trade Adjustment .I B. Medium-term Vision and Links to Other Elements of the transition. 2 II. Broad Policy Concerns. 3 A. Export Growth Must be a Primary Goal. 3 B. Unrestricted Trade is Essential for Production 8 C. Trade Can Contribute to Fiscal Revenue .12 Ill. Reforming the Trade Regime -- Current Distortions and the Transition .13 A. State Trading through Bilateral Agreements 13 B. Trade Policy Instruments .23 C. Exchange Regime .32 D. Export Promotion .37 1. transport, communication and business services .... 37 2. financial services .40 E. Other Trade Relations .43 IV. Other Indirect Incentives .45 A. Property Rights .45 B. Barriers to Entry -- Enabling Environment for Traders . . 46 C. Price and Competition Policy .49 D. Taxation ............ 50 Tables .52-55 Annex: Agricultural Marketing Links - Current Arrangements and the Transition .56 A. Links Among Production, Domestic and External Trade -- Present Institutions and Policies .57 B. Intersectoral Transfers and Taxation of the Sector 61 C. Emergence of New Trading Relationships: Barriers to Entry ................... 65 D. Food Security .67 Executive Summary Kyrgyz Republic: External Trade Policy KYRGYZ REPUBLIC EXTERNAL TRADE POLICY POSTSCRIPT i. This report was based on the findings of a mission to the Kyrgyz Republic in June and July 1993 and presented to the Government in December 1993. Since that time- the Kyrgyz Government has taken a number of policy steps in the direction endorsed by the report.. The scope of direct trade restrictions such as export licensing and other controls on trading activities such as trading margins has been reduced. The system of state orders has been abolished and domestic supply contracts have been discontinued. Access to trade in foreign exchange has been widened. In addition, the Government has the intention of making further reforms to enhance the ability of a range of agents in the economy to respond to external trading opportunities and to facilitate the required trade adjustment. ii. To capture the rapid evolution of events in the Kyrgyz Republic, the Executive Summary has been updated. However, the remainder of the report has not been modified fully. The initial section lays out the broad policy concerns that will continue to underlie Government policy toward external trade. In the discussion of the various components of the trade reform agenda, the analysis has not been updated, but the recommendations on a path of policy change have been supplemented with an update on specific recent progress. , . .~~~~~~~~~~ Executive Summary Kyrgz Republic: External Trade Policy EXECUTIVE SUMMARY A. Broad Policy Concerns 1. Like other republics prior to the dissolution of the Soviet Union, the Kyrgyz economy was highly integrated with the other Soviet republics, part of an extensive division of labor which left Kyrgyz enterprises with little autonomy and often little knowledge about the identity of their eventual customers. The Kyrgyz Republic's trade was characterized by a sizeable trade deficit with both the FSU and the rest of the world. The collapse of the Soviet Union and the attendant economic difficulties faced by the now-independent republics have led to a breakdown of the customary supply linkages among enterprises located in different republics, aggravating the shock of the dissolution and compounded by a deterioration in the terms of trade, estimated at about 20 percent for 1992 and over 40 percent for 1993, with fujrther deterioration expected for 1994-95. Hence, the magnitude of the required external trade expansion for the Kyrgyz Republic is daunting. 2. Initially, the Government's trade policy, as in other Republics, was shaped primarily by the demands of short-run pressures, marked by the need to ensure energy and raw material supplies through clearing arrangements, desire to satisfy local needs by restricting exports, and resistance to reorienitation of production and trading patterns. That trade policy regime was clearly inappropriate to the daunting task at hand. The design of the trade regime needed to recognize the particular difficulties inherent in the transition while at the same time leading the economy toward trading patterns consistent with the vision for the Kyrgyz Republic. Given the economic crisis facing the authorities, it is not surprising that there was tension in the choice between quantity considerations and price mechanisms. However, because of the negative impact of the former on efficient allocation of resources and economic adjustment, the authorities have become very judicious in their use of such quantitative controls and focused on the measures which will ensure price mechanisms can be effective. To design a trade regime that will serve the Kyrgyz economy well, the authorities have begun to step back from concerns with supply arrangements and focus on objectives for both the transition and medium- term, namely, (1) earning foreign exchange through export growth so as to resume availability of imports; (2) encouraging production through multiple trade channels and adjustment of productive capacity; and (3) raising government revenue through the tax regime. These broad policy concerns run throughout the report's analysis and recommendations. 3. The export vision is to exploit fully the markets that already are being tapped and at the same time to diversify markets wherever appropriate. FSU markets cannot be neglected, particularly for the next several years. Recent data show non-FSU exports ii Executive Summal3 Kyrgyz Republic: External Trade Policy representing 15-30 percent of total. Even if these exports were to grow by 25 percent (an ambitious target that has only been achieved by countries with strong pro-export orientation), FSU export levels would have to be maintained, or even grow slightly to attain projected export growth requirements for the coming three years. In light of history, lack of language barriers, infrastructure and geographical proximity, the Kyrgyz Republic will no doubt remain highly dependent on trade with the FSU in the medium to long-run as well, particularly Russia, Kazakhstan and Uzbekistan, and it is important to have successful regional integration. This does not imply a maintenance in the composition of imports and exports with those markets since much of the trading pattern was inefficient and inappropriate. It does imply that access to those markets be facilitated. Hence, the other element of export growth is expansion of agents and channels to ensure access to both competitive imports and export markets. This implies the need not on,y to avoid explicit restrictive trade policies but also to create a supportive approach towards market activity in general. New market intermediaries are critical for movement and storage, which are as critical as production. Realistic management of the exchange rate is another must for exporters. 4. Given that the Kyrgyz economy is relatively small but has a diverse set of neighboring markets, expanded production will be able to concentrate on those commodities for which it is ideally suited combined with high trade integration with other economies. Trade should continue to play a major role, perhaps greater than under the previous system. To secure raw materials essential for production, the focus should be on maximizing availability of foreign exchange, including eliminating and avoiding export controls. But there will be a difficult period for the productive sectors to move into line with efficiencies and gains from trade, and policy makers will come under pressure to use the trade regime as a means of protecting specific industries from making the necessary adjustment. The objective is to move as quickly as possible to a trade regime that is not susceptible to selective protection. Some other parts of the economy always pay for that protection. Agriculture and mining sectors, in particular, should be advocates of low protection. However, it is a mistake to believe that industrialization will not occur unless it is artificially fostered through protection and the discouragement of exporting raw materials. Other countries' experiences illustrate how successful manufacturing exporters can grow alongside an agricultural and mining base. At the same time, to ensure that a policy pronouncement on open trade is credible, the Government's establishment of a less ad-hoc system for dealing with the largest and most problematic enterprises is an important complementary action. 5. Given the importance of fiscal revenue for the Kyrgyz economy, the trade regime can help, provided taxing is modest, transparent and efficient. A web of implicit subsidies and taxes (for example, via quantitative restrictions and clearing arrangements) means lost revenues. If taxes are imposed, they need to be at low rates and kept simple, with similar rates for all commodities. iii Executive Su mmarY Kvrgyz Repuolic: External Trade Policy B. Reforming the Trade Regime 6. The maior trade distortion channels prevailing in 1992 and 1993 were: state trading through bilateral agreements, direct trade restrictions including export licensing and taxes, emergence of a dual exchange rate regime, and absence of supportive infrastructural and financial services and access to markets in a multilateral framework. The trade regime has evolved rapidly since then. In early 1994 the Government has taken a number of policy steps in the direction endorsed by the report and has stated its intention to move forward on a i.umber of other fronts. In particular, there has been progress in reducing direct trade restrictions and widening access to foreign exchange markets. It wi.l be critical to follow through on other policy changes and then consolidate those policy measures with adequate institutional and financial measures to ensure efrective implementation. 7. Bilateral Agreements. The legacy of the FSU is prominent in the trade regime of the Kyrgyz Republic in the form oi bilateral agreements which resemble the coordination of inputs and outputs including imports and exports under the planning process. Important changes have taken place in scope and terms. There is increasec focus on key partners and commodities in the context of clearing (barter) arrangements and reduction in number of commodities covered in the remainder of the agreement. The Kyrgyz economy is increasingly relying on non-c.,earing arrangements for its energy and food security, for example, about half of petroleum product imports. At the same time, there is a strong reluctance in mejor imports and exports to move away from quantity arrangements toward reliance on pricing mechanisms. The clearing arrangements appear to provide some assurance for achieving a minimum quantitative objective in the face of short-term interrepublican payments uncertainty and lack of stocks. A closer relationship to world prices is implicit in the clearing arrangements. However, there are some important exceptions, namely, tobacco and wool exports in the Russia 1993 agreement which grants an implicit subsidy to the Kyrgvz Republic of 125 percent and 40 percent, respectively, and natural gas imports in the Uzbek 1993 agreement, with an implicit subsidy estimated at 40 percent. For 1994 agreements are limited to those reached with Russia, Uzbekistan, Azerbaijan and Tadjikistan. 8. These limited and short-term benefits have to be weighed against the major defects in the agreements and, in particular, their medium-term negative impact. One, the bilateral agreements have a negative spillover on the rest of the economy via trade restrictions. In early 1994, in addition to reducing direct restrictions, the Government started the dismantling of the state trading system associated with bilateral agreements. In February 1994 a Government decree recognized the need to phase out bilateral clearing arrangements as soon as feasible, the Government passed a decree explicitly abolishing state orders and establishing that state needs will be executed on a contractual basis, and by-laws related to domestic supply contracts were allowed to iv Executive Summary Kyrgyz Republic: External Trade Policy expire. In addition, from Februar; 994 restrictions on business activities have been eliminated from privatization contracts However, large state or former state trading institutions continue to dominate the r.;arket, leaving de-facto monopolies, including on the four majer agricultural commodities, wool, tobacco, cotton and wheat, and hampering the -growth of more efficient market-oriented trading networks. There remains considerable ambiguity among producers and traders as to whether supplying state needs is compulsory. 9. Two, while the agreements are close to world prices, the domestic pricing and payment system results in significant cross-subsidization. Energy users continue being subsidized, primarily through the emergence of oil arrears, while agricultural producers and mining enterprises have been required to sell to the state at domestic prices less than world equivalents. Delays in payments; farmers have resulted in an additional implicit tax. With the state unable any longer to assure either the physical delivery of inputs and the previous extent of price subsidy, the payment of effectively low output prices is clearly no longer tenable. In 1993, the Kyrgyz Government delivered about 90 percent of its wool commitments under the Russia agreement but only about 40 percent of its tobacco commitment. The Government is developing a competitive procurement system and plans to allow both producers and private traders to participate. However, the Government faces budgetary and financial ccnstraints that will continue to inhibit its ability to play a reliable role in agricultural marketing and in meeting commitments under clearing arrangements. Hence, the private sector will play a central role in taking up the slack wherever possible. 10. To ensure the development of a market oriented base where the majority of transactions is carried out directly by firms, the report recommends: o Clarify and publicize the rules of the state needs system and break up the dominant state trading companies into commercially oriented and competitive units. Give an explicit commitment to private sector participants that their contribution is regarded positively by government. Redefine role of local authorities to preclude interference in trade. o Eliminate bilateral clearing arrangements. If there is a short interim period before the trading partner eliminates the attractive terms, a limited and focused arrangement could be made. Procurement prices should reflect market prices, with the difference between the market and favorable clearing arrangement implicit price accruing to the government. If key neighboring trading partners insist on such clearing arrangements for other commodities, the focus should be on setting up transparent bidding and procurement arrangements, with a view to transferring those trading house capabilities to private hands, and on using the negotiations to achieve v Executive Summary Kyrgyz Republic: External Trade Policy broad-based removal of trade restrictions. To increase the certainty of ability to obtain supplies of critical imports in tne next trading round via market mechanisms, renew efforts to strengthen the interrepublican payments system and assure adequate stocks. o To realize the trade subsidy implicit in any limited bilateral clearing agreements and to reduce the need to tax implicitly the agricultural sector, resist the build-up in further arrears on domestic oil sales, for example, through uelect cutoffs of supplies. o To ensure delivery of given quantities under interim clearing arrangements, for example, in the agricultural sector, accelerate payments to producers for commodities delivered to state agents and make appropriate seasonal financing arrangements, preferably through 100 percent financing and immediate cash payments. 11. Direct Trade Restrctions. The key culprit in the web of restrictive trade policy instruments was export restrictions, which amounted to a formidable obstacle to export activity. They also represented a major source of protection to potentially inefficient enterprises which had access to the exportable inputs at the resulting depressed prices. Over half of exports had been subject to licensing and nearly a third to export taxation. Licensing produced no revenue while export taxes ranging up to 150 percent either prohibited export or were evaded, with export taxes accounting for under 3 percent of export value. These charges were compounded by unofficial charges by various administering officials. In addition, local authorities often impose further restrictions and administrative interventions. To the extent the origins of many restrictions are in reaction to imposition of export controls by neighboring countries, such retaliation was counterproductive for a small country. Export taxes can be relevant when a country has a oligopolist position in world markets, but even its shares of the world mercury and antimony markets are only 20 percent and 13 percent, respectively. Given the time already elapsed since the real depreciation of the currency, any attempt to capture windfall gains through export taxation would have had an impact on current production and investment needed to strengthen medium-term prospects. Some modest revenue objectives are, however, legitimate. 12. In early 1994 the Government moved far in eliminating this web of restrictions. Specifically, the Government effectively abolished both the export and import licensing systems except on 8 categories for health and security reasons. The Govemment abolished import duties, except for alcoholic beverages and tobacco products, and the intention is to establish a simple tariff schedule. The Government intends to eliminate export taxes in mid-1994 with the exception of a few goods, largely food items, for a temporary period and at moderate rates. It will be critical to withstand any pressure to vi Executive Summary Kyrgyz Rep.~blic: External Trade Policy reintroduce such quantitative restrictions and to guard against introduction of ally other institutional impediments. 13. Exchange and payments reaime. The Government made an important step by introducing its own national currency. However, the convertibility of the som initially was fragile and limited. The parallel market rate commanded a premium over the auction rate, and access to the official exchange auction was restricted. Since early 1994 access to foreign currency auctions was widened and simplified to include participation by all foreign exchange bureaux without restrictions. The spread between the commercial banks' exchange rates and the parallel market rates ',has virtually disappeared. Keeping the official rate attractive to exporters is critical to increase exports. Any attempt to defend a much less depreciated rate would merely exhaust scarce international reserves and require quantitative restrictions on access to foreign exchange, further exacerbating the pressure on the som by damaging the credibility of its convertibility for trade purposes. Rather the case needs to be made for greater international financial support during the difficult transition, which will prevent depreciation of the exchange rate much beyond its medium-term equilibrium. 14. A serious impediment to external trade is the continuing interrepublican payments difficulties. The reliance on decentralized correspondent bank accounts has not succeeded to date in resolving those difficulties, and traders are encouraged to resort to barter transactions. Trade in rubles and other currencies of neighboring countries is hampered by highly segmented markets and absence of a portfolio of these currencies held by the large financial institutions. Dollars in the official exchange market are not sufficiently available for trade transactions with the FSU. Cash trade is further hampered by lack of a framework for volume transactions. Addressing this through collaboration with neighboring countries is of the highest priority. 15. To ensure an exchange and payments regime supportive of exports, the report recommends: o Investigate the possibility of establishing a venue for non-dollar trading by interested parties with the facilitation of an impartial intermediary. This would include rubles and the newly introduced currencies of neighboring countries. If the central bank were to play that role of intermediary, it would not need to take open positions. The National Bank and commercial banks are studying the possibility of creating a mechanism for nondollar trade, both rubles and national currencies of neighboring countries. 16. Supportive services and multilateral framework. Experience in other countries indicates that action in certain complementary areas is equally critical for export growth in former socialist economies in transition. Maintenance and development of suitable vii Executive Summary Kyrgyz Republic: External Trade Policy communications and transport links means increased reliance on road transport and smaller transport companies, combined with simplified procedures for accessing those services. The substantial knowledge of FSU markets is trapped in the Ministry of Industry, Trade and Material Resources and state trading companies unsuited to a fast evolving market, and other services such as procurement agents, freight forwarder and certification of laboratories are virtually non-existent. With the collapse of the payments system and indiscipline associated with interrepublican interenterprise arrears, trade has resorted to primitive methods of payments. The capability to cover trade risk is only emerging. To provide complementary services for external trade, the report recommends: e To facilitate the development of responsive road transport, accelerate the divestment of transport assets in enterprise restructuring. * Eliminate unnecessary delays in trade flows, for example, by simplifying and aligning trade documentation and eliminating financial and security delays. S Spin off market-making services of MITMR, convert into private trading companies and remove barriers to entry of other providers of services. * Enhance access to credit for viable traders and enterprises by restricting access of enterprises which are not adjusting to the changed circumstances. Develop export finance capacity through preparation for the introduction of a rediscounting mechanism by the National Bank for preshipment export loans granted by commercial banks backed by export lefters of credit, bills of exchange and other negotiable instruments. 17. The Kyrgyz Republic has yet to initiate efforts to gain from the existing multilateral trade framework which would make the country eligible for preferential tariffs on its exports to a range of future trading partners. The major framework is the Ge, feral Agreement on Tariffs and Trade (GATT). In addition, the OECD offers General System of Preferences (GSP) benefits for some developing countries. Currently the Kyrgyz Republic is a member of both the CIS free-trade union and the ECO. As a small, open economy, it is imperative that the Kyrgyz Republic be able to trade freely in a multilateral setting without being left out of any significant regional grouping. The report recommends: o Apply for observer status and eventual membership to GATT, as is the Government's intention. Explore options for eligibility for GSP benefts. O Participate in as many free trade zones as possible, including in the viii Executive Summary Kyrgyz Republic: External Trade Policy context of both the CIS and ECO, and resist any pressures to impose high common external barriers in the process, as is the Government's intention. Links with Other Reforms 18. While trade policy is important, a number of other factors are having as much of a negative impact as the direct factors. Continuing reforms particularly in the following areas is critical to achieving the daunting task of trade expansion. The report recommends: o Accelerate efforts to clarify property rights. Changes to strengthen the privatization process adopted in December 1993 were an important step. D Create an enabling environment for traders and reduce barriers to entry. Reducing the extent of margin controls on traders was an important step, and the Government intends to lift remaining margin controls with the exception of bread. o Increase competition through reducing impediments to competing traders and limit anti-monopoly regulation. The reduction in the number of enterprises classified as monopolies and subject to direct price controls was an important step, and the Government intends to reduce the number further in mid-1994. e Strengthen the overall tax effort. 19. In combination with the trade-specific measures recommended, these policy directions would move the Kyrgyz Republic a long way towards meeting both its short- term trade exigencies and its medium-term trade vision. ix TRADE AND TRADE POLICY FOR THE TRANSITION I. INTRODUCTION A. Magnitude of the Adjustment 1. Prior to the dissolution of the Soviet Union, the Kyrgyz economy was highly integrated with other Soviet- republics, though not unlike other republics, with interrepublican imports and exports representing 39 and 31 percent of GDP, respectively on average for 1989-90. It was part of an extensive division of labor which left Kyrgyz enterprises with little autonomy and often little knowledge about the identity of their eventual customers. Kyrgyz Republic's trade was characterized by negligible hard currency exports and hard currency imports amounting to about an additional 10 percent of GDP (though a third was sugar from Cuba for processing), compounded by the trade deficit with the FSU. From the Soviet Union, the Kyrgyz Republic received sizeable official transfers, on the order of 10 percent of GDP for 1989-91, plus additional financing from parent enterprises. 2. The collapse of the Soviet Union and the attendant economic difficulties faced by the now-independent republics have led to a breakdown of the customary supply linkages among enterprises located in different republics. This has aggravated the shock of the dissolution. Compounding that, movement toward world market prices implies a deterioration in the terms of trade, estimated at about 20 percent for 1992 and a further 40 percent for 1993. Hence, Kyrgyz Republic inherits an incipient structural trade deficit where the value of traditional imports such as. oil and gas, pharmaceuticals, grain and agricultural inputs far exceeds the value of traditional exports such as tobacco, wool and electrical engineering products; where external export markets are undeveloped; and where trade was critical for energy and food security.' 3. In the area of trade, the magnitude of the required trade expansion is daunting, especially given the historically large :Daundng trade structural trade deficit and small export base outside the FSU. The expansion effort rise in the price of energy imported from neighboring republics and -required the breakdown of inter-republican payments arrangements as well as the traditional supply linkages have hit the Kyrgyz economy very hard. Because of the less than expected trade financing to be secured from Russia, the speed at which the trade account needs to adjust may be greater than estimated in the context of / Kyrgyz Republic traditionally imporited wheat equivalent to about 40 percent of domestic consumption and energy equivalent to about 60 percent of domestic consumption. Page 1 Krygyz Republic: External Trade Policy the Consultative Group meeting unless additional external financing is secured. At that time it was projected that Kyrgyz Republic's current account deficit would remain high, on average 15 percent of GDP, for 1993-95 before declining by end of the decade. The case can be made for greater international financial support during the difficult transition. Under the optimistic assumption that such deficits can be financed, it was estimated that exports would need to grow by about 5 percent per year, implying a doubling by the year 2000 in exports to the rest of the world from their 1993 levels. The development of dynamic trade patterns is clearly essential for recovery and stability. B. Medium-term Vision and Links to Other Elements of the Transition 4. As Kyrgyz Republic makes its transition towards a market economy and reorients its external trade, the government will need to put in place a trade regime that facilitates this transition. So far, the government's trade policy, as in other republics, has been shaped by the demands of short-run pressures, emanating from the immediate difficulties faced by all the republics. Responding to these pressures, trade policy has been marked by: e the need to ensure energy and some other raw material supplies by negotiating inter-republican clearing arrangements; o the desire to ensure that local needs are satisfied before raw materials are exported; o resistance to reorientation of trading patterns so as to protect the current structure of production; e the relative neglect of import policy, as the undervaluation of the ruble (in purchasing-power terms) relieved the pressure of import competition. 5. These have resulted in a web of restrictive policies, most notably on the export side, which taken together amount to a formidable obstacle to any meaningful economic activity. The restrictiveness of the Kyrgyz export regime is compounded by a lack of transparency. 6. This trade policy regime is inappropriate to the daunting task at hand. As difficult as the current situation is, there are even more important challenges ahead. The Government recognizes that there will need to be considerable reorientation of production Page 2 Krygyz Republic: External Trade Policy and trading patterns, with those industries uncompetitive at world prices having to be scaled down or liquidated. This is not the time to doubt the effectiveness of the government's strategy to promote private initiative, private enterprise and market activities as the most effective way to respond to world markets. 7. The design of the trade regime needs to recognize the particular difficulties inherent in the transition while at the same time leading the economy toward trading patterns consistent with the vision for Kyrgyz Republic. This report will lay out the broad pQlicy concerns and link them to both facilitating the transition and achieving the medium- term vision. It will describe the current trade regime, analyze ways in which it is inconsistent with both short-term transition and medium-term vision objectives and identify a path of policy changes. II. BROAD POLICY CONCERNS 8. To design a trade regime that will serve the Kyrgyz Step back from economy well, we have to step back from short-term concerns short-term with supply arrangements and ask what are the longer-term concerns and objectives that the trade regime ought to fulfill. Three such identify objectives are paramount, in view of their centrality to the Kyrgyz objectives economy: (1) earning foreign exchange, (2) encouraging production and (3) raising govemment revenue. A desirable trade regime for Kyrgyz Republic will be one that serves these goals at least cost to the rest of the economy. This will comprise: (1) export growth as a primary goal; (2) unrestricted trade as essential for production; and (3) trade as a source of revenue. A brief discussion of each objective follows. A. Export growth must be a primary goal 9. The importance of foreign exchange is obvious. Kyrgyz Republic has large and, for the medium run, unsustainable trade deficits with both the ruble area and the hard- currency area. The projections for the 1993 CG indicated a likely trade deficit of about $370 million annually for 1993-95 or 15 percent of GDP, about $235 for interrepublican trade and $135 million for trade with the rest of the world. These deficits will eventually have to be reduced to more manageable levels (of perhaps no more than 3-4 percent of GDP). There are only two ways that this can be done: restricting imports and expanding exports. The trouble with the first strategy--import compression--is that it works only temporarily, and even then only at great cost to the economy. On this, the experience Page 3 Krygyz Republic: External Trade Policy of developing countries since the early 1960s provides an unqualified lesson. Those countries in Africa and Latin America that chose to save foreign exchange by restricting imports repeatedly found themselves in balance-of-payments crises, and frequently overcome by foreign-exchange bottlenecks that strangled their economies. Those countries in East Asia (and occasionally in Latin America) that tackled the problem by encouraging (and eliminating restrictions on) exports avoided these bottlenecks and experienced much faster economic growth. For Kyrgyz Republic, at this stage, exports and demand rom foreign markets will be the critical element to ensure recovery of output. Hence, export growth must be a primary goal of the Kyrgyz trade regime. 10. The vision is to exploit fully the markets that already are being tapped and at the same time to diversify markets, in terms FSU markets of both products and geography. One element of export growth must be main- is maintaining links to existing markets. The simulations outlined -tained below confirm that FSU markets must be maintained, if not grow slightly, even with outstanding export growth in non-FSU markets. Currently Kyrgyz external trade is highly concentrated which heightens the short-term importance of existing markets. FSU markets are critical for the next couple of years as non-FSU markets are developing. Also, in terms of geography, given that Kyrgyz Republic is small and land-locked, the country is well-placed to serve its neighboring markets. Traditionally, Kyrgyz Republic traded very little outside the Soviet Union. Hence, in view of history, lack of language barriers, infrastructure and geographical proximity, Kyrgyz Republic will no doubt remain highly dependent on trade with former Soviet Republics in the medium to long-run as well, particularly Russia, Kazakhstan and Uzbekistan. It is critical to have effective regional integration. 11. This does not imply a maintenance in the composition of imports and exports with those markets since much of the trading * ...but the pattern was inefficient and inappropriate. It does imply that access composition of to those markets be facilitated. Hence, the other element of export trade must growth is expansion of markets. change 12. While the neighboring FSU markets are essential to export performance over the next couple of years, non-FSU trade will still need to expand rapidly. The simulations below indicate that growth rates are of the kind only consistent with a strong export orientation, and the strategy should be consistent with this vision. There is some evidence from 1992 and 1993 of increased trade with Turkey in 1992 and sharply increased trade with China (representing 60 percent of non-FSU trade for first quarter 1993, though much of this is Page 4 Krygyz Republic: External Trade Policy suspected to be transit or reexports). The neighboring Chinese New markets province of Xinjiang alone represents a market of 15 million with without rising per capita incomes. It is quite adequate for a small country neglecting old to have a dynamic and stable trade regime that is largely with ones neighboring countries. At the same time, it will be important not to preclude development of trade links with more far flung partners. Already in 1992 and 1993 trade increased with countries such as Korea, France, UK, Switzerland, Germany, and Austria. 13. Because of data problems, we use a range of assumptions, but all plausible scenarios confirm the message that old markets cannot be neglected while new ones must be developed. An attempt to understand recent trade developments is warranted to put the scenarios in context. As outlined in data in Annex Table 1.1, it is likely that recorded exports to the FSU collapsed further in the first half of 1993. Recorded exports to the non-FSU in the first half of 1993 remain similar to recent levels, but their share would be increasing sharply, from 2 percent historically to 12 percent in 1992 and about 25 percent of total.2 Although it is difficult to value FSU exports in comparable terms, another possible story is that recorded exports to the FSU have not collapsed significantly in the recent period. In either case, by mid 1993 exports to the non-FSU appear to represent a sizeable share of recorded exports. However, this is likely an overestimate for two other reasons. Recorded exports include a significant amount of reexports and transit goods, for example, metal sheets and automobiles moving from Russia to China (which represented 21 and 4 percent, respectively, of 1993 first quarter exports). At the same time, exports through unofficial and unrecorded channels are likely higher as well, including unrecorded barter trade, but much of this is with neighboring FSU countries. Recorded exports may not be an inappropriate proxy for current export levels, but the share of FSU trade likely remains large. 14. Table 1.1 presents the simulations which indicate by how much each market (FSU and non-FSU) would need to grow, depending on the performance of the other, to meet the export targets projected in the 1994 Economic Report. Plus, as noted, these targets may not be ambitious enough in light of increased difficulty in attracting the required external deficit financing. By 1997/98 a step increase in exports is likely from the new gold concession, but these flows will be offset partly by dividend outflows, neutralizing much of the impact on the current account balance. Using recorded 2/ Except for first quarter 1993, only ruble data on non-FSU exports Is available. For conversion back to dollars, I is assumed that non-FSU expotts were converted Into rubles at the accounting exchange rate. 31 For example, using the market ruble/dollar exchange rate which diverged sharply from the accounting rate in 1990-92. Page 5 Krygyz Republic: External Trade Policy aggregate levels and estimated non-FSU share of 30 percent of total and assuming exports to the rest of the world grow by about 25 percent per annum (an ambitious target), FSU trade would need to remain constant in real terms and could not be allowed to collapse further. Assuming a still ambitious non-FSU export growth rate of 15 percent per annum, FSU exports would have to grow by 6 percent per year, or 8 percent assuming a lower 15 percent share for the non-FSU base. The few countries which have attained such growth rates of 15-25 percent have only done so in the context of strong pro-export policies. Ones relevant for the Kyrgyz Repuiblic are outlined below. Table 1.1 ALTERNATIVE SCENARIOS FOR ExpoRT GROWTH (FSU and Non-FSU Shares) Assumed Initial Share Required Growth Rate Scenarios (1993) (1994.96) Percentage Percentage Scenario 1: FSU Exports 70 0 Non-FSU Exports 30 25 Total Exports 100 9 Scenarb s 2: FSU Exports 85 6 Non-FSU Exports 15 is Total Exports 100 9 S;egnarig 3: FSU Exports 85 8 Non-FSU Exports 15 15 Total Exports 100 9 Notes: Based on BOP projections for Consultative Group, 1994 Source: Mission esUimates 15. The mission sees potential in both old markets and new markets (e.g., China, Europe), traditional exports and new activities (e.g., mining, hydroelectricity, Page 6 Kiygyz Repubic: LAernal 2hde Policy manufacturing niches, high value agricultural crOps). The future of th-ec Ki; Gj: economy ties, as experienced in Poland for example, not in the ii dustrial dsino;aurs C' Ihe past (even though no doubt many of these will surviv(. and become suubesfuD, but ri newly- formed private enterprises undertaking entirely new activiiies. 16. In terms of products, tihie oth-cr uomfZ o _xpor growth is expansion of agenis and channels to access both iniport and More trade export markets. Again, currently the rarge in Kyr gyz Republic is channels restricted and narrow, a remnant of the centrally planned economy. The Ministry of Industry, Trade and Matoi-la Rosources (MITMR) (formerly the Ministry of Trade and Material Resources, MTMR) continues to play an exaggerated role in light of supply contracts, state orders, controls on external trade and trading margins. Institutions close to the market and responsiveness to demand will need to develop. Currently the critical role of trade facilitator is being played by a variety of entities. The Foreign Trade Association acts as agent for commissions of about 2 percent. Other private intermediaries are playing a similar role, with specific examples given below. Although there currently are incentives to transfer profits from state-owned enterprises (SOE) (as weli as coliectivized privatized enterprises) to intermediaries controlled by particular principals of the enterprises, clarification in ownership and better corporate governance should resolve this. 17. In both dimensions, attitudes to external trade and to the Competitive private sector, we think the problem lies not primarily in specific exchange rate a policies per se, but with the Kyrgyz policy makers' general must for approach towards market activity and its regulation. The frequent exporters changes and arbitrary application of rules and regulations gives business people no certainty with which to develop external markets. Tax retes particularly on export activities are self- defeating because they discourage exports without generating fiscal revenues. The web of export restrictions outlined in greater detail below is inconsistent with the imperative to encourage exports. Indeed, import duties act indirectly as export taxes as well: they do so by increasing the cost of inputs used in exporting activities and by enabling a more appreciated exchange rate than could have been otherwise sustained. There is a tendency to over-regulate and over-intervene at the appearance of any perceived market imperfection such as monopolies. The distinction often made between "producers" and "traders" and the discrimination against the latter stifles the emergence of market institutions in external trade. Trade and commercial activities in general are perceived to be wasteful activities, especially when production is so low. However, they perform crucial functions which enable producers to operate at lower cost e.g., they provide insurance against risk, they procure raw Page 7 Krygyz Republic: External Trade Policy materials from foreign and domestic sources using extensive trading networks, they provide finance etc. Many of these syndromes are left over from the past and are the legacy of socialist economic policies. What is presently absent and urgently needed, then, is a change in attitudes towards trade, markets and microeconomic policy -- as significant as the one in macroeconomic and financial policy that the government has introduced. Without this second leg of the reforms, macroeconomic stability will be at a great cost to economic activity. 18. Realistic management of the exchange rate is needed to provide exporters adequate and stable incentives and to prevent the emergence of a significant black- market premium for foreign currency. The experience of successful exporters shows that the most potent form of export encouragement is an exchange-rate policy that provides stable and sustained incentive for undertaking export activities. This requires maintaining a competitive (i.e., sufficiently depreciated) exchange rate and avoiding cycles in the real (i.e., relative-price deflated) exchange rate. A unified exchange rate is absolutely essential here. The National Bank's revised policy of allowing the som to approach the black- market rate for foreign currency is giving exporters greater incentive to earn foreign exchange (or to bring foreign exchange back to Kyrgyz Republic) when domestic commercial banks pay them a rate for dollars or rubles that is comparable to market levels. 19. There also is a need for increased efficiency of import use. The reduction of price controls and more economic pricing for those remaining under control is an important step to signalling this need. Alternative channels will also play a role in identifying lower cost sources for imports and expanding competitiveness of import procurement. B. Unrestricted trade Is essential for production 20. Given that Kyrgyz Republic is a relatively small economy, it will have no choice but to remain highly integrated with other economies. Trade should continue to play a major role in both exports and imports. In fact, comparative data from other small economies indicate that trade shares may well be greater than those under the previous system, with total exports and imports representing a sizeable share of GNP for Netherlands, Ireland and Belgium as well as for land-locked countries such as Bolivia. 21. Given that many features of the existing production structure are not consistent with those efficiencies and gains from trade, there is going to be a difficult period of adjustment for the productive sectors. Kyrgyz policy makers will come under pressure Page 8 Krygyz Republic: External Trade Policy to use the trade regime as a means of protecting specific industries from making the necessary adjustment. These pressures will come from enterprises that fir,d themselves in financial difficulty. Policy makers also will come under pressure to promote specific industries, namely, those that portray themselves as ustrategic" industries crucial to the Kyrgyz economy's future. It is important that policy makers prepare themselves for such pressure, and that they be ready to withstand it. 22. As noted in the report below, several sub-sectors already are being protected, through trade restrictions as well as other vehicles. The objective is to move as quickly as possible to a trade regime that is not susceptible to selective protection -- whether in the form of higher trade barriers on domestic inputs, higher trade barriers on competing imports, or reduced tariffs for imported inputs. The reason such measures are inappropriate for the medium-term trade vision is not that no sub-sector ever deserves state assistance. Often, there are good reasons for promoting an industry. However, when there is a legitimate case for industrial assistance, that assistance can be far more effective when provided directly through the budget, i.e., in production subsidies. Trade protection is inefficient and ineffective for a the form of cash grants, or investment, employment, and number of reasons: 23. Unlike direct cash subsidies, trade protection generates a by-product distortion for the economy. The people and Someone always industries which are not well organized -- which is often the case pays for because losses tend to be widely diffused -- tend to lose out. protection Since the assistance is off-budget when it comes in the form of trade protection, its costs are not immediately evident to the public and to the government, which leads to protection being granted too readily, as well as its perpetuation past the point of usefulness. This report gives specific examples cf losers (producers and consumers) and magnitudes of losses to help arm officials with counter arguments from the people standing to lose from protection. 24. As noted in the examples below, the Ministry of Agriculture would best serve the interests of farmers and consumers by pushing for low protection for all sectors. Officials need to be aware that policies proposed by other ministries for Agriculture their sectors (such as industry) also matter to them. Export should be an restrictions should not be used to keep raw materials at home and advotcate for low to encourage domestic processing of these raw materials. Trade protection policy making in Kyrgyz Republic is often marked by an autarkic attitude towards raw materials. There is a perception that keeping raw materials at home, either to satisfy final consumer demand or Page 9 Krygyz Republic: ELter"tal 2 rade Policy for further locaJ processing, is more desirable than exporting. This attituda is inimical to the deveiopnrieiit of Kyrgyz Republic's trade and counterproductive. The abundance of local raw materiais such as wool, hides, and tobacco already provides local processors a transport-cost advantage relative to their competitors in other courtries. Export restrictiuns applied on the raw materials would further subsidize these processors, but at the cost of dan-iaUing the agricultural sector, foregoing foreign currency earnings, and impoverishing ihei nation as a whole. It is a mistake to regard one ton of wool adding greater value to anr economy when it is processed thian when it is in raw form, especially when the purocessing is under-taken only because of the distoltion of production incentives generated by tlhw export restriction. The reason is that the processing diverts labor and capital fhoriom othur sectors of the econonmy where they would have been better utilized. ss +>-s -- ~ 25. It is a mistake to believe that industrialization will not .Agriultural plus (0ocur unless it is artificially fostered in this manner. Ths iner export experience of Taiwan provides an appropriate example: in the late base consist 1950s sugar and rice accounted for virtually all of Taiwan's with itidustrial exports, yet today the country is one of the world's most successtul exporters of manufactures. And in Latin America, growth Chile's comparatively stellar economic performance since the mid- __________ ___ 1980s is built on natural resource-based exports (forestry, fruits and vegetables, fish) alongside solid copper export performance. The negative examples ar -, provided by many cases in Africa and Southeast Asia in which restrictions on exports of raw materials have done a great deal of damage to agricultural producers' well-being without significantly benefiting the rest of the economy. 26. A strong orientation of current policy is to discourage export of raw materials, especially those which are also inputs into domestic processing industry. This is part of a general policy towards the protection of local industry at the expense of agriculture. There are a number of countries such as New Zealand, Switzerland and Thailand that encouraged raw material exports while domestic industrial capacity developed in parallel. In Kyrgyz Republic, it must be recognized that the implicit cross subsidies are at the expense of other sectors which are themselves under stress. Second, Kyrgyz Republic agricultural and min,,al exports face few non-tariff barriers and will need to be a critical ingredient in the most immediate export expansion. Third, some of the industries thus protected will have no long-term economic rationale and will in perpetuity require subsidization from the budget or domestic users. Export controls on raw materials may not have the desired effect of increasing export revenues. 27. Trade protection is ineffective because it rarely provides the incentive to the protected firm(s) for undertaking the requisite adjustments--it simply rewards them, Page 10 Krygyz Republic: External Trade Policy irrespective of whether the adjustment is undertaken or not. While it is possible in principle to provide temporary protection continge on specified actions to be undertaken by firms, in practice such policies have worked very rarely (the only notable exception is that of South Korea, where administrative capacity has been much stronger than in other countries). For these reasons, trade policy is a very poor instrument for achieving industrial-policy goals. Once again, the Kyrgyz government should learn from the mistakes of other countries. 28. Raising protection now with a view to reducing it later would add to uncertainty and hamper restoration of production. Keep it Predictability and stability of incentives generated by the trade predictable regime are a key requirement for attaining the desired response and credible from enterprises, both private and public. When regulations change often and are implemented arbitrarily, when exemptions are granted on an ad-hoc basis, and when bureaucrats continue to regard trade as secondary to the satisfaction of domestic demand, the trade regime fails to perform its function. Under such conditions, enterprise managers rationally choose not to enter into the long-term commitments needed to expand exports. It is particularly important to signal the govemment's attitude on trade given the high level of policy instability in Kyrgyz Republic. Consequently, an important consideration while putting a new trade regime in place is the need to send a clear signal to producers and traders that the government is serious about encouraging trade. To communicate such a change in attitude, it would help to announce these reforms as a package and to do so at the highest political level. 29. At the same time, to ensure that the policy pronouncement is credible, the government also will need to be establishing a less ad-hoc system for dealing with the largest and most problematic industries u.'ider stress, including support to displaced workers, divestment of assets into other uses and other passive restructuring mechanisms. 30. Growth depends on secure supplies of critical goods. -securing Increasing availability of foreign exchange is an important element. :=ssentials In particular, the trade regime will need to be consistent with food t-1hroug having and energy security. The option of domestic self-sufficiency has altenative an immediate appeal with a commodity of such importance to market channels national food security as wheat. However, it is quite likely that a policy of self-sufficiency in grain may substitute production risks for market risks, and may substitute low-value grains for higher value alternative crops which would make a more efficient use of scarce factors of production. It is striking that grain production in Kyrgyz Republic is already Page 11 Krygyz Republic: External Trade Policy highly dependent on imported inputs, and, hence, greater domestic production of wheat may therefore not reduce import dependency as much as is hoped. There may be greater security by ensuring minimal barriers to access of alternative sources such as China. Establishing multiple market channels will be the most secure. While bilateral trade agreements may play an interim role as an instrument to mitigate the extreme uncertainty regarding the availability of essential inputs, it is important that the institutional procedures encourage expansion of alternative private channels. Already about half of petroleum imports are via channels other than obligatory list trade, providing an important supplemental supply. The implications for the design of bilateral arrangements are discussed below. C. Trade can contribute to fiscal revenues 31. The importance of fiscal revenue for the Kyrgyz economy does not need much discussion either. The government has already lost the budgetary subsidies and transfers that originated from the Soviet Republic. Taxes collected from the traditional enterprise base are being reduced as state enterprises come under financial difficulty. In the medium-run, these state enterprises will cede their role in the economy to new, private ventures. The latter, in turn, will prove more difficult to tax. While the state will be curtailing its role and relevant expenditures accordingly, there will be new demands on the government for social expenditure as unemployment makes itself felt during the industrial restructuring. To give a sense of things to come, it is worth noting that in all of the Eastern European countries, fiscal deficits are now rising despite the significant adjustments made since 1990. In such a context, any solid source of government revenue should be exploited. While the VAT and income tax system will need to carry the major burden for raising revenues, the trade regime can be of help here, provided taxing is implemented in a reasonably transparent and efficient manner. 32. Prevailing practices on access to foreign currency, licensing, bilateral agreements, pricing and state purchases/orders Tra policy have created a web of implicit subsidies and taxes. Estimates of a1rea= y tari g the magnitude and identification of the groups affected are made impli-it-y in the sections belcw. Not only is the implicit taxation discouraging economic activity in certain areas (such as agriculture) but also the implicit subsidization is not connected to any commitment for change and, hence, is costly indefinitely. 33. Ucensing and quantitative restrictions (QRs) restrict and discourage trade (mplicitly taxing certain groups) without generating any government revenue. So they Page 12 Krygyz Republic.' External Trade Policy have detrimental consequences for the economy with no offsetting benefits. State-run monopolies on the import or export side are akin to QRs (noted above), and should also be avoided. Such QRs should be replaced by explicit forms of taxation. 34. At the same time, taxes need to be at low rates and kept simple, with similar rates for all commodities. An export tax Licensing and schedule and/or an import tariff schedule should have as its controls mean primary objectve to raise revenue rather than to protect domestic lost revenues producers. In that case, it makes no sense to have tariffs that are so high as to be past the revenue-maximizing level. In an economy like the Kyrgyz one, with porous border and well- developed links to neighboring countries, smuggling can be fairly easy. Tax or tariff rates that are higher than 30-40 percent on easily transported items (e.g., liquor or cigarettes) are unlikely to be enforceable; it will be cheaper for exporters and importers to pay the costs and bear the risk of smuggling, and evasion will result in lower revenues than would have been collected with lower rates. Even when smuggling considerations are not important, rates above 50 percent become highly punitive to trade and may stop trade transactions. 111. REFORMING THE TRADE REGIME -- CURRENT DISTORTIONS AND THE TRANSITION 35. This section outlines the major trade distortion channels, roughly estimates their negative economic impact and identifies options for reforming the regime in line with the broad concerns of trade policy. The major direct channels are: state trading through bilateral agreements, direct trade restrictions including export licensing and taxes and absence of supportive export promotion framework. Given the economic crisis facing the authorities, it is not surprising that there is tension in the choice between quantitative controls and price mechanisms. Because of the negative impact of the former on the efficient allocation and adjustment, the authorities must be very judicious in their use of such quantitative controls and focus on the measures which will ensure price mechanisms can be effective in the next trading round. A. State Trading through Bilateral Agreements 36. The legacy of the FSU is prominent in the trade regime of Kyrgyz Republic in the form of bilateral agreements (or protocols). Resembling the coordination of inputs and outputs including imports and exports under the planning process, they still define the particular commodities to be traded and amounts. There are three notable changes. Page 13 Kiygyz Republic: Exteral 7rade Policy First, attention is focused increasingly on agreements with key FSU partners that obligate the signing governments to trade a portion of the total list, this subset to be mutually supplied (bartered) called obligatory or clearing. For 1993 and 1994 these agreements have been reached with Russia and Uzbekistan, with additional ones with Azerbaijan and Tadjikistan in 1994. To overcome difficulties of enforcing fulfillment as experienced in 1992, a system of closely monitoring flows has been implemented --Russia for instance supervises the fulfillment of quarterly commitments every 10 days and has the right to halt shipments in the event of non-fulfillment. Despite this, only - percent and - percent of the value of Russia and Uzbek clearing agreements, respectively, were fulfilled. The non- obligatory portion defines levels of exports on which the originating country agree not to impose restrictions by issuing export licenses; for any transaction under the list, the price is determined between the buying and selling enterprises. 37. Second, the number of commodities covered by the agreement has been reduced. For instance, the number of commodities expected to be delivered from Russia to Kyrgyz Republic decreased from 118 to 70 from 1992 to 1993. This trend is applicable to the rest of the republics except Turkmenistan and Azerbaijan. For clearing arrangements, the number is relatively small, for example, 8 commodities from Russia in exchange for 7 commodities from Kyrgyz Republic. However, the Uzbek clearing arrangement includes 12 commodities from Uzbekistan, all but 4 of which are valued at less than $1 million, and 16 commodities from Kyrgyz Republic, half of which are valued at less than $1 million. 38. Third, the terms for barter of the obligatory list are now defined in dollars with a closer relationship to world prices. 39. Overall, the centralized character of trade in Kyrgyz Republic has not changed significantly. Practically all recorded trade with the FSU in 1992 falls under the umbrella of the bilateral TadneIs -X agreements, as is shown in Annex Table IlI.A.t. For 1993, the reduction of indicative items will decrease the importance of the wontrolled mutual deliveries in total trade but not by much.4 The value of more restrictive trade under obligatory or clearing agreements negotiated for 1993 is equivalent to about 34 percent of projected 1993 exports and 20 percent of imports. In addition, direct procurement and distribution of commodities under the agreements is dominated by the state-owned trading companies under the coordination of the MITMR as outlined below. 4/ 60 percent of projected exports for 1993, if the protocols are fuffliled Page 14 Krygyz Republic: External Trade Policy 40. Despite movement in underlying prices toward world Reluctance to levels, the clearing arrangements continue to be quantity move away from arrangements, with producers obliged to offer given quantities and quantity vice-versa. The developments in bilateral agreements reflect the arrangements tension in the policy choice between quantitative arrangements in a crisis situation and price mechanisms aimed at efficient allocation and adjustment. While the authorities have narrowed the scope of .xW -E: the most compelling quantitative arrangements, there has been reluctance in the trade of major imports and exports to move away from quantity arrangements to ones based on pricing. Part of this reluctance reflects an old system no longer suited to the circumstances. At the same, part of the reluctance may reflect uncertainty with respect to the pricing and procurement regime that will generate given quantities combined with high costs to not obtaining such quantities. As noted below, the interrepublican payments system is not yet reliable, contributing to this uncertainty. In addition, given the tight financial constraints facing the economy, building up stocks as a precaution against quantity shortfalls is an expensive alternative with high opportunity cost of the resources used to build up those stocks. But the negative impact of quantity arrangements on the ability of the market to operate is clear. We turn to, one, the disruption to incentives from the resulting distorted price structure and, two, other r:egative spillovers, which weigh against the limited and short-term benefits. 41. Recent agreements have encouraged world prices in US ClSearin,g dollars as the implicit mechanism to balance the flows of goods arrangements under the obligatory list, with details given in Annex Table III.A.2. ; }ve moved This shift has represented an approximate 20 percent deterioration Yag yry in the terms of trade, with a large relative increase in energy and - toward world grain prices offset by an increase in relative prices of some key exports. Table III.A.1 shows that agreed prices for major exports _________________ and imports in the protocols with Russia and Uzbekistan are close to world prices with a few exceptions discussed below. Hence, the role for bilateral agreements as a potential channel for trade subsidies from neighboring countries is shrinking fast. 42. Intentional favorable treatment appears to be limited to wool and tobacco under the Russia agreement and natural gas under the Uzbek agreement. The implicit price paid by Russia is higher than the estimated world price, by about 35 percent for tobacco and over 100 percent for wool. Given the collapse in world wool prices, the trade subsidy imbedded in the Russia agreement has stabilizec' prices for Kyrgyz Republic. The implicit price paid by Kyrgyz Republic for Uzbekistan natural gas is 40 percent less than estimated world price, but this is interrelated to hydropower and water interdependency, Page 15 Krygyz Republic: External Trade Policy - where Kyrgyz Republic's hydropower needs contrasting with Tems for wool, Uzbekistan's irrigation needs. At the same time, the price for tbacc and gas potassium fertilizers appears to be above world levels. The stil very mercury and antimony prices also exceed current world levels, by .ifvorab1e under about 45 percent for mercury for both Russian and Uzbek clearing agreements and by about 14 percent for antimony. When the arrangements agreement originally negotiated, world prices for both minerals were considerably higher, in line with implicit clearing prices, and in essence the agreement provided insurance against the actual downward slide in prices. It is important that the Kyrgyz authorities glean as much information as possible from the futures market on those minerals before negotiating another fixed price. Given the attractive terms for certain commodities, the short term position should be to fulfill the agreements, with options discussed below, where the excess of agreement price over world price represents a potential source of revenue to the Government. 43. It is not expected that Russia will continue to provide such favorable terms under the bilateral clearing arrangements. Further terms of Adjustment of implicit agricultural and mineral prices implies a trade further terms of trade deterioration of about 4 percent of GDP by detedooration 1995-96. In addition, imports of petroleum products, the majority to come of which are carried out outside the context of bilateral clearing arrangements, are being obtained at significantly below world prices. Average import price is $100-110/ton compared with average world prices for petroleum products ranging from $120/ton to $195/ton. Some of these transactions are even below Russia domestic prices. Part of this implicit subsidy stems from the lack of transparency in the CIS oil markets, including existence of unofficial channels. However, it is not expected that access to such favorably priced petroleum products will continue beyond the next year. Adjustment to world prices implies a further terms of trade deterioration by 1995-96. 44. Despite the fact that domestic prices for oil are adjusted quarterly so as to reflect international ones, several (primarily Clearing industrial) enterprises have not paid their bills and are running arrangements: Rrrears. This indirect subsidization as estimated by the size of ismplcit industry arrears is 170 million som (about $30 million) as of July 1993. -subsidizaton Further subsidization (primarily to household consurrmers) is implicit in natural gas pricing, where the domestic price is not half of the implicit import price (which already is 40 percent less than world Page 16 Krygyz Republic: Erternal Trade Policy levels), estimated at $15 million. Domestic prices for 1993 (implicit in averages) for aluminum and copper are also a fraction of the world prices approximated in the clearing arrangements. Although calculations are not possible for less homogenous products, it is likely that other inputs such as metal products also sell below world levels. Table Ill. A. 1 1993 CLEARING ARRANGEMENTS, PRICE COMPARISONS IN US DOLLARS PRICES CLEARING WORLi DOMESTIC . .~~~~~~~~4 -.) lb) IC] l (} (1)(2). (3)(2) (2) ~~~(3) EXPORTS TO UZBEKISTAN: Antimony 1480.0 1530 1230 96.7% 80.4% Mercury [el 4350.0 3000 4630 145.0% 154.3% EXPORTS TO RUSSU: Antimony 1749.0 1530 1230 114.3% 80.4% Mercury le] 4350.0 3000 4630 145.0% 154.3% Cotton fiber 1134.0 1300 87.2% Natural wool 4500.0 2000 1733 225.0% 108.3%[dJ Raw tobacco 3000.0 2160 1000 138.9% 55.6%[d] IMPORTS FROM UZSEIKSTAN: Natural Gas 48.0 80 21.0 60.0% 26.4% Automoble Gasollne 200.0 195 200 102.6% 102.6% Diesel Fuel 160.0 162 160 98.8% 98.8% Heavy Fuel Oil (mazut) 80.0 65 123.1% Refined Copper 2200.0 1922 114.5% Raw Aluminum 1220.0 1922 114.5% Notes: [a]: Refers generally to prices per ton or cubic meter, not adjusted for transport commission or insurance. lb]: July prices from several sources including Wodd Bank pink sheet, The Financial Times, the Mining Page 17 Krygyz Republic: External Trade Policy Journal and the Metal Week. Mercury prices are estimated from the Bank's Mining Sector Review. As In the case of clearing prices, wotid prices do not account for transport commission of Insurance. [cl: Average producer price January-June 1993. (dJ: These two ratios are based on world prices adjusted for an estirm -i ed 20% for transport commission and Insurance costs, e.g., Including scowing for wool. le]: World prices of Mercury may be an overestimate of the relevant price for the Kyrgyz, some sources indicate a world price of $3000/ton. 45. Part of the burden falls on agricultural producers enterprises which are required to sell to the state and which are receiving ... and net domestic prices less than world equivalents. (Calculations assume taxation of that it would be appropriate for the Government to realize the gain agricultre for any trade subsidies from neighboring countries implicit in prices and mining different from world levels.) For example, the proposed tobacco procurement price is estimated to be about 60 percent below what _NMEAL1- can be received directly on world markets. Given the currently severely depressed world price for wool, the proposed wool procurement price appears closer in line with international prices, though direct trade in secluded neighboring markets has been securing better prices. This implcit output taxation is partly offset by implicit input subsidy. For example, as outlined below, fertilizer prices continue below world equivalents, though problems of availability of subsidized inputs are reducing the impact. An additional tax is the delay in payments to producers. Should the situation reoccur as in 1992/93 with about a six-month delay, producers would be taxed a further 50 percent.5 However, as shown by the experience in 1992 and discussed below, the attempt to realize such large revenues on the traditional agricultural sector already under stress cannot be successful. 46. In the mining sector, antimony producers receive about 20 percent less than export market equivalents. (In contrast, mercury producers appear to be receiving the above- market attractive price implicit in the clearing arrangements.) For the mining sector, more transparent taxation methods should and can be used, but moderate levels of taxation are essential for attracting the foreign investment required to develop the mining potential of the Kyrgyz Republic. Also, even if prices are temporarily favorable (as may be the case for mercury), it is important for producers in the mining sector to be attuned closely to developments in the international market, which is precluded by dominating obligations under the bilateral agreements. 5/ Assuming an inflation rate of 200 percent, also in line with current interest rates. Page 18 Krygyz Republic: External Trade Policy 47. At the same time, not even a fraction of the potential revenue, from either (i) trade subsidies from neighboring countries or (ii) implicit taxation of traditional exports, is realized currently. The potential revenue is being lost to subsidize primarily (i) enterprises consuming oil but not paying for it and (ii) gas consumers. In principle, the state would obtain financial resources from sale of barter imports such as oil to finance purchases of barter exports such as agricultural commodities. The arrears situation disrupted this financing. To secure finance for short-term seasonal crop procurement, extraordinary measures needed to be taken in July and August by the Government and National Bank of Kyrgyz Republic. However, crisis management will not allay farmers' fears about future compensation, plus the burden for subsidization of oil-arrears enterprises was extended to other (presumably productive) users of credit who were cut off so as to maintain overall credit control. Therefore, incentives to optimize import consumptior. as well as traditional export production have not been transmitted and this is perhaps the most serious challenge in reforming clearing arrangements. 48. The bilateral agreements need to be seen in the light of their broader impact on _________________ external trade in any goods covered. The protocols for 1993 with Russia and Uzbekistan commit the state to commercialize directly more than 60% of the volume traded internationally the previous Negative year for gasoline, timber, raw aluminum, copper, steel tubes, spUlover of antimony, mercury, cotton fibre, wool, and tobacco as shown in agreements Annex Table III.A.2. The magnitude of state intervention in the external trade of these commodities spills over into the remaining trade through other trade restrictions used to enforce the agreements. As discussed further below, export licensing and taxes are particularly onerous. Obligatory trade (with Russia and Uzbekistan) represents 34 percent of projected 1993 exports and 20 percent of projected 1993 imports. Total trade in these goods accounted for about 40 percent of imports and exports in 1992. 49. The non-clearing indicative list potentially is an instrument, albeit imperfect, to facilitate trade in the face of restrictive export licensing by FSU partners and to give a sense of security on availability of critical inputs. However, much of the trade organized in this manner mirrors the central planning system of supply contracts based on inefficient mechanisms of procurement and distribution. The forecasts prepared by MOEF, submitted to Parliament and implemented by MTMR for the whole economy forestall movement to market behavior and price responsiveness in the Kyrgyz economy. The bilateral lists are a reflection of the implied export supplies and import requirements of that exercise. While the government supposedly now encourages enterprises to establish direct relations with their suppliers and to secure inputs on a barter basis, the ministries have been able to exercise indirect control over production by obtaining inputs and using Page 19 Krygyz Republic. External Trade Policy them to direct outputs. No breakdown of official trade is available which indicates how much of actual trade is carried out by state-owned trading companies rather than by the producing or consuming enterprises and farms directly. Anecdotal evidence from both manufacturing and agricultural sector interviews indicates that the share of the former has been declining and the latter has been struggling to increase. Nevertheless, the supply contract system delays the movement away from cumbersome single state channel trade to more market-responsive enterprise-to-enterprise transactions. The signals from the govemment on what is encouraged in external trade need to be made clear through expeditious elimination of the supply contract exercise and restructuring of the state trading apparatus into a multiple channel commercial one. Furthermore, the agreements are tied to and open access to bilateral technicat credits at subsidized rates. This restricts access to financial resources by often more productive users. The govemment needs to explore ways to broaden access to the ruble technical credits. If the rubles are not tied by the granting country, introducing an auction along the lines of that for foreign exchange could be considered. If the rubles are tied to purchases of particular commodities through particular trading enterprises, introducing competitive bidding for those commodities could be considered. 50. Trade in Kyrgyz Republic has to move toward a market oriented base where the majority of transactions is carried directly by firms. Success in Eastem Europe in reducing dependence on former CMEA contracts has proven that smaller government intervention in setting the tradeable commodities, their price and quantity, the greater the benefit from trade (like in Poland and Hungary). Given the current interdependence, the transition to this environment may take several steps but the first have to be implemented at the earliest opportunity. ******* ***** SUMMARY OF RECOMMENDATIONS AND RECENT PROGRESS Bilateral Agreements 0 Curtail the role of the state by eliminating the supply contract exercise as the root of the bilateral agreements and by breaking up the dominant state trading companies into commercially oriented and competitive units. Do not restrict the trading spheres of such privatized entities. Give an explicit commitment to private sector participants that their contribution is regarded positively by government. Redefine functions of local authorities to preclude interference in trade. Progress: In recent months the Government has started the dismantling of the state trading system associated with bilateral agreements. In February Page 20 Krygyz Republic: External Trade Policy 1994, the Government passed a decree explicitly abolishing state orders and establishing that state needs will be executed on a contract-Jal basis, and by- laws related to domestic supply contracts were allowed to expire, thereby discontinuing that practice. In addition, from February 1994 restrictions on business activities have been eliminated from privatization contracts. At the same time there remains considerable ambiguity among producers and traders as to whether supplying state needs is compulsory, and further clarification and publicity is required. o To create the environment for direct enterprise transactions, move toward negotiating for removal of trade restrictions on the productive (and trading) sectors rather than bilateral agreements on specific commodities. For example, the general constraints to border trade with Uzbekistan are important to address bilaterally. 3 To facilitate the expedition of export licenses granted by CIS countries for Kyrgyz imports, delink the indicative list exercise from the supply contract exercise and then encourage an expanded number of commodities and volumes for exports from other countries in exchange for the corresponding elimination of export licenses for all those goods previously being exported to those countries. Note that the expansion of the indicative list facilitates trade only if it is not accompanied by a increase of the obligatory list. Progress: As noted, the supply contract exercise has been suspended. * Broaden access to the ruble technical credits, including consideration of auctions and/or competitive bidding for tied commodities. Progress: The Government is considering the possibility of holding auctions and/or competitive tenders for goods being purchases. Clearing Arrangements: * Eliminate bilateral clearing arrangements. If there is a short interim period before the trading partner eliminates the attractive terms, as may be the case with Russia, a limited and focused arrangement could be made on critical commodities or those for which the trading partner is willing to offer an attractive price; eliminate commodities with insignificant volume of trade. Procurement prices should reflect market prices, with the difference between the market and any favorable clearing arrangement implicit price accruing the government. To secure raw materials that are of national interest, the focus should be on maximizing availability of foreign exchange which can only be achieved by dismantling export controls. Progress: In a decree in February Page 21 Krygyz Republic: External Trade Policy 1994, the Government recognized the need to phase out clearing agreements as soon as feasible. If key neighboring trading partners insist on such clearing arrangements for other commodities, as may be the case with Uzbekistan, the focus should be on setting up transparent bidding arrangements for the bartered imports and procurement arrangements for the bartered exports within Kyrgyz Republic, for as few goods as possible. The organization in charge of commercialization should have separate accounts in the budget - and manage its own budget. A possibility to consider is to separate this institution into branches with a view to eventually transferring those trading house capabilities to private hands. Progress: The Government intends to introduce a system of competitive deliveries, with participation by both producers and private trade organization. • To increase the certainty of ability to obtain supplies of critical imports in the next trading round via market mechanisms, renew efforts to strengthen the interrepublican payments system and assure adequate stocks. Progress: The Kyrgyz Republic has reached agreement with Russia and most other former FSU states to establish an Interstate Bank to facilitate interstate payments. • To reaize the trade subsidy implicit in the bilateral clearing agreements and to reduce the need to tax the agricultural sector via artificially low prices paid to farmers, the government should resist the build-up in further arrears on domestic oil sales. For example, it should set an example by cutting off energy supply to select enterprises which have failed to reduce their arrears. o To ensure delivery of given quantities under interim clearing arrangements, for example, in the agricultural sector, accelerate payments to producers for commodities delivered to state agents, through 100 percent financing and immediate cash payments. Introduce competitive procurement for export commodities to be delivered under bilateral clearing arrangements, restricting state procurement to such narrowly defined quantities. As noted above, the procurement price should be based on market terms, which will be less than the favorable implicit price offered to the Kyrgyz Republic for tobacco and wool under the clearing arrangements. However, the Government faces budgetary and financial constraints that will continue to inhibit its ability to play a reliable role in agricultural marketing, and the slowly emerging private trade will need to take up the slack. ************** Page 22 Krygyz Republic: External Trade Policy Trade Policy Instruments 51. The key culprit in the web of restrictive policies are export restrictions, which amount to a formidable obstacle to export MoSt signitica.t activity and a major source of protection to potentially inefficient trade barrer - enterprises. The restrictiveness of the Kyrgyz export regime is compounded by a lack of transparency. In addition to the direct - resiions impact of bilateral agreements described above, other arduous impediments imposed on Kyrgyz exports and their impact are described below. The estimated share of exports affected by such restrictions is given in Table llI.B.1. Table l1l. B.1 EXPORT RESTRICTIONS IN 1993 AS SHARE OF EXPORTS 11 ~TYPES OF PERCENT OF l RESTRICTIONS E-XPORTS a/ Bilateral Agreement b/ 80 of which Clearing 34 Arrangements b/ Export Ucensing d/ 53 ExpoR Tax e/ 27 Note: a/ Weighted by export value In 1992. / Assuming 1993 protocols are fulfilled. However other FSU exports may not be recorded, making the recorded share appear higher ex-post. / With Russia and Uzbekistan only 5/ Based on broader FSU list given that negligible amounts of goods on FSU list but excluded from non-FSU list are exported to non-FSU. e/ 57 percent of exports to Russia which account for 30 percent of total, plus 85 percent of exports to rest of worid which account for 12 percent of total In 1992. Source: Mission calculations, Annex Table Page 23 Krygyz Republic: External Trade Policy 52. Ucenses are required for all exports of a specified set of commodities. Table 111.1.2 lists the 17 categories of goods for which export licenses are required for export outside the FSU because they are deemed to have "state significance".6 The list of goods requiring export licenses for FSU trade covers about 60 categories, including in addition to those on the non-FSU list other foodstuffs (e.g., meat and meat products, vegetable oil, sugar, honey) and raw materials (e.g., timber, fur, starch) as well as manufactured items (e.g., knitted goods, yarn, glass, electric lamps). These goods represented over 50 percent of total exports in 1992. TherF are also export bans on a restricted list of items which include weapons and military equipment, explosives, nuclear materials used for military purposes, poisons, drugs, and articles with cultural significance. 53. The government recently proposed reducing the number of goods requiring export licenses to six, namely, tobacco, grain, wool, cotton, raw leather and fur, and silk cocoon. These represent the subset of major commodities under bilateral clearing arrangements where there is the most uncertainty with regard to ability to procure given quantities because of the diversified nature of the producers, for example, compared with minerals where there are generally only one or two producers for each mineral. This is a step in the right direction. 54. The licenses issued by the former MTMR are one of three types; a specific license for single commodity contracts; a general license for large quantities of commodities and/or exports over a period of time; and, an intermediate license for certain works and services (not goods). No open licenses are issued for exports, and general licenses are uncommon. The more tedious specific licenses dominate. An application fee of $US70 must be paid for an export license, relatively high for small consignments which are likely to be common in the initial stages of non-traditional export development. Once the license is received exporters complete a customs house declaration form which details the product quantities and costs. Customs officers inspect the merchandise and for this they charge a duty of 0.15 percent of the product cost, for which two thirds is payable in Som and one third in US dollars. Once the customs inspectors give their stamp of approval the goods are exported. Former MTMR officials claim that it takes 7 to 10 days to obtain a license if the paperwork is in order. However, a number of managers reported much longer delays and instances were cited where bribes were required to hasten the process. f/ These licenses are required under decree No. 121 dated the 2nd of ApnI, 1992. Page 24 Krygyz Republic: External Trade Policy Table Ill. B.2 GooDs REQUIRING EXPORT ICENSES FOR NON-FSU TRADE Oil and Oil Products Wool Natural Gas Hides Coal Tobacco Ores and Concentrates Silk worm cocoon Non-ferrous rare and Sugar beetroot, rare-earth metals alpha seeds Ferrous and non-ferrous Products of Tibethian metal scrap Medicine Precious metals, stone Ether-oii crops articles Grain Herbs Cotton Source: Ministry of Trade and Material Resources 55. The export licensing system gives the former MTMR considerable influence over extemal trade flows because it has the discretion to deny applications for licenses which are required for an extensive list of commodities. A number of private traders complained that it was very difficult for newly established organizations to obtain licenses from the former MTMR. There are occasions where licenses are refused because the former Ministry of Industry (MOI) wants the former MTMR to ensure adequate domestic supplies of inputs at low prices to state-owned enterprises in Kyrgyz Republic. Export licensing gives government officials, particularly those within the former MTMR, the machinery to achieve a number of goals: (i) to delay the necessary closure of unprofitable enterprises by directing low cost inputs their way; (ii) to obtain self-sufficiency in a number of key commodities, mainly for the purpose of food security; and, (iii) to monitor the terms and conditions of export contracts. 56. Export licensing is a major vehicle for providing protection to domestic manufacturing firms. There are two cases to consider; the first when Kyrgyz exporters are price-takers for exports and the second when they are large enough to affect international export prices a ice-makers. For most of its exports Kyrgyz Republic is a price-taker because it is a small country in external markets. This is the case we Page 25 Krygyz Republic: Exteal rade Policy consider here. When licenses are used to restrict exports, Incidence of domestic prices fall below the foreign prices for the commodities export licenses in question. This occurs because some of the output not domestic exported is directed back onto the domestic market thereby driving manufacture's down domestic prices; Kyrgyz buyers benefit, while Kyrgyz gain but at producers are (implicitly) taxed. The more exports are restricted, exporters the larger is the implicit taxation. 57. Despite the apparent equivalence of export taxes and export licenses, there are important differences between them. One is ... and govern- the allocation of the revenue. The export licenses have value ment's loss. because they allow exporters to purchase their products In Kyrgyz Republic at prices below what they obtain for them as exports. This price difference creates revenue (as rent) which accrues to the Government if it sells the licenses, and it accrues to exporters when the licenses are allocated to them free of charge. Explicit export taxes are attractive to the Government because they collect revenue for the budget. When exports are subject to both licensing and direct taxation, the taxes act purely as revenue raising devices whenever they are less then or equal to the implicit taxes irnposed by the licenses. The other difference between taxes and licenses is how the domestic price and exports change when demand and production costs change. The tnderlying changes are reflected immediately in prices facing agents when explicit taxes are used, whereas with licenses the changes are reflected in the value of the licenses. 58. The Russian Federation was the first to introduce explicit export taxes. This was in part, to raise revenue for the govemment budget, but also to restrict exports of primary products. The Gcvernment of Kyrgyz Republic retaliated in March 1993 by taxing many of its exports to the Russian Federation.' The tax rates vary widely across commodities ranging from 10 to 150 percent on Russian exports with an additional 10 to 50 percent imposed for barter exports, including several specific taxes denominated in ECUs. Some major commodities with prohibitive rates include honey (70 percent, 105 percent barter) and tobacco (100 percent, 150 percent barter). 7/ While there are political reasons for retaliating in this way it is not recognized by many Kyrgyz Govemment officials that this has potentially large economic costs. We detail these costs in section 3.3 below. Page 26 Krygyz Republic: External Trade Policy 59. There are no taxes on exports to other FSU countries, but they do apply to exports outside the FSU (third countries). Different tax rates apply, but in general they are higher on exports to the Russian Federation. There are two reasons for this; the first is that the taxes on Russian exports were a retaliatory measure, while the second is that taxes on non-CIS exports are for revenue purposes and there is a concern not to discourage non- Ruble hard currency earnings too greatly. The higher tax rates which apply to official barter exports are additional penalties on imports which cannot be obtained with hard currency due to the current problems with the payments mechanism. Barter is an important, albeit imperfect, means of payment being used by many enterprises to secure imported inputs for production. Such high discriminatory tax rates exaceroate the current trade problems. 60. Countries which surround Kyrgyz Republic do not at present tax their Russian exports, nor does Kyrgyz Republic tax its exports to other FSU countries. Consequently there is scope for Kyrgyz producers to avoid taxes on Russian exports by sourcing them indirectly through neighboring republics (i.e., by re-exporting them). This is only profitable if, (i) the licenses for re-exports through neighboring republics do not result in larger implicit taxes than the explicit taxes on direct Russian exports, and (ii) the transportation costs on re-exports are not too great. While there are no explicit taxes on exports between neighboring republics (except Russia) there was evidence of large uunofficial5 export taxes being applied at most borders. A number of traders reported they had to pay these "unofficial" taxes, sometimes in full view of customs officials. 61. Restrictions on exports ultimately reduce Kyrgyz Republic's capacity to import, and this means some enterprises cannot obtain inputs. They delay many of the desirable changes that should be flowing from the economic reforms, and lock down traditional production patterns. This taxes the national economy by delaying the efficiency gains which will accompany the restructuring program. Some examples illustrate the impact of the export restriction problem under the current Kyrgyz regime. In the case of tobacco, deliveries to processors of 17,700 tons at the official price resulted in revenu'es of $18 million compared with $32 million that likely could have been received on wo. ld markets and provided significant protection to the relevant processing industry. Ir the case of wool, domestic manufacturers of yarn, cloth and rugs receive a subsidy of aboui 20 percent on their input relative to parallel market prices. Assuming that wool represents about 45-65 percent of total costs, those manufacturers face a magnified effective protection rate of 36-52 percent. The effective protection rate would be much higher for cotton textife manufacturers where the implicit subsidy on cotton inputs is much higher.8 8/ For example, domestic inputs have been estimated roughly at 45 percent of total costs for a worsted woolen cloth manufacturer and 65 percent for a wool yarn manufacturer. Note that in the current policy environment it is not possible to make precise calculations. Page 27 Krygyz Republic: External Trade Policy 62. The origins of many of the export restrictions are in reaction to the imposition of export controls (including licensing and taxes) Retaliautin is by neighboring countries. Policy makers may ask whether it is counter- appropriate to follow a similar restrictive export policy. The productive preoccupation of Kyrgyz Republic and neighboring republics to secure imports of raw material supplies and intermediate inputs while, at the same, restricting their export have together contributed to the collapse of interrepublican and international trade. A reason for a small country not to follow a similar restrictive export policy is that when the goods are traded in international markets, the export tax falls directly on the domestic producer of the good and is a disincentive to export. For example, the Russian exporter of sheet metal to a Kyrgyz producer has had to sell at a fraction of the world price (70 percent) so that after the 50 percent export tax and 8 percent transport costs it is able to compete with the producer's alternative German source plus 10 percent transport costs and 5 percent customs duty. Another example is the Kyrgyz export of honey which sells at R3000 in Kyrgyz Republic and R4000 in Russia. With the imposition of a 100 percent export tax, it is no longer profitable for Kyrgyz Republic to export. The export tax falls on the exporter entirely. 63. Furthermore, high rates of export taxation are counterproductive to revenue objectives. Despite relatively high High rates mean taxes on all major exports, preliminary figures indicate they have low revenue raised very little revenue for the Government budget. In the first five months of 1993 export tax revenue is estimated to be 4,532 million Som, which is approximately 2 percent of the value of exports in the same period. There are three reasons for this. Firs+, a number of export transactions are exempt, including those under bilateral agreements. Secondly, very high tax rates dramatically reduce official exports, in fact, when commodities are subject to tax rates of 100 percent or more there are few, if any, official exports of the goods.9 Third, export taxes raise the incentive to uillegallyu export commodities. A rate of 5-10 percent on key commodities would be more transparent and more likely to collect the same, if not greater, level of revenue. 21 Kyrgyz honey sells at 3,000 rubles in Kyrgyz Republic and 4,000 rubles in Russia The 100 percent export tax on honey has eliminated Kyrgyz exports to Russia. Sometimes expofts occur when there are tax rates of 10o percent because they are the only available means of paying for impolts which are crucial inputs for some enterprises. Page 28 Krygyz Republic: External Trade Policy 64. The only case in which export taxes may not necessarily penalize exporters is when a country has a monopolistic or oligopotistic position in the world trade of a given commodity. In that case, there may be a case for imposing an export tax as a way of restricting supply and Is Mercury an extracting some monopoly rents from the rest of the world, but at exception? best, such calculations are difficult to make and, if resulting rates are high, again such taxes are difficult to enforce. For the Kyrgyz Republic the only commodities for which it is a major world producer are in the mineral sector, namely, mercury and possibly antimony, accounting for 20 percent and 15 percent, respectively, of total world consumption. This would not be sufficiently oligopolistic to justify an export tax, and optimal pricing policy should be analyzed in detail in the context of the overall marketing strategy for this mineral. Another justification sometimes given for export taxation is in the event of windfall profits. Since 1991 there has been a sharp real depreciation of the currency, first the ruble and then replaced by the som. However, given the time already elapsed since the real depreciation of the currency, any attempt to capture windfall gains through export taxation will have an impact on current production and investment needed to strengthen medium-term prospects. 65. There are few direct barriers to imports because the Continue to Government aims to minimize any restrictions on the supply of minimize raw materials and commodities from any source, as summarized barriers to in Table III.B.3. Imports from non-CIS countries are subject to low imports. rates of customs duties ranging between 5 and 15 percent of their value at world prices, and no customs duty is levied on imports from within the CIS. Exporters do not receive rebates for any duties paid on imported inputs, but the Government has indicated its intention to abolish these duties in the near future. By eliminating import duties there is a reduced incentive for particular industries to lobby the Government for protection from imports; fewer resources will be wasted on rent seeking. As long as rates remain relatively low, the amount of effective protection will not be high. But the absence of import duties on raw materials and capital goods alone in the presence of continued duties on processed and final goods exaggerates the impact of protecting domestic production and deterring production of competitive exports. Should any import duties remain on inputs, it is critical to protect the tax-free status of exports. Of the four main administrative instruments used in market economies, namely, duty exemption system, duty drawback system, in-bond system, and one or more export processing zones, experience in other small countries shows that the easier and more effective is a system based on exemptions (waivers) of import duties. The exemption is generally allowed automatically when the imported inputs arrive, based on either an export order the Page 29 Krygyz Republic: External Trade Policy enterprise has received or else an established exporting enterprises's export plan, using a formula and technical coefficients for export production. 66. Imports from all sources are subject to VAT, while all exports are exempt. To secure extra Government revenue by expanding the tax base, the VAT is now being levied as an expenditure type tax, rather than a tax on value added. It raises the consumer prices of importables and exportables, but leaves their producer prices unchanged. Accordingly there is no production distortion, and any consumption distortion is minimized when the tax is broadly based. Table Ill. B.3. BARRIERS TO IMPORTS IN 1993, AS SHARE OF IMPORTS TYPE OF RESTRICTION PERCENT OF IMPORTS a/ Bilateral Agreement b/ 93 of which Clearing 20 Arrangement c/ Customs duty (rariffs) d/ 7 Excise Tax 24 Note: a/ Weighted by Import Value In 1992. b/ Assuming 1993 protocols are fulfllxid. However, FSU Imports outside bilateral agreements are less likely to be recorded. c/ WIth Russia and Uzbekistan only. d/ Calculated as the light and food Industry share of non-FSU Imports. Source: Mission calculation, Annex Table III.B. 67. Another tax instrument where it is important to harmonize treatment of domestic production and trade is the excise taxes which are levied on a specified set of commodities. In a decree dated January 3, 1993 the Government raised excise tax rates Page 30 Krygyz Republic: External Trade Policy appreciably to generate additional revenue. The goods subject to the tax are alcoholic beverages (including Vodka, beer, champagne and wine), tobacco products, natural fur products, confectionery, carpets, oil processing products, automobiles and furniture sets. The rates are levied on the purchase price of imports and the pre-VAT wholesale prices of domestic production, and there are different rates for imports and locally manufactured commodities; but there are lower rates on imports, the reverse of a tariff on imports. For example, on January 3, 1993 the excise tax on domestically produced Vodka was amended to 100 percent of cost measured at selling prices, while the excise tax on imports of Vodka was set at 77 percent of the landed price. This additional tax on Kyrgyz production must be borne by producers rather than consumers because the domestic price of imports rises only by the excise tax on imports. 68. Some modest revenue objectives are, however, legitimate. Either export taxes or import tariffs have a similar impact. While most countries use import duties, there is no need for an immediate round of administrative and policy change away from the current reliance on export taxes. What is important is to avoid compounding discrimination against external trade through the use of both instruments. In particular, it would be advisable to avoid the high administrative costs that would be associated with Customs evaluating both exported and imported shipments. SUMMARY OF RECOMMENDATIONS AND RECENT PROGRESS: - Abolish export licensing system. As discussed in the Annex on agricultural marketing, take another critical look at the proposed six commodities to require export licenses and evaluate options for procurement regimes that can provide the necessary quantity assurances. Progress: Export licensing has been effectively abolished. Ucensing remains only for military goods, poisons, narcotics, works of art, precious metals and rare types of raw materials. e Revise export taxes downward to a low, preferably uniform rate, and in the medium term review them with a view to eliminating them in the context of a comprehensive tax reform. Strengthen the Customs service, with an emphasis on transparency and simplicity. The maximum export tax should be reduced further and consideration given to a minimum uniform export tax. Progress: The Government intends to eliminate export taxes with the exception of a few items, primarily food items such as bread and sugar but also silk worm, raw cotton, scrap metal, and rare animals. The maximum rate would be 30 percent with the exception of rare animals. Page 31 Krygyz Republic: External Trade Policy Eliminate import duties in the short term, not only on raw materials and capital goods but also on competing final goods to avoid high effective rates of protection to inefficient domestic industry. Such duties should only be introduced at a later stage for revenue purposes only. In that case, e simple tax rebate scheme should be established to exempt exporters from any t. KS on their inputs. Use excise taxes to tax both imported and domestic tobacl, alcoholic and !uxury consumption goods. Progrgss: Recently the Government abolished import duties, except for alcoholic beverages and tobacco products. The intention is to establish a simple tariff schedule. C. Exchange Regime 69. The Government of Kyrgyz Republic has made an important break with the past by introducing its own national currency. However, convertibility which is critical to trade expansion in a market economy is fragile and limited currently. In particular, the emergence of a dual-exchange rate system became one of the most important impediments to expanding exports and increasing foreign exchange earnings. While recent adjustments in management of the exchange regime have reduced the premium between the official and parallel exchange rate, further efforts are required to free up access to foreign exchange for importers combined with access to the market exchange rate for exporters. 70. Access to foreign exchange at the official ("auction") rate is rationed, with bank customers queuing, while there exists a free, parallel market alongside, with an exchange rate premium of about 20 percent.'° Nominally, the official value of the som against the dollar is determined by the free interplay of supply and demand in weekly auctions held by the National Bank of Kyrgyz Republic (NBK), but there are restrictions that limit demand at the auction including a ceiling on individual banks' bids, arbitrary ruling out of some bids by the NBK, and restricted access to licensed commercial banks which satisfy additional requirements. The dollars obtained by commercial banks in this manner are sold to their preferred customers with the banks' margin rarely exceeding 8 percent Hence most of the rents generated by the NBK's sale of cheap dollars are ultimately captured by these enterprises. The principle source of supply of dollars to the banking system is the NBK weekly auction. The official supply from exporters is negligible. 1 / For example, in September, the official selling rate stood at 5.9 som4 while the rate at exchange bureaus run by commercial banks was about 7 som4. This is a sharp reducUon from the premium of about 50 percent prevailing in June and July during the mission's visit. Page 32 Krygyz Republic: Fxernal Trade Policy 71. From a macroeconomic perspective, there are concerns about the extent to which the exchange rate in the short-run has Severe pressures depreciated excessively relative to the longer-run equilibrium on the exchange exchange rate for trade account purposes consistent with growth rate and balance of payments viability. Pressures on the parallel exchange market reflect the realities of the demand for the currency. For example, emigration and the resulting smaller population in Kyrgyz Republic implies a lower demand for domestic currency and a demand for cash rubles to be met. Other pressures include the remaining uncertainty with respect to som convertibility, inflation, lack of alternative domestic assets in which to hold wealth and the critical shortage of key imports into the economy. While the currency may appear undervalued at the prevailing exchange rate from a purchasing power parity perspective, it reflects the scarcity under the current difficult external circumstances. Without addressing underlying pressures, options which alter the basic market design of an exchange regime would be costly and not enforceable. The present regime of restricting access to the official exchange auction for trade transactions and tolerating the spillover of other trade account transactions into the parallel market dominated by capital account transactions is the most segmentation that should be envisaged. The rates between the two markets necessarily will need to remain close. Any attempt to defend a much less depreciated rate would merely exhaust scarce international reserves or require introduction of quantitative restrictions on access to foreign exchange for imports, which implicitly increase cost to importers anyway by encouraging rent-seeking activities. 72. Keeping the official rate attractive to exporters is critical to increase exports and the inflow of dollars into the banking sector. Keep rate close Exporters also are facing rising costs of production given current to the paralel inflationary conditions, and one expects the exchange regime to reflect those pressures. If exporters receive a below-market price for their foreign exchange earnings when they exchange them for som at the commercial banks, they naturally prefer to use the black market, or to leave their earnings outside Kyrgyz Republic. When these options are not available or they are too costly, they simply choose not export even though exporting would have been socially beneficial at a market-determined exchange rate. Hence, the authorities should strive for a unified exchange rate regime, keeping the managed rate close to the parallel rate. No doubt, a black market for foreign currency will continue to exist to satisfy demand for unofficial or underground transactions. The NBK need only be concerned when the gap gets too large, certainly no more than the current premium. As long as the government's conservative monetary and fiscal policies are maintained, there is iittle reason to expect that the black market rate would depreciate more than it already has (barring, of course, Page 33 Krygyz Republic: External Trade Policy further adverse shocks to the Kyrgyz economy). The market rate may even appreciate as inflationary expectations are quelled and the NBK's reputation is established. The government should not fear that a more liberal approach to foreign exchange and true current-account convertibility for the som will resuft in a continuous depreciation or a depletion of reserves. Quite to the contrary, nothing magnifies the demand for foreign currency today like the fear that its availability may be in doubt tomorrow or the day after tomorrow. Consequently, there is no better way to moderate demand for foreign currency than to establish a reputation that dollars will be freely available to importers at a market-clearing price. 73. Rather than obstruct the effective functioning of the foreign exchange market, the case can be made for greater international financial support during the difficult transition. This will prevent depreciation of the exchange rate much beyond its medium-term equilibrium and at the same time allow the authorities to manage a market-based exchange and trade regime. 74. The design of the exchange regime can be improved to avoid International detrimental consequences for the Kyrgyz economy, in general, and financial suppot for foreign trade in particular. vital to exchange rate management 75. Additional problems confront the non-dollar exchange regime. Improving the p- yments system for interrepublican trade is critica! to increase ava ability of the currencies required for interrepublican trade and re ice pressures on the som relative to the ruble. Given the recrnt introduction by the Kazakh and Uzbek authofities of their own currencies, the existing problems will be exacerbated and require immediate attention. Because of the uncertainties surrounding the ruble, it is understandable that the central bank is unwilling to take positions in that currency but it can still facilitate that market. The option of importers and exporters using dollars as the intermediary currency is a costly one. The financial services section recommends the establishment of a venue for non-dollar trading by interested parties with the facilitation of an impartial intermediary. This would include not only rubles but also the newly introduced currencies of neighboring countries. 76. Those enterprises with ownership or other links to licensed commercial banks are able to obtain dollars, and therefore they are encouraged to waste one of this economy's scarcest resources-foreign exchange. Meanwhile, many new agents, in particular, private traders critical to successful trade expansion are denied access to dollars because they do not have a privileged position as customers of the licensed commercial banks. One private businessman pointed out that he was lost in a vicious circle: his prospective Page 34 Krygyz Republic: External Trade Policy foreign partners did not want to sign an agreement with him until they had a guarantee that he would have access to dollars; but Access to without such a contract he was unable to furnish the documentary foreign evidence needed to enter a bid through a commercial bank, exchange needs Enterprise managers often expressed concerns about the lack of to be broadened inputs and demand for their products because they had no experience in importing or exporting commodities in world markets. A number of traders are establishing such experience including in imports of agricultural and industrial inputs; yet none of them had obtained foreign exchange at any of the auctions. For example, while the enterprises were unsuccessful, a trader recently found an alternative foreign source for a critical dye for the textile sector. Hence, the authorities should relax access to the foreign currency auctions. This could include measures to make it easier for individual banks to spoil any privileged access and opening the auction to other entiies besides commercial banks. Opening the auction to non-bank entities would also eliminate an anomaly in the present system: some importers are denied access to foreign currency because the financial weakness of their commercial banks prevents the latter from participating in the auctions, no matter how well-deserving importers' needs are. Finally, it is important that the NBK not disqualify bids arbitrarily on the grounds of weak or improper documentary evidence. To ensure foreign currency availability and build up confidence in the system, it is far better to err on the side of selling too many dollars than to render access to dollars unpredictable and erratic. The recent proposal to introduce exchange bureaus is a move in the right direction. 7 7. In addition to problems from the auction rate differing from Inconsistent the market rate, a further distortion arises from the exchange rate conversions used for purposes of bilateral agreements and state-controlled worsen cross- trade which do not always reflect the correct official rates and subsidization cross-rates. The three currencies used are: (i) dollar for the agreed price; (ii) rubles when setting procurement prices and (iii) som, the currency at which payments and inflows to the budget are realized. In many cases, the conversion of external (dollar, ruble) prices into domestic (som) prices is made at one point in time but either with reference to an exchange rate that no longer prevails or not recalculated periodically as the exchange rate changes. The one case where the adjustment into domestic currency terms is both made at the prevailing rate and adjusted periodically (quarterly) is for barter oil imports. It is only temporarily during the quarter until the next adjustment that there may be a greater degree of implicit cross-subsidization as the som price would remain fixed despite changes in the exchange rate. 78. However, for most imports and exports under state control, implicit cross- Page 35 Krygyz Republic: External Trade Policy subsidization is worsened. One, the ruble/som rate being used for calculations was 200 rubles/som. This was an approximate cross-rate assuming 1000 rubles/$ and 5 som/$, but the appropriate implicit rate given the depreciation of the som against the dollar is now 160 rubles/som, giving a higher som price for imports than that actually calculated. The implicit subsidization of the importer is greater than the static price calculations alone indicate. The conversion rates used by the MTMR and MOEF need to be adjusted regularly and reflect consistent cross-rates among the three currencies. Two, the producer price is announced early in the season. By the time of transaction, the prevailing domestic currency of the export would be much greater because of the likely nominal depreciation of the some against the dollar during the year. The implicit taxation of the exporter is greater than the static price calculations alone indicate. The government has been adjusting the domestic currency price during the year based on inflation and costs of production but without specific reference to the external market price. One option is to formalize the adjustment at time of purchase. * ** *** ***** * SUMMARY OF RECOMMENDATIONS AND RECENT PROGRESS Strive for a unified exchange rate regime, with the managed rate closer to the parallel rate, and convertibility of the som for trade purposes. Progress: Recently the spread between the commercial banks' exchange rates and the parallel market rates has virtually disappeared. Relax access to the foreign currency auctions, by making it easier for indiidual banks to spoil privileged access and/or opening the auction to non-bank entites. Progress: Since early 1994 access to foreign currency auctions has been widened and simplified to include participation by all foreign exchange bureaux without restriction and without regard to their financial posftion vis-a-vis commercial banks. e Make the case for greater international financial support during the difficult transition, so as to prevent depreciation of the exchange rate beyond its medium-term equilibrium. * Facilitate resolution of interrepublican payments problems (see financial services) and other constraints to financial stability. e Conversion rates should be updated regularly. Procurement prices should be Page 36 Krygyz Republic: Fxternal Trade Policy set in som rather than in rubles, to eliminate the distortions from inconsistent cross-exchange rates. Progress: Currency exchange rates are revised weekly by the National Bank and set in som. D. Export Promotion 79. Experience in other countries indicates that action in certain complementary areas is almost certain to be critically important for export growth in former socialist economies in transition. These are (1) suitable communications and transport links combined with simplified procedures for accessing those infrastructural services; (2) supporting financial services including smooth payments system and trade finance. Transport. Communication and Business Services 80. Kyrgyz Republic has a relatively well developed system of roads, railways and air links with most neighboring republics and China and road links with other southern neighbors via China. Firm managers claim the freight system copes quite well with large bulk shipments, especially where there is plenty of advance notice In the shipping schedule and time is not of the essence. Economic costs of rail transport for the Kyrgyz Republic are estimated at $.02 per km ton. Although this is much greater than the rates of $.005 and $.01 that are currently being charged per km ton in FSU and China, respectively, it should not prevent the competitiveness of many agricultural and mineral bulk exports. For example, the adjustment for rail charges from Kyrgyz Republic to Russia ports in economic terms to achieve export parity represent about 20 percent of world prices for tobacco and wool. 81. However, the transport system is unsuitable for smaller shipments and quick-response trade movements. In other words, the transport system suits the old, rather than the newly emerging, structure of production and trade. This implies the following - - -. ~ adjustments to transport policy. One, there will be a greater reliance on road traffic. Although its economic costs is estimated roads at $.05 per km ton, about triple the cost of rail, for non-bulk commodity trade it will be the most efficient. For example, a ________________ critical input that is imported quickly may prevent the shutting of production (as has been the case of a textile firm in the absence of a critical dye), or an export to fill a market niche may be worthless if it reaches the destination too late. The extemal road intrastructure is partly in place, with highways to Page 37 Krygyz Republic: External Trade Policy major centers in Kazakhstan and Uzbekistan and the Karakoram highway through China to Pakistan. The cost of road transport from Kyrgyz Republic along the Karakoram highway to the sea is estimated at $50 per ton. [confirm Crochet's numbers] Attention will need to be paid to maintaining such critical road links and developing others when viable. 82. Two, there will need to be a greater reliance on small transport companies, implying the need to focus immediate ... and divest the attention on selling companies off the transport assets of not only trucks to smaller the large trading but also those of large distressed enterprises so companies that they can be effectively reallocated to more dynamic sectors of the economy. It is important that competition is introduced in this sector so that capital investment is maintained and transport technologies are adapted to the needs of traders. This will give exporters (and importers) the competitive edge they need to compete in extemal markets. 83. How business is done is of the essence] Improvement of telecommunication links has made possible the rapid growth of How business is manufactured exports. The needs of this market change quickly. done is of the To share in that market, the Kyrgyz Republic will need dependable essence telephone, fax and cable linking main business and industrial areas with business centers around the world and to potential buyers and imports in major markets. Like other FSU republics, the Kyrgyz Republic is endowed with a sufficient minimal technical capacity. But in world manufacturing trade, contacts with foreign buyers, shortened response time for meeting orders, and quality control are more critical than technical innovation. Most exports from developing country firms are made to buyers' orders and detailed specifications; only a small share of exports from countries with low labor costs to leading market economies are based on the local firm's own product designs, even though socialist countries have a long history of trying to sell their products ready made. It is important that government policy not prevent traders and other enterprises from accessing the business services that may be needed Oargely from abroad - Chinese nationals have been particularly successful in this regard) to assist in transforming the way Kyrgyz manufacturing business is handled. 84. Since time is usually of the essence, rapid telecommunications are necessary but not sufficient. Transport and customs procedures so that imports for use in making exports can be delivered to the exporting enterprise within hours of their arrival at an Page 38 Krygyz Republic: Exteral Trade Policy airport or land frontier, and exports can be shipped promptly when ready. Trade facilitation experts can identify the steps to shorten the time required, but this generally calls for changes in practices in several areas, from military ir.tpections and public security (for example, delaying road traffic) to banking and finance. A committee for simplification has worked successfully in other countries, such as Morocco drawing on earlier experience in France and elsewhere. Trade procedures need to be speedy. Computerizing the country's documents and procedures for international trade and aligning its computerized documents with United Nations prototypes used by most developed countries can minimize the delay and processing costs of exports going to Europe or other advanced market economies. These advances should be easier in the Kyrgyz Republic by the availability of many skilled people with strong training in mathematics, science and engineering. 85. There already, is substantial knowledge of FSU markets, though it needs to be continually updated in a fast evolving market Spin off public situation. Also, much of that knowledge is contained in staff of market-making previously state trading companies and the MITMR itself, rather services than close to the producing enterprises which need to respond rapidly. To maximize utilization of knowledge of existing FSU markets while increasing market responsiveness, relevant components of the trading companies and MITMR (staff accompanied by basic communications equipment and premises) could usefully be spun off and converted into private trading companies. For example, in Estonia a substantial number of private trading companies have developed in the past year, many as spinoffs from the old state trading companies. Other parts of the MTMR could be spun off and join together to create a Commodities and Trading Exchange. Severance payments could be in the form of precisely the physical assets needed to succeed, for example, phones, fax and copying machines and office space. GIHHISESR~ 86. Finally, other services such as procurement agents, Need new shipping agents and freight forwarders, customs brokers, and services such as certification laboratories need to be supported by the authorities. freight The major policy would be not to impose any barriers on the forwarders development of such services, including in parallel and in competition with those provided by public bodies. The proposed spin-off from trading companies and MTMR could be one source of such services to be run on a commercial (and private) basis. Page 39 Krygyz Republic: External Trade Policy 2. Financial Services 87. In the medium-term financial services supporting external Interrepublican trade will become vital. Current problems with payments payments and arrangements need to be resolved quickly and, as noted above, non-dollar trade are important to the satisfactory operations of the exchange needs to be regime. Following introduction of the som, a number of facilitated adjustments needed to be made. One, the NBK entered into agreements with the central banks of its key FSU partners, namely, Uzbekistan (June 14, 1993), Kazakhstan (June 8, 1993) and Russia (July 1993) as well as Turkmenistan and Belarus at the time of the mission. The respective Governments also entered new arrangements to handle mutual obligations (direct government receipts and expenditures). Two, the most positive development for market trade is that a number of commercial banks are finalizing arrangements on direct correspondent accounts including in the CIS which will expedite payments. However, these are still inadequate particularly for interrepublican payments. Third, a number of Kyrgyz trading concerns accumulated cash balances in banks in other FSU countries, both rubles and dollars. These are mainly used for purchasing imports and restored through corresponding export sales. At the time of the mission, rubles in particular were scarce within the Kyrgyz Republic. (It is not known how much of these balances were in old cash rubles and, hence, how much disruption the recent limited Russian monetary reform had on the ability of those enterprises to effect payments.) A serious impediment to external trade is the continuing interrepublican payments difficulties. The reliance on decentralized correspondent bank accounts has not succeeded to date in completely resolving those difficulties. Difficulty of obtaining rubles for trade purposes is not only putting further pressure on the som but also encouraging traders to resort to barter transactions. Ruble trade is hampered by highly segmented markets and absence of a portfolio of various rubles held by the large financial institutions. Cash ruble trade is further hampered by lack of a framework for volume transactions. These problems will be exacerbated with the recent introduction of the Kazakh and Uzbek currencies. A significant portion of interrepublican trade appears to be settled on a barter basis. As noted, the breakdown in the interrepublican payments system is not the only reason for barter. It is a frequent officially-sanctioned mechanism for developing market channels outside the state order and purchase system. The recommendations on the exchange regime will further alleviate payments obstacles, including holding of foreign currency accounts by enterprises and traders to facilitate their trade payments and full convertibility of the som so as to provide access to foreign exchange via the auction for those clients wishing to import. But in addition, non-dollar trade needs to be facilitated by the authorities to overcome volume and segmentation imperfections of the existing arrangements. Such a facilitation role can be played by developing a forum and Page 40 Krygyz Republic: External Trade Policy establishing a venue for non-dollar trading by interested parties with the facilitation of an impartial intermediary. This would include not only rubles but also the newly introduced currencies of neighboring countries. If the central bank were to play that role of intermediary, it need not take open positions in the non-dollar the various currencies nor participate in the trading directly. 88. With the collapse of the payments system and indiscipline associated with interrepublican interenterprise arrears, trade has Start building resorted to primitive methods of payments largely through pre- capability to payment. While building institutions to provide risk coverage in -cover trade risk trade will take time, the existing system of commercial banks are now beginning to provide documentary collection and credit. Risk :_______________ coverage provided by these instruments is of particular important in a country where many enterprises have a number of recent business relationships, where the financial status of most enterprises is uncertain, where interrepublican trade is complicated by political relations and where the legal system is underdeveloped. Broader reliance on these methods in trade with non-FSU partners will enhance the competitiveness of Kyrgyz non-traditional exports, save some foreign exchange for importers and reduce the incentive for capital flight needed to build up enterprises' own foreign currency accounts abroad for trade transactions. 89. It is also important to begin developing a policy framework that facilitates the introduction and/or development of pre- and post-shipment export finance. The most important finance for exports in the short run is preshipment credit for working capital. Preshipment finance is composed of production finance, inventory finance, import finance and domestic input purchase finance. Loans for this purpose could be encouraged by central bank directives and made more attractive to commercial banks. The emphasis should be implementing a rediscounting mechanism by National Bank of the Kyrgyz Republic for preshipment export loans granted by commercial banks. In order to have confidence that only performing loans are rediscounted, the central bank should rediscount only those loans backed by export letters of credit, bills of exchange and other negotiable instruments. At first, while the data bank of foreign borrowers is being developed, the bank could rediscount only those commercial papers confirmed by reputable foreign banks or backed by their letters of guarantees. But more than a few countries impede credit for exports by trying to make it artificially cheap; it is important that any such facilities use market-based rates. Also, improving access to working capital in general (of which a part may be allocated for export production by the relevant bank client) as well as pre-shipment finance in particular is critical at this stage of development of the financial sector in the Kyrgyz Republic. Clearly the efforts to contain the financial resources directed to low-potential high-distress SOEs are the most important for Page 41 Krygyz Republic: External Trade Policy releasing funds. The commercial banks are joint-stock companies whose shares are largely held by their important customers, frequently giving rise to these enterprises having favorable access to foreign currency and credit at subsidized rates of interest. The broader issues of financial sector reform, including bank supervision and interest rate policy, are relevant. SUMMARY OF RECOMMENDATIONS AND RECENT PROGRESS: To facilitate the development of responsive road transport, highlight the divestment of transport assets in enterprise restructuring. o Eliminate unnecessary delays in trade flows, for example, by simplifying and aligning trade documentation and removing, but also other financial and security delays. o Spin off market-making services of MTMR, convert into private trading companies and remove barriers to entry of other providers of services including commodities traders, procurement agents, shipping agents and freight forwarders, customs brokers, and certification laboratories. o Investigate the possibility of establishing a venue for non-dollar trading with the facilitation of an impartial intermediary. This would investigate the possibility of establishing a venue for non-dollar trading by interested parties with the facilitation of an impartial intermediary. This would include not only rubles but also the newly-introduced currencies of neighboring countries. If the central bank were to play that role of intermediary, it would not need to take open positions. Progress: The National Bank and commercial banks are studying the possibility of creating a mechanism for nondollar trade, both ruble transactions and transactions in national currencies of neighboring countries. o Encourage development of export finance through preparation for the introduction of a rediscounting mechanism by National Bank of the Kyrgyz Republic for preshipment export loans granted by commercial banks backed by export letters of credit, bills of exchange and other negotiable instruments. Continue efforts to improve access to working capital in general through financial sector reform, including containment of the financial resources directed to iow-potential high-distress SOEs, bank supervision and interest rate policy. Page*2******* Page 42 Krygyz Republic: External Trade Policy B. Other Trade Relations 90. The detrimental effects that result from export cor.trols and other trade impediments have been recognized, by the OECD and its traditional trading partners, recently by other republics of the FSU, and by other neighboring trading partners. Kyrgyz Republic has yet to initiate efforts to gain from the existing multilateral trade framework. At the same time, it is being approached by other bilateral and regional trading partners to enter into agreements so as to provide a framework for trade. 91. The major framework for multilateral trade is the General Agreement on Tariffs and Trade (GATT). The Kyrgyz Republic would benefit from joining on several grounds. One is through Seek to join familiarization with the set of rules governing commercial policies GATT of member nations which represent the bulk of world trade. immediately Another is by becoming eligible to preferential tariffs imposed on imports into a wide range of potential future partners. This can be negotiated in the framework of Most Favorable Nation Status (MFN), which means that any advantage trade policy applied to another country be immediately and unconditionally applied in the same way to all other GATT contracting parties. Kyrgyz Republic would claim from GATT members reciprocal tariff structure for its commodities, similar to the current low tariffs the country applies to the rest of the world. Third, with much to gain in terms of market access, the Kyrgyz Republic also will gain from playing by GATT rules and ensuring its trade policies continue to not restrict imports. Finally, the country would have access to the forum in which international disputes over commercial policy can be mediated. 92. GATT was devised to provide a framework for multilateral tariff bargaining sessions. The negotiations take place by rounds of topics, the first five of these (1947-58), consisted of simultaneous batteries of bilateral negotiations of tariff reductions. Later, the Kennedy Round was the first multilateral tariff bargaining, completed in 1967, departing from bilateral bargaining in that suppliers of industrial countries agreed on the target of an across the board 50 percent cut in all tariff rates. This round was the most sweeping tariff reduction and provides one of the immediate benefits of membership: access to preferential treatment from the rest of the members. The Tokyo Round (1973-79) approached the problem of non-tariff barriers to trade (NTB), although with little success. Hence, the current Uruguay round, which ends in mid-December, has aimed not only to reduce tariffs but NTBs as well--the so called 'zero for zero' approach. The efforts are concentrated in a group of products including pharmaceutical, construction equipment, textiles, medical equipment, steel, furniture, farm equipment, beer and spirits. Additionally, Europe may be giving grounds on electronic industries which are also in the republic's interest. NTBs are not currently affecting Kyrgyz Republic major exports, i.e. wool and Page 43 Krygyz Republic. External Trade Policy tobacco, but they would certainly undermine future development of non-traditional exports. Reduction in NTBs facing Kyrgyz exports will encourage trade with the rest of the world. 93. The OECD offers General System of Preferences (GSP) benefits, an exception to the GATT MFN principle, to accord even lower tariff rates for imports into industrial countries from developing countries. The advantage of GSP tariff rates over the MFN levels tends to be modest. However, the extension of GSP to previously planned economies has varied considerably among the OECD member countries given the flexibility of both the concept of 'developing country' and the way the program is implemented. The GSP option would need to be explored bilaterally, such as with the EC, US and Japan, to see what it offers additionally to GATT in the particular case of the Kyrgyz Republic. 94. To the extent possible, Kyrgyz authorities should avoid committing themselves in full to any single regional economic Refuse to grouping, while maintaining good relationships with all. As a small, choose open economy, it is imperative that Kyrgyz Republic be able to trade among freely in a multilateral setting. Exclusive orientation of trade towards regional any specific group of trade partners is undesirable because it will limit groupings options and potentially deny access to more dynamic markets. At the same time the Kyrgyz Republic cannot afford to be left out of any significant regional grouping. The government should ensure that it maintains good economic and political relations with all such groupings. 95. Currently, Kyrgyz Republic is a member of the Economic Cooperation Organization, which seeks to further economic ties between Muslim countries (Turkey, Iran, Pakistan, Afghanistan and five republics of the FSU). This should not conflict with its membership in the CIS. The Kyrgyz authorities should resist any attempt to make them choose between these two groupings. Initial steps have been taken with respect to the recently announced tripartie economic union among Russia, Ukraine and Belarus and other options for relations with Russia (such as the new ruble zone) to move them beyond intention to reality. Kyrgyz Republic should continue to negotiate membership in the associated free-trade union. Just possibly, the republic's small size may spare it from political pressure to uchoose sidesu in a way that a larger republic would not be. Kazakhstan and China have discussed turning their common border, which stretches 1700 kilometers, into a free economic zone. Kyrgyz Republic already trades with China and is also negotiating the possibility of making their common border a free trade zone. There are clear economic benefits from freer trade with all and any of these units. Rather Page 44 Krygyz Republic: External Trade Policy than trying to promote particular trade patterns the Government seek to develop free trade agreements wth as many countries as it can while continuing the process of economic reform, including unilateral lowering of as many existing barriers to trade as is possible. Again, because of size, the Kyrgyz Republic's ability to extract concessions in exchange for lowering its own barriers is minimal. **** ***** SUMMARY OF RECOMMENDATIONS AND RECENT PROGRESS: Apply to join GATT immediately. Explore options for eligibility for GSP benefits. Progress: The Government intends to apply for observer status and eventual membership in GATT. Participate in as many free trade zones as possible, including in the context of both the CIS and ECO, and resist any pressures to impose high common external barriers in the process. IV. OTHER INDIRECT INCENTIVES 96. A number of other factors are having a negative impact on trade as important as the direct factors identified above. In particular, we identify those factors which are constraining the operating activities of representative producing and trading enterprises from contributing to robust external trade. A. Property Rights 97. It is important, where feasible, that resources be transferred to private ownership for private sector reallocation to occur. Property rights must be clearly defined and enforceable under law if mutually agreed commodity trades and private capital investments are going to occur. Kyrgyz Republic is undertaking an ambitious program to privatize a large proportion of its state-owned enterprises, but while the quantity of privatization has been impressive, the quality of privatization has not been. It is critical improve the kind of privatization so as to establish incentives to adopt new technologies and management techniques for competing in international markets. Foreign ownership, and foreign investment, are important for not only modernization and new efficient technologies but also the establishment of quality control and contacts with foreign buyers Page 45 Krygyz Republic: External Trade Policy which are critical to the export promotion effort. A major impediment to foreign investment is the lack of any long-term property right assignment over land, particularly commercial and industrial but also agricultural. Only short-term leases are offered, and they can be withdrawn at short notice. Hence, most foreign investment to date has been in tangible assets, like patents to technologies, which are separable from land and can easily be removed. Hence, property rights should be assigned to land. 98. A stable legal framework must be established very quickly to protect and define the transfer of property rights in financial assets, land and other real resources. Many laws are enacted or changed frequently, and this creates uncertainty which deters capital investment. Tax and commercial laws are changed so often that business managers complain they cannot keep pace with them. Often the legislative changes have unanticipated effects because they have not been analyzed carefully enough. *** * ** ** **** SUMMARY OF RECOMMENDATIONS AND RECENT PROGRESS Efforts to clarify property rights, including improving the quality of privatization and assigning property rights to commercial and industrial land, should be accelerated. Progress: Changes to strengthen the privatization process were adopted in December 1993. B. Barriers to Entry -- Enabling Environment for Traders 99. The freedom of firms to enter and leave industries plays the crucial role of moving resources to their most profitable uses, including for export production. An effective approach to increased competition in the Kyrgyz economy would be to reduce the impediments which traders face in bringing in competing imports (or likewise impediments which new competing producers face). Hence, it is important to reduce barriers to entry and facilitate exit. All firms must be registered, and this process is costly and takes considerable time. Final approval is at the discretion of the Local Committee of People's Deputies who will deny registration if they decide the activities will not be profitable. Entry is restricted to a specified number of activities, and the number of entrants may be restricted within these activities. Financial flows to enterprises are highly distorted in ways Page 46 Krygyz Republic: External Trade Policy that also restrict entry. First, state-owned enterprises continue to receive the vast majority of financing, in some cases at subsidized rates of interest. Second, a number of existing enterprises get subsidized credit as major shareholders and customers in privatized commercial banks. Clearly, these financing patterns underwrite the traditional structure of production and disadvantages new entrants into existing and new activities which are critical for improved export performance. For exit, the recently promulgated bankruptcy legislation is an important step. 100. Perhaps the most harmful barriers to entry apply to private trading. These are relatively profitable activities because they are under-represented at the present time. Retail trading enterprises registered with the authorities grew in total from 8,937 1991 to 9,442 in 1992. Among these, there was a marked shift towards private ownership. Ownership 1991 1992 State 3801 3228 Consumer Coops 5117 4905 Joint-stock 4 85 Collective and Privatized 11 632 New Private 0 468 New Cooperatives 8 26 Other 0 183 However, the policy environment is not trader-friendly. Traders pay 53 percent profits tax while producers only pay 30 percent. A recent decree limits the trade margin of private traders to 25 percent. If they exceed this figure they will be penalized by the tax authorities or good confiscated. Many traders have rental costs alone which exceed 25 percent. Traders are also required to deposit all cash takings daily and are forbidden to make cash payments for the goods and services they buy. Simple presumptive tax procedures are preferable ways to minimize tax avoidance. Further proposals for imposing draconian constraints on private traders were under consideration, including strngent licensing requirements. Page 47 Krygyz Republic: External Trade Policy SUMMARY OF RECOMMENDATIONS AND RECENT PROGRESS o Financial sector measures which ensure flow of funds to new and proftable enterprises should be strengthened. o Forthcoming legislation relating to entrepreneurship should take a neutral stance with regard to trading activities relative to production activities. O Registration requirements for new firms and traders should be simplified. In market economies, consumer information plays the central role in quality control and any health or related concerns are handled by the relevant authority. Progress: Business registration has been simplified. ' The government should consider equalizing the profit tax rate on private traders with that of other businesses. o The limit on trading margins which was introduced as temporary anyway should be abolished immediately. There is distaste for "excessive" profits which is a carry over from the planned economy where profits were strictly regulated. In a market economy profits attract entry, while sustained losses drive firms into alternative activiies. They are an important signal which drives resource allocation. If they are regulated the resource flows are disrupted. The most powerful instrument for countering inflationary expectations is continued attention to credit policy. Progress: In November 1993 trade margin controls were eliminated with the exception of several food products, and the Government intends to life remaining margin controls with the exception of bread. * Tax reports should be required as regularly as they are for all other enterprises and tax inspections should be limited to irregular audits. * The requirement to deposit all cash takings on a daily basis and to prohibit cash purchases of merchandise should be eliminated. o Private traders should have equal access to foreign exchange and export licenses. Progress: As noted, access to foreign exchange has been broadened and export licenses eliminated. ************* Page 48 Krygyz Republic: External 7rade Policy C. Price and Competition Policy 101. Given the highly interdependent and concentrated industrial structure of the FSU, the government is concerned with thwarting monopoly pricing. However, the threat of competition including that from imports is a critical element of market economies' competition policies, rather than price control except in certain cases. While the Government eliminated price controls in January 1992, with only the prices of a few commodities subject to control (bread, milk, poultry, vodka, transport and rent), the Anti- Monopoly and Pricing Commission (AMC) sets prices of commodities produced by enterprises considered monopolies. The choice of 35 percent or more of domestic sales as the criteria for regulation by the Anti-Monopoly and Pricing Commission (AMC) is too low even without competition through trade and irrelevant as a measure of monopoly power for most industrial products which can be imported, even i not from neighboring republics. The failure to take into account trade is particularly misleading in the definition of monopolies defined at an oblast level. In market economies, with the exception of natural monopolies such as utilities, no anti-monopoly actions are taken until proven rather than the current Kyrgyz policy of presumption of monopoly power until proven otherwise. Exemptions appear to be granted to firms which export most of their output which is appropriate. Another bias toward excessive mo.aopoly regulation is the inability of separating Kyrgyz enterprise accounts to make any anti-monopoly charge product- specific as is the case in market economies. 102. A more effective approach to increased competition in the Kyrgyz economy would be to reduce the impediments which traders face in bringing in those competing imports (or likewise impediments which new competing producers face). Competition from imports is currently limited by the tariffs which are levied on them, and by the trade restrictions applying to exports; the laKter being more significant. Taxes and quantitative restrictions on exports lowers their prices relative to the prices of imported goods in just the same way tariffs on imports. * ** * *** ***** * SUMMARY OF RECOMMENDATIONS AND RECENT PROGRESS The government's desire to strengthen competition and anti-monopoly policy should focus on minimal regulation and analysis which places greater weight on import competition. The 35 percent test of monopoly power is too restrictive and should be amended to take into account competition from imports and potential competition from new entrants. Recent progress: The number of enterprises classified as monopolies and subject to direct price controls was reduced to 15, and the Government intends to reduce the number further in Page 49 Krygyz Republic: External Trade Policy mid-1994. 0 Monopoly regulation should be product-specific and not enterprise-specific. o With the exception of natural monopolies such as utilities, no monopoly regulation should be initiated until a complaint demonstrating the possibility of market power is submitted. o The government should reduce impediments to traders, resulting in greater flows of ccmpeting imports, discussed in greater detail above. D. Taxation 103. Business firms must pay a large variety of taxes and meet other financial obligations to the state. There are three main taxes: (1) a profits tax - which is 53 percent for private traders and 30 percent for other private enterprises (and additional tax of 15 percent levied when paid as dividends and interest); (2) a value added tax (VAT) of 20 percent - which is currently levied on price rather than value added (exports are exempt from the VAT); and, (3) excise tax - which applies to a specified list of commodities - it is essentially a tax on imported commodities, and is a percentage of the purchase price; the excise tax rates are higher on domestic production than they are on imports. A large number of smaller taxes must also be paid by business firms. They include: road tax which ranges from 0.08% to 0.8% of gross turnover (the rate depends on the sector); land tax of 1.0% on gross turnover; land-use tax of 2.0% of fixed assets; forced majore of 1.5% of gross tumover; geological exploration tax of 0.2% of gross tumover; plus an ecological tax. In addition to these taxes firms must contribute between 26 and 37 percent of their payroll to social insurance and pension funds. The Council of Entrepreneurs is seeking to have a number of these taxes collapsed into a single business tax. Under a law on foreign investment tax concessions are granted for foreign capital. Firms which receive in excess of 20 percent of their capital as foreign currency are granted tax exemptions of between 5 to 10 years on 25 to 50 percent of profit. The tax exemptions increase wth time and the amount of foreign capital invested. 104. One firm estimated that the sum of these taxes, excluding social insurance and pension fund contributions, were equivalent to a 65 percent tax on profit There are too many individual tax rates and frequent changes to the rates and tax bases which makes it difficult for firms to determine their tax liabilities. To add to these problems, private traders must submit tax reports every three months and their records are regularly Page 50 Krjygyz Republic: Ertemnal Trade Policy inspected. Tax officers are overly concerned with compliance, and are vigorous in their pursuit of firms which do not meet their tax liabilities, particularly private traders. The tax system is biased against private traders in favor of "productive activities". 105. Given the fiscal pressures that will continue in the transition, any solid source of government revenue should be exploited. Hence, the VAT and income tax system will need to carry the major t-urden for raising revenues, but the base will need to be broadened and the systemn implemented in a reasonably transparent and efficient manner. This is also essential to resist pressures to impose excessive trade taxes that will jeopardize export growth and trade efficiency. * ** * ******* SUMMARY OF RECOMMENDATIONS AND RECENT PROGRESS in the context of a comprehensive tax review, the large number of dffferent taxes levied on enterprises should be rationalized. There should be more uniformity in the tax rates applied to income and expenditure, and less discretion in the way they are applied. Administrative measures for broadening the base to enable lowering the rates should be explored. * Efforts should be made to reduce labor taxes and eliminate other impediments to flexible hiring and firing of labor. 106. In combination with the trade-specific measures recommended, these policy directions would move the Kyrgyz Republic a long way towards meeting both its short- term trade exigencies and its medium-term trade vision. Page 51 ArrLx Table 1.1 Recet Export Perforv=o mid Cose3ition In KyrYg Rombtic EXCHAGE RATES EXPORTS 8T Aceow- Average Total FSU lal 00*f0SU(b) Totat fJU Eln 4-FSUCW time warket SET OF ASSWIPTlIiNS t Cc] (I an iiLiQn of rubias} 1987 0.6 0.6 2326 2269 55 350M 278t 723 1Q88 0.6 0.6 2596 257 59 3765 22 7 198 0.6 8.9 2600 2549 51 4296 3U 3 199 0.6 ¶8.8 26" 2446 53 4246 3179 1047 1991 1.8 S9.8 654? 6506 41 67 540 1316 1992 66.4 222.1 52742 4630 64 0572 67407 3MM5 1993-1 245.8 572.6 2676 21125 5660 32947 28 420 1993i 570.6 749.1 92050 680B 23967 1Z3524 108949 14675 (In Ditiwo of US dot rea) 1987 3810 3720 90 5764 4559 115 1988 4256 4159 9T 6139 482 167 1989 4262 4179 84 703 5511 1531 1990 4097 4010 87 6961 5211 1749 1991 3741 3718 23 3876 3091 783 1992 795 698 9? 1063 1016 48 1993-! 109 23 134 117 17 1993-11 161 119 42 216 191 26 (In percmt of tho total) 1987 100 97.6 2.4 ¶00 79.4 20.6 1988 100 97.7 2.3 100 79.4 20.6 1989 100 98.0 2.0 100 78.3 21.7 1990 100 97.9 2.1 100 74.9 25.1 1991 100 99.4 0.6 100 79.7 20.3 1992 100 87.8 12.2 100 95.5 4.5 1993-1 100 78.9 21.1 100 87.2 12.8 1993-11 100 74.0 26.0 100 88.1 11.9 .. __.._ ....... ... ....______.___.............._._._._................... .... ....... _._.._........... SET OF ASSW.DITIONS 2 tCd (In millfon of nbles) 1987 0.6 0.6 2326 2269 57 3531 2781 750 1988 0.6 0.6 2596 2537 59 3742 2972 770 1989 0.6 8.9 3293 2549 744 16989 3362 13627 1990 0.6 18.8 4079 2446 1633 36064 3179 32885 1991 1.8 59.8 7Ya7 6506 1401 52361 5409 46952 1992 66.4 2.1 67924 46301 21623 77999 67407 10592 19S3-1 245.8 572.6 26764 21125 13137 32947 28738 9805 1993-11 570.6 749.1 99544 68083 31461 123112 108849 19264 (In millions of US dotlars) 1987 3676 3586 90 5580 4395 1185 1988 4269 4173 97 6155 4888 1267 1989 370 286 84 1909 378 1531 1990 217 130 87 1918 169 174Q 1991 132 109 23 876 90 783 1992 306 208 97 351 303 48 1993-I 60 37 23 67 50 17 1993-1l 133 91 42 171 145 26 (in percent of the total) 1987 100 97.5 2.5 100 73.8 21.2 - 1988 100 97.7 2.3 ¶00 79.4 20.6 1989 100 77.4 22.6 100 19.8 80.2 1990 100 60.0 44.0 100 8.8 91.2 1991 100 82.3 17.7 100 10.3 89.7 1992 100 68.2 31.8 100 86.4 13.6 1993-! 100 61.7 38.3 100 74.6 25.4 1993-il 100 68.4 31.6 100 85.0 15.0 NOTES: Cal: FStl official date is repoted in rubles, the teo scemrios in the table desl with fts vatuation fn dollars. Lb]: The orisinl value In dollars of ron-FSU trade is recovered, approxicstely, by using awvA aceamting exchange rates. The to scenarios in the table deal with Its ruble valustion. Cc]: The first scenario asws5s the relevent exchange rate for alL the data is tho mccomttins rate. td: The second *c rio use mrket exchange rates to cam.*r FSU data from rubles to dollars *nd non-FsU date fran dollars to rubies. Paoe 52 Annrx Tabte IZI.A.l: ltw& Detiveries b Cteering Arrang2tes In Dittoin of Current "ibtOo 1992 SHARE 1f9 S (ActuaL) (Agred as of Jan*-693) EXPORTS BY AGREENIIT 46301.2 100.0% 31507.6 100.02 Russia 18096.7 39.1% 15734.1 42.42 Kazakhatan 10352.4 22.4X 919S.0 24.82 Ukrnine am.1 17.3% 4012.5 10.8Z Uzb2kiatan 4796.3 10.4% 3644.3 9.32 Batarue 1385.4 3.02 94.5 2.5% Turbineetan 1126.6 2.6% 1923.4 5.22 LIthuain 692.1 1.5S 22?.5 0.62 Tadilkistan 646.9 1.4Z 358.9 1.02 Azerbei jan 397.0 0.9% 1f66.5 3.15 Moldova 263.3 0.62 101.1 0.32 Georgia 191.4 0.4b 36.9 8,1 Latvia 124.8 0.3Z ArWnio 109.9 0.2Z 6.9 0.02 Estonia 105.9 0.2Z -- IMPORTS BY ACGEEIENT 66910.2 100.0Z 62229.4 100.02 Russia 32641.1 48.82 21900.0 35.22 Kazakhstan 15583.1 23.31 22234.0 35.72 Uzbokistan 6136.3 9.22 14868.0 23.9% Ukraine 5478.1 8.22 1190.2 1.9% Turkmenistan 4105.4 6.1Z 715.5 1.12 Betarus 1033.4 1.55 378.6 0.62 TadJikistan 461.7 0.72 330.8 0.32 Motdova 349.0 0.52 48.6 0.12 Azerbaijan 327.1 0.52 61.5 0.12 Georgia 300.5 0.42 3.2 0.02 Lithuania 215.6 0.3 4699.1 0.12 Latvia 153.2 0.22 Armnia 9S.1 0.1% n.1 0. Estonia 30.6 0.02 SaORCE: Ministry of Trade. Page 53 Anrmx Tb^to III.A.2: Clearing Arrai =t Fof 1993 end COPneon with 199I TPt43 Agreed iat for 1993 Tre 1tio of equivoent euoditeioo during 1992 th. to Pr. U5 Vfilu til. tW3 MX C = 0I TT (1) (2) (3) (4) M1A1(O) (5) IMPORTS FRI RUSSIA Automobile goalr; 250 200 50.0 296 84.5X 4133 OloseL fugt 70 160 11.2 342 20.52 576f FaL zil 160 8 12.8 496 32A1Z 2908 Tiabor 290 100 79.0 at1L 133.0% " Rnt ohtuminifu . 3 1220 3.1 1 226.5X 11s Rofined coppr0 3 2200 6.6 5 58.0% 669 Ferrouas eanljt 60 214 12.S - 5S86 StoQl tubos 20 332 6.6 29 67.9% 527 IMPORTS FROM UZBEKISTANi Naturel Gas EW 700 48 33.60 1815 38.62 4461 Rolled Sheets 20 230 4.60 157 12.n 2280 Cact Iron Tibesa 460 0.9 0.41 5264 8.7% 57 Motlybenum t cJ 102 20 2.04 . 7Z otoIT rolled shoots 7 110 0.77 ... ... Hard ALloYS OK 2 70 0.14 Hard Alloys TB 2.3 60 0.14 N-fertilizer 10 96.5 0.97 74 13.42 281 P-fertilizer 7 130 0.91 76 9.2% 639 Cable articles 11000 22 Power cable 100 16 1.60 -- Hose CabLe 100 1.34 0.13 Rose Wire 100 0.9 0.09 Controt cabLo 100 0.9 0.09 --- ... TOTAL IMPORTS 18 27067 0/ti Russia 133 EXPORTs TO RUSSIA Antimony, matal 7.6 1749 13.3 14 59.1Z 2331 Metal mercury 0.3 4350 1.4 0.5 162.6% 391 Cotton fibre 5 1136 :.7 6 111.8% 377 Wool 5 4500 22.5 7 69.72 2418 Wool yarn 1 9000 9.0 3 39.1t 228 Tobacco raw material 25 3000 75.0 34 73.3% 2321 Non-ferrous Scrap df 3 1980 5.9 -.- --- 2629 EXPORTS TO UZBEKISTAN Scrap 45.6 86.6 3.95 186 Non-ferrous Scrap 1.8 730 1.35 -- Monocrystat Silic Sf02 0.2 80 0.02 Antimony 0.8 1.48 0.00 ... --- ... Dioxide Cerium 0.7 200 0.16 1 .. 'mercury - 0.5 4.35 0.00 ... ... --- Enamailed Wire 2132 6 8.53 --- Products of Electric industry 5031 Electric Motor 13221 0.26 3.46 74408 17.82 287 Electric lanS 25000 0.5 12.50 238089 10.5 1403 slitchers 20 98 1.96 -. Magnetic Starters 25.8 62 1.60 660 3.9Z 151 Food Industry Fat TedcnicaL 115 0.19 0.02 59S Butter 1 1500 1.50 --- --- ... Starch aotassas 5000 0.072 0.36 14119 35.62 383 Beef extract 500 0.0048 0.00 . . -.-- . Mutton 5 900 4.50 3 159.2% 197 TOTAL EXPORTS 173 17088 O/N Russis 133 (al: thmand cubic moters. (bI: sillion eubIe m (c]: laports of other prodcts of non-ferrouA metallurgy. SOACE: Ministry of Tra &n Roskstat. Page 54 ANNEX TABLE UII.8. - Kyrg RepFlLc, EAport M Import Rotritclrnm bY C icy, JuLY 1' 1992 Share in Expert liconce ...-Export ta... Ezioo Cte4rire Major Code Categories INP0L1TS EXPORTS ----- RUSSIA lIES? Tax Arrugc=nt Codity cis tO-CItS CSM. ..O............ CeI (M (XEur) (S or EOJUten () (t: RuQSie llhk. Totat in tiltiom of eulo3 70572 5Z762 0/u interr"eplfc: 96Z 88Z Wool products 75000 1.0 15.6 X X E -Washed -goal 0.0 4.6 X X 100 10 70 E -Wool Yarn 0.0 4.3 X X ¶00 150 70 B -WOl emteriet °.O ZJ. X X 20 -Rugs, Carpota 0.0 4.0 X ¶0 Vehicles 4100 11,8 ¶1.0 X -Cargo-vehictes 0.0 7.5 X 10 -Automobi les 9.5 0.0 Nonferrous metals aJ 14000 3.5 10.7 X X CC: I to f-^O 50 E -Antimony 0.0 4.4 70 £ E -Others (incl.unrcury) b/ 0.0 5.0 X ccu I to 150 ¶o-0 E-1 E -Rare mutats 0.0 X X E E Electric engineerin 32000 1.5 9.S 5 Etectric powar 1001 0.0 5.8 Agric. machinery 4;QQQ 0.8 5.0 -Parts for maintennc 0.0 2.0 X Cottes! products 73000 2.2 6.9 x X E -Cotton matoriale 0.8 3.7 X X -Cotton fiber 0.9 0.0 X X t00 150 30 E -Cotton yarn 0.3 0.0 x X ocu: 208 - 312 25 Tobacco prods. 89000 0.4 6.5 X X 100 150 75 E -Fermented Tobacco 0.0 4.4 X X 10 E -Cigarrettes 0.0 0.0 X X 45 E Cables 33000 0.3 2.1 £ -Wires Cuinding and orm=ltod) 0.0 1.9 E Coal 500 3.0 1.9 x X ecu- 6 to 6 10 Clothing 79000 1.0 1.6 X Glass e ceramics 72000 0.2 1.6 X Crops 101000 5.8 1.4 -Grain (mostly ehoat) 6.9 0.0 x X 70 105 50 -Grapes, Fruits end be-ries 0.0 0.0 30 -Vegetables (fresh ard processed) 0.0 0.9 30 Ferrous metals 9000 5. 1.0 X X Gcu: 25 to 38 50 1 I Other industrial producta 100000 0.7 1.0 Sitk products 76000 0.5 0.9 X 70 -Silk Cocoonw 0_0 0.0 X X 100 150 -Silk yarn 0.0 0.0 X ocu:1o00 to 1500 30 Household appifances 50000 0.4 0.9 10 E Other food industry cf 90o00 0.8 0.7 X 15 Z3 1 Petrelejn, refined 3000 21.6 0.1 X X ecu. 30 to 120 30 10 I Natural gas pruc icts 6000 6.3 0.0 X X 30 1 Bearings 42242 Z.9 0.0 l0 10 Chemicals dI 16000 3.0 O.S 30 1 t -Nutrition ubstantee 1.6 0.0 cu: 103 to 153 -Potessius fertilizer a/ 0.9 0.0 ecu: 500 to 750 30 1 Chemical fibers 17046 1.8 0.0 1S 23 Light ind. equip. 46000 1.7 0.0 -Technicat equip. for cablo prod. 1.7 0.0 Flour e cereatl 95000 0.8 0.2 X 100 150 35 Butter-oil preducts 84000 0.8 0.1 X 70 105 50 E -Oft preduinr crpa 0.0 0.0 X X 70 105 PERCENT OF TOTAL EXPTIS 78.85 281 24 25S 83 Notes: This tabte su¢arizea inforaation collteed fra3 the Ministry of Trcda. Infor=ution frem other uree1s fe not cmua-s tent. For Instance, Kyrgyzattin orguas that atl expeot tax on minarets hawe been reacindcd, uith the exception of e 70M tax on rare earths. (el: highest point in the rarme of oxport taxes Is for Urenius, rest of nn-f erreum have a tariff botemcn 1-50o0mi. tbl: Inctudes Mercwry. The amntionzd expotr tax for Russia eoVrs Grqsphite, ulfuor, DOid, qsartz, Kalatine. Ecl: Things tike toito paste, yeast, nuts require export licenaes for CIS. tdc: Several export taxes to Ruesie 4epwridinr an the product. L.e.:proplitn tax is 75X (1053 for borter). Sel: The Russia exprt tax is for Potuasiun !=export, llnpvrt. Page 5 5 ANNEX: AGRICULTURAL MARKETING LINKS-- CURRENT ARRANGEMENTS AND THE TRANSITION 1. A halting transition in agricultural trade policy towards liberalization has been under way since 1991, but the system remains highly controlled. There are major inconsistencies in present arrangements, and the resulting difficulties in agricultural trade are contributing to the decline in production both of agriculture (estimated to be by 15% from 1990 to 1992, with a continued fall since) and of processing industries (a decline of 48% over the same period). 2. The reforms which began in 1991 included the liberalization of the marketing and pricing of horticuitural commodities, perishable high-value items which had for long been partly produced and traded privately. In 1992, private trading in a number of other commodities was permitted, subject to qualifications. The state continued its involvement in price setting; and the State Order system for strategically important export and industrial commodities (wool, tobacco and cotton) and food (wheat) was replaced by more flexible State Purchases. However, for two reasons, these reforms were reversed in February 1993, with an effective reimposition of State Orders. First, the state had been unable to secure the quantity of tobaccr required to meet bilateral external trade obligations; and second, with the marketing system operating in effect as a mechanism for heavy implicit and explicit taxation of the agricultural sector, fiscal pressures caused the state to reimpose the system. 3. The present situation is not sustainable, and the case for -icultura pressing ahead in the immediate future with the reforms already marketing begun is a strong one. Continued exclusion of the private sector system is from trading key commodities while farmers' deliveries to the state blocked - are subject to (a) long-delays in payment and/or (b) prices below production is those prevailing in parallel markets, is leading to two outcomes: a unprofitable falling market share for the state as parallel market sales rise, and declines in output as adverse terms of trade and unpaid arrears render production unprofitable. Difficult as these reforms are proving to be, the breakdown of the present system is forcing unplanned change through two means. First, the blockage of marketing channels is making the production of a range of commodities unprofitable and is a major caused of declining output. This is often strikingly visible, with some producers unable or unwilling to sell to the state, while processing plants stand idle for lack of raw material. Second, malfunctioning official marketing channels are simultaneously causing producers to try to bypass them. This is occurring with partial success as a result of growing, if still inadequate, private Page 56 Krygyz Republic: External Trade Policy marketing activity and through direct enterprise to enterprise sales, often for barter. The existence of these alternative channels means that the scope for the state to continue to use the official trading system as a mechanism for heavy taxation is limited. Liberalization of the trading system is therefore desirable. 4. While the present breakdown in the trading system has high -=Mwnmma~ costs in terms of lost income and production, it should also be recognized that the unplanned change is moving the trading Unplanned but system towards more flexible multiple channel arrangements which beneficial are more responsive to market conditions. A challenge for policy movement to must therefore be to encourage this direction of change, while private channels minimizing short-term costs. One of the main elements of the latter is the tactical consideraton of ensuring that Kyrgyz Republic - is able to continue supplying commodities under agreed list arrangements to the CIS where, at least at present, the terms are favorable. A. Links Among Production, Domestic and External Trade -- Present Institutions and Policies 5. Agricultural commodities fall into three groups according to the arrangements in place for marketing and pricing in export and domestic markets. First, there are those whose markets are largely liberalized, principally horticultural goods. Second, those where high levels of state involvement in price regulation coexists with increasingly pluralistic marketing channels, notably meat and milk. Third, the strategically important export and food security commodities whose marketing is subject to legal monopoly and where prices are determined administratively."1 Largely Uberalized Commodities 6. This group has comparatively few trade problems. The main commodities in this group are fruit, vegetables and potatoes, accounting for an estimated 11% of the value of sectoral production in 1992, and around 10% of recorded agricultural exports in 1991 (excluding sugar, which was largely Cuban re-exports.) The liberalization in the trade of these commodities has caused comparatively few problems. The main outstanding issues relate to crop purchase by the state, and to the ownership, financing and 1l/ Details on marketing and trade in these groups of commodities are contained in Alex Duncan, *Kyrgyz Republic - Agticultural Trade Issues, Annex- September, 1993, World Bank. Page 57 Krygyz Republic: External Trade Policy management of the processing industries. Recorded production has fallen by 9% between 1990 and 1992, although data difficulties in a largely privatized subsector make this estimate uncertain. The public sector is a major purchaser both from collective and private producers, principally through three organizations: the Ministry of Agriculture's fruit and vegetable corporation; Tamak-Ash, a major processor; and the partially public consumer cooperative, Portrebsoyuz. However, there have been recent falls in deliveries to these organizations from private producers, related to the state's difficulties in making payments. While there are active local markets, private sector involvement in buying for export appears to be limited at present. A large industrial infrastructure is involved in processing horticulture products, almost entirely state owned, or recently privatized as joint-stock companies, though with the state continuing in ownership through the SPF. Producer and consumer prices were administratively datermined until July 1991, though even prior to this date there must be some doubt about the extent of enforcement in private markets. Since that date, producer and consumer prices have been largely decontrolled. However, competitive price formation may not exist as a small number of state agencies continue to play a dominant role in procurement. Export trade in horticultural products, which had been centrally determined up to 1991, is now subject to the indicative list only, with prices agreed on a consignment by consignment basis negotiated between the exporter and buyer. Kyrgyz Republic expects to export 124,000 tons in the present year, although only 74,000 and 58,000 tons were recorded as being exported in 1991 and 1992. Semi-liberalized Commodities. 7. Private trade is expanding for this group despite ambiguities in trade policies. This group includes commodities whose producer prices are set administratively, but where State Orders are not applied and some multiple channel marketing is permitted. Even in these cases, however, state-owned processing and marketing plants are among the major buyers, and there is pressure on collective producers to sell through official channels. The principal commodities are meat and milk, which together accounted for an estimated 50.2% of the value of sectoral production in 1992 but a negligible share of exports. There are considerable ambiguities in the marketing arrangements for these commodities and, as compared with the largely liberalized items, greater restrictions on market entry, reinforced by price controls. Together, these serve to make producers and consumers especially vulnerable to the operating and financial difficulties of public sector agencies. Production of meat and milk is falling, affected by decreases in inputs, including fodder crops and veterinary inputs, largely imported. The real declines are magnified in the eyes of public sector officials by the decrease in the market share of state agencies, which are facing a growing problem of under-used processing capacity, while there is evidence of growing private sector involvement. Official prices set administratively are in principle Page 58 Krygyz Republic: External Trade Policy applicable both to state farms and to private producers, although it is clear that price controls on private markets are not implementable. A pattern is emerging of divergences between prices on official and on parallel markets, with most users finding supplies increasingly difficult to obtain from official sources at controlled prices, although favored institutions and individuals continue to do so, while parallel markets provide supplies at higher prices for others. State Monopoly Commodities. 8. The most problematic trade policy issues arise for this group. Four major commodities, wool, tobacco, cotton and wheat, are subjece both o administratively-set prices and to single channel markets regulated through State Purchases. They raise the most Most problem- problematic trade policy issues. These commodities together atic trade policy accounted for 28% of the value of production in 1992 and have issues strategic importance as the main export commodities (wool, tobacco and cotton which account for some 87% of agricultural exports) and the major food security item (wheat). Production of these commodities by 1992 had fallen, according to official statistical sources, as follows: tobacco by 20%, cotton by 35% and wool by 14% from their 1990 peaks; and wheat by 24% between 1989 and 1991, recovering strongly in 1992 (discussed further under Food Security). 9. The State Purchase system is the basis for trade in monopoly commodities. State Purchases specify the proportion of total production to be delivered to the state, currently 80% for collective producers, and 60% for private producers. The system was briefly liberalized in 1992, but reasserted by decree in February 1993 as a response to declines in delivery to the state, especially of tobacco, undermining its ability to fulfil export commitments to CIS countries under obligatory list bilateral agreements. For example, only 32,00 tons of 42,000 tons requirement for tobacco was delivered in 1992; the wool processing plant closed for 3-4 months in 1992 and several months in 1993. After fulfilling State Purchases, farms have some freedom to sell directly, either to the private sector, or on barter or cash terms to other enterprises. Subject to export licensing and taxation, they are also permitted to export. There is uncertainty surrounding this issue, however. Some in the private sector, even those involved in trade, report that there is official disapproval of over-quota sales to the private sector, and some collective farm managers report being obliged to deliver all monopoly commodities to the state. Government officials in Osh and Bishkek, by contrast, emphasize the freedom to sell over-quota to the private sector. In reality, such sales are occurring widely, although associated uncertainties must raise costs. Page 59 Kygyz Republic: External Trade Policy 10. Prices for monopoly commodities were formerly set centrally for the whole of the Union, and are now determined administratively for Kyrgyz Republic by committee, involving: the Ministry of Agriculture, representing producer interests; the major state purchasers (e.g. Tamak-Ash (tobacco ar'd cotton); the Takmak yam plant (wool) and the Bread Products Corporation (wheat)); and the Anti-monopoly and Pricing Commission which if necessary resolves disputes between the other parties. Background analysis includes costs of production prepared by the Ministry of Agriculture. Producer prices are announced before planting, but these are increasingly considered minimum prices as they can be raised during the course of the season, as has occurred during the present year when high rates of inflation have rapidly rendered inadequate previously announced prices. The previous basis for producer prices has been the cost of production. This has in the past taken into account very low input prices. However, a shift is currently under way to raise producer prices towards market prices, and there is considerable uncertainty as to the present basis of price determination. Prices in Kazakhstan, the dominant regional wheat producer, are one major influence, as developing trade channels mean that Kyrgyz Republic's prices for this commodity will be less able to diverge too far from regional prices. The future of bilateral trade agreements with other CIS members will also affect domestic prices. As shown in Table IV.A.1 present official producer prices are slightly below world market levels for tobacco and about world market levels for wool, using 20 percent for insurance and freight charges. (The higher than world market price specified in the bilateral agreements should be viewed as a trade subsidy being made available to the Kyrgyz government and not the agricultural producers, per se, per the discussion on Bilateral Agreements above.) Present official prices also are below prices currently offered by the parallel market for wool. The system of State Purchases and official pricing is currently under considerable stress which has the dual effect of (a) causing an increasing number of producers and market participants to try to by-pass regulations, inter alia through the widespread practice of barter, and (b) raising strong doubts about the durability of the present arrangements. 11. There are several sources of pressure on the present system: (a) The agricultural marketing system is subject to the wider national problem of inter-enterprise arrears, and of shortage of seasonal credit. Many producers have not been paid for deliveries made during 1992 and in the early part of 1393. Overall amounts involved could not be ascertained, but for one Province, Osh, Som 15 million currently due to producers was reported to be outstanding against crop and livestock commodities delivered in 1992, and wool delivered since February 1993. Discussion with private and collective producers, with state enterprises and with government officials confirm a universal view of the seriousness of the situation and underlie the decision to Page 60 Krygyz Republic: External Trade Policy ration credit to the agricultural sector in July/August 1993. [CHECK where this was discussed above] (b) The prospects for payments by state agencies for the 1993 harvest are, if anything, worse. Assurances to producers that a 25 percent advance payment would be made against 1993 harvest deliveries have not been fulfilled. Similar scarcity of working capital affects most private sector buyers, who are unable to borrow from the banking system under present tight monetary policies. (c) Prices offered by the state are in many cases lower than prices prevailing on the open market. This is not, however, universally true, and producers are in some cases obliged to accept lower prices from private buyers who offer prompt cash payments. This is discussed further below. (d) Producer non-price incentives, both positive and negative, to participate in the present marketing arrangements have also weakened over the past two years. With the state unable to continue to provide low-priced inputs, the major gij pro quo for low official output prices has disappeared. Increasingly producers are insisting on the right to enter into sales with other enterprises, in order to secure inputs. Penalties for non-delivery of quotas to the state are weak, and in the case of one oblast, officials were unable to recall any recent demotions or dismissals of managers not fulfilling quotas. 12. Several factors coincide to render the present state-dominated trading arrangements unsustainable: the inviability of many farms; the growing availability of private sector trading outlets which pay cash and often higher prices than official channels; and the reduced means available to the state to enforce single channel regulations. To the extent that the state does apply current regulations to selected commodities, producers will have an incentive to move out of producing these items towards commodities with fewer controls. Present arrangements can therefore not be maintained indefinitely. B. Intersectoral Transfers and Taxation of the Sector 13. Marketing and pricing arrangements for two of the three commodity groups identified above, semi-liberalized and state monopoly, accounting for some 80% of sectoral output, are currently operating in two ways as a means of transferring income from agriculture. In the first place, current official producer prices are below (a) open market prices for wool and (b) world prices for tobacco, cotton and wheat. Orders of magnitude are given in Table IV.A.1. Page 61 Krygyz Republic: External Trade Policy market prices for wool and (b) world prices for tobacco, cotton and wheat. Orders of magnitude are given in Table IV.A.1. 80 percent of agriculture -being taxed Table IV. A.1 COMPARATIVE PRICES FOR MAJOR AGRICULTURAL COMMODITIES ADJUSTED FOR TRAwSPORT (In equivalent US Dollar/kg) Offlcial Producer Estimate Wotid Estimate Free Clearingi Market Arrangement Commodity Price a/ Price b/ Price Pdce c/ 3.60 Wool, washed 1.73 1.60 2.80 Tobacco, 1.00 1.80 NA 2.40 fermented Cotton fibre 0.13 1.10 NA 1.13 Wheat (average) 0.79 1.30 NA 0.75 Notes: a/ Official produced price as of mid-1993 converted from rubles to som at %200/som and to dollar at S6/$. b/ Border price of exports (tobacco, wool, cotton) assumes 20 percent Insurance and freight charges; border price for imports (wheat) is actual 01, 1993. c/ Contracted price less 20 percent for cost to market. Sources: Ministry of Agriculture for official price, mission calculations for for World price, farm/enterprise survey for market price, Ministry of Trade and Material Resources for clearing arrangement price. Page 62 Krygyz Republic: External Trade Policy 14. Second, for many producers, levels of official prices are of academic value only, owing to widespread arrears payment. At a time of rapid inflation, these have the effect of drastically Delayed reducing real income. For example, a six-month delay with payments inflation at 10 percent monthly represents an additional 50 percent are large tax, and at recent inflation levels of 20 percent monthly a additional ta prohibitive tax exceeding 80 percent. While the full extent of arrears has not been quantified, discussions with producers, processors and government officials indicate that many, perhaps most, payments are subject to six-month delay, and that in many cases payments for deliveries made after the 1992 harvest are still outstanding after nine to twelve months. Under these conditions, the real value of income when received is a small proportion of the value when the delivery was made. 15. As noted above, the beneficiaries from these transfers from agriculture are a combination of: (a) those domestic consumers or industrial users who are able to obtain commodities at official prices; (b) the government which is offering producer prices (price less cost of delayed payment) lower than equivalent world market levels being received in export markets (any trade subsidy from other CIS partners is considered as accruing to the government, not to the sector whose goods are being subsidized by that CIS partner); (c) part of government's share to importers under bilateral clearing arrangements which are running domestic arrears. 16. An emerging issue which also affects taxation levels on agriculture as an exporting sector, is the valuation of the currency. Should the som become, or remain, overvalued, with exports being marketed through official channels and credited in som to the producer at official rates, taxation rates would be further raised, as noted above. 17. The viability of low official output prices under the previous marketing arrangements was based on delivery to farms of highly No longer subsidized inputs. With the state unable any longer to assure either offset by the physical delivery of these, or the subsidies, the payment of low highly output prices is clearly no longer a tenable approach. Agricultural subsidized production in Kyrgyz Republic has been badly affected by a rapid fall inlputs in the use of agricultural inputs, as documented in the Annex, with fertilizer sales falling by 74% from 1988 to 1992, and pesticides by 57%. The reasons for this decline are linked to the need to reform the trade regime: traditional FSU suppliers are themselves in short supply and are giving priority to domestic users; payments difficulties; adverse terms of trade of the sector which have rendered the use of some inputs unprofitable; and scarcity of foreign exchange. Agro-chemicals and fertilizers are wholly imported, principally from Page 63 Krygyz Republic: External Trade Policy Russia and Uzbekistan. The main state channels, principally Kyrgyz Agricultural Chemicals and Agropromimpex, have had difficulties procuring more than an estimated 10-15 percent of historical levels from the FSU. There are increasing reports of individual enterprises obtaining inputs from neighboring countries through barter arrangements. There are few private companies purchasing agricultural inputs on a significant scale. 18. During 1993, there has been a rapid move towards world market price levels. For example, urea import prices were R141,500/ton c.i.f, comparable to prices in Europe of $145/ton. However, producer prices have lagged behind the cost of imports. Full cost- recovery on inputs will not be an option until the difficulties faced by producers in being paid have been resolved. Also, under the impact of drastic absolute and relative changes to input and output prices, producers are likely to arrive at different input use levels than those technical specifications recommended in the past. * ** *** ** ***** SUMMARY OF RECOMMENDATIONS AND RECENT PROGRESS: o The elimination of the supply contract system recommended above would remove the state's dominance in agricultural trade. However, in the remaining cases where large state enterprises continue to have a predominant role in price- setting (for example, where processing remains highly concentrated), link prices closely to border prices rather than, as at present, to costs of production, for example, implying higher tobacco prices. o Accelerate payments to producers for commodities delivered to state agents, preferably through immediate cash payments, since delays are as important as low prices in disrupting production and marketing, for example, in wool. Ensure that 100 percent financing has been arranged to cover such purchases. Progress: As noted, the Government's financial and budgetary situation will continue to inhibit reliable crop financing by state agencies. * Eliminate the effective state monopoly for the four monopoly commodities. During the interim period of attractive terms and continuation of bilateral clearing arrangements, restrict state procurement to quantities needed to fulfill state commitments narrowly defined. Progress: As noted, tecthnically the state monopoly has been eliminated, but this decision needs to be clarified and publicized and other complementary actions taken to demonopolize relevant agroprocessors so as to gradually eliminate remaining de facto monopoly. Page 64 Krygyz Republic: External Trade Policy o To ensure adequate delivery, offer a price and payment terms to attract voluntary delivery. Allow both producers and private traders to participate in the competitive procurement process. Proqress: As noted, this is the Government's intention. C. Emergence of New Trading Relationships: reducing barriers to entry 19.. The evidence reviewed by the mission, and reported on a commodity-specific basis, revealed active if uneven response of the private sector to ___.,__,_,_____, new trading opportunities, and very little response yet in agro- processing other than through the privatization program. Private sector trading is most active in horticultural items and is less, Trade pogiCy not although growing, in tobacco, wool and private meat slaughtering, enough despite the various regulations to the contrary. There are also reportedly Provincial differences, with certain local authorities imposing additional barriers to entry. This pattem of uneven response is characteristic of other reforming economies. The government needs to be very clear about where it welcomes direct private sector involvement. 20. The need for new market intermediaries to emerge to diversify channels for both export and domestic markets, for new links between producers processors or consumers to develop, and for a supportive environment to trading activity, as explored earlier in this report, is critical for agricultural trade. Hostility towards trade can arise for reasons of ideology, ethnicity (traders may be members of ethnic minorities), or perceptions of profiteering. The latter is especially likely to arise where a competitive trading system does not exist. It is clear, however, that certain trading functions are as essential to meeting consumer needs as the physical production of the commodity concerned. These include geographical movement of agricultural commodities, storage through time (within a single Private trade year, between years), or physical transformation. Unwillingness emerging despite to recognize the value of these activities manifests itself in a hostile number of attitudes and actions which currently discourage trade. environment These include social disapproval; equating trade with criminaiity; onerous and costly l,censing and regulatory requirements, by both national and regional authorities; and price controls which may render private trade unprofitable. For key sub-sectors particular Page 65 Krygyz Republic: External Trade Policy attention needs to be paid to access of the private sector to storage and transport. In other countries' experience, transport has been relatively easy to decentralize and privatize. For storage, leasing space in state structures may be an option until more efficient lower-volume structures have been developed. 21. And as noted earlier, raw materials exports should not be discriminated against in favor of the domestic processing industry. 22. Several general recommendations in other parts of this report are particularly critical for agricultural exports, including elimination of specific export licensing, foreign exchange convertibility, and creation of a supportive environment for traders. In addition, the predominance of state or partially privatized institutions in agro-processing means there are tendencies still to operate by monopoly, and there is potential for discriminaton against private sector entrants. This may be reinforced by the large scale and centralized nature of infrastructure and productive capacity, for instance, the few wool-scouring and tobacco-fermentation plants. While this is already being modified by on-farm investments, time wil be needed to match past investments with future more decentralized and competitive arrangements. Although there may well be some sector-specific economies of scale, enterprise restructuring will need to factor in a future structure of processing that is less centralized. Because processing is highly concentrated and relatively inefficient, freedom to export unprocessed raw materials is even more important for producers' welfare. 23. Finally, there are important linkages between the agricultural trading system and the production base of the sector. While some production reforms have been introduced, for example, in land ownership and in the redistribution of animals to private owners, most production is still carried out collectively, and for major commodities is still subject to directives from govemment which set area and output targets. This is inconsistent with a responsive and flexible trade regime that can take advantage of opportunities with the rest of the world. SUMMARY OF RECOMMENDATIONS AND RECENT PROGRESS: e Give an explicit commitment to private sector participants in agricultural trade and processing that their contribution is regarded positively by govemment. Redefine functions of local authorities to eliminate interference in trade. Page 66 Krygyz Republic: External Trade Policy 0 Accelerate the pace of agricultural production reform, including land reform and farm restructuring. D. Food Security 24. Food pricing and food security are issues of great welfare and political importance. Assuring national wheat supplies is a source of considerable concern to policy-makers. The economic costs and benefits of recent domestic production expansion are not, however, known and need to be established as a matter of some urgency: the costs of domestic production need to be assessed against the costs and risks of imports. At the level of household food security, government continues to apply consumer subsidies to bread to avoid adverse effects on nutrition from the recent sharp falls in real income levels. 25. Experience of other countries indicates that efficient domestic production combined with flexible external trading arrangements and with a minimal level of grain reserves are the most cost-effective way to assure food security. Traditionally Kyrgyz Republic has met most of its foodgrain needs from domestic production. Grain imports, of about 1-1.5 million tons per year have been largely to augment livestock feed. However, grain production shortfalls occurred in 1990 and 1991, due to adverse weather, economic system and enterprise restructuring and input shortages. At the same time availability of funds for USSR imports fell, causing extremely tight and nominally more expensive supplies of both food and feed grain. These events have resulted in serious concerns by the Government about food security and a shift of resources towards ensuring domestic self-sufficiency in foodgrains and some restructuring of livestock production to more extensive character. Wheat production in 1992 was about 50 percent more than in 1991, and 15 percent above the 1985-90 average. 26. Of course, significant improvement of efficiency in domestic production requires the very substantial reorganization necessary to move to a market economy. For foodgrains, the current system of procurement, processing and distribution has few market characteristics, including centrally controlled state and collective farms and a nation-wide procurement-processing-wholesaling conglomerate handling grain and grain products from the producers to the state retail shops and markets, some of which are also part of the conglomerate. This Kyrgyz Republic Bread Production Conglomerate dominates grain trade, using its own procurement department and contracting with the Kyrgyz Republic Consumer's Union. There is little private trade in grains or grain products because of distortions caused by consumer subsidies for bread (of 50-75 percent) through state Page 67 Krygyz Republic: Extemal Trade Policy channels, although most farm grain producers have their own small mills and bakery facilities. Restructuring and privatization of this structure are the first step towards improving food security. 27. At the same time, there should be other adjustments which reduce total grain demand, whether for domestic or external supply. * Decreased consumption of feedgrain as stocking levels are reduced and the structure of the herd changed. o Changing consumption patterns within Kyrgyz Republic. Increased bread prices will encourage reduction of waste. 28. Food security, in particular, assuring national wheat supplies, is an issue of concern to policymakers. Although domestic self-sufficiency in wheat has been considered as a policy option, it does not appear to be attainable at acceptable cost in the short run, nor is it likely to be a good policy in the long run. Within two to three years, as domestic consumers of grain in Russia and Kazakhstan increasingly pay world prices to domestic producers, consumption will fall, production rise, and exportable surpluses of wheat will grow. World wheat markets will have difficult absorbing significant exports from Russia and Kazakhstan, and the Kyrgyz Republic is likely to have access to commercial imports at favorable prices. For the corring year, 1994, domestic self- sufficiency in wheat does not appear attainable, since yields are likely to be down in 1994 due to shortage of fertilizer at the time of planting in fall of 1993. This indicates the high dependence of domestic production of wheat on imports as well. 29. Therefore policies to encourage timely imports, sufficient commercial and strategic reserves, adequate returns to domestic producers, and efficient domestic marketing of wheat will be needed to safeguard domestic consumption at appropriate levels. Quantities of wheat procured by the state should be those requlired only for the armed forces, hospitals, orphanages, and other consumers supplied directly through the state budget. If these needs can be met through wheat donations from bilateral aid programs, the state should withdraw from wheat procurement. Imports and exports of wheat should be liberalized so that domestic buyers are forced to pay producers border prices. Domestic prices of wheat, flour, and bread should be liberalized so that millers and bakeries can function normally, and secure commercial financing for their operations. The current subsidies for flour and bread should be replaced by cash payments or food coupons, on a targeted basis as early as possible. Mechanisms of compensation for increased prices of flour and bread are currently under evaluation. Page 68 Krygyz Republic: External Trade Policy 30. The importance of wheat in the Kyrgyz Republic and the likely continued dependence on imports means that the country cannot afford to- waste this valuable commodity. The marketing regime of the recent past, with the state monopoly on deliveries, complex system of subsidies, and inability of the bread complex to qualify for commercial financing (due to non-commercial prices) has engendered waste. The needed policy response is full liberalization of pricing, procurement, and foreign trade, and restructuring ot the bread complex followed by speedy privatization. Compensation to needy consumers is an essential component of the policy response. The needed compensation will be in many cases less than the full increase in the price of bread, since many consumers, particularly in rural areas, will buy flour instead of bread. The costs of transport from the various potential supplying markets. Kyrgyz Republic's landlocked situation provides a degree of natural protection for producers within the country and in the immediate region, principally Kazakhstan but also neighboring Xinjiang region of China. Recent production data indicate that Xinjiang is a net exporter of wheat and corn to other regions of China and potentially for export. Transport costs have risen sharply in recent months and as they do so, they raise this level of protection. • The availability of foreign exci ,ange and/or continuation of barter arrangements with FSU suppliers and/or introduction of grain export restrictions. Because of its net exporter position, Kazakhstan has no self-interest incentive to restrict exports to Kyrgyz Republic. China is increasingly devolving responsibility on grain trade to the regions. 31. But it is not only a matter of strategic choice of trading patterns. The same reforms in the structure of grain production and trade that are prerequisites for efficient domestic production also will facilitate the establishment of stable external grain trade. To the extent that a central body facilitates discussions with grain importers who themselves have a centralized structure, for example, the Kazakhs or regional authorities in China, the private sector can compete in the processing, distribution and marketing of that grain. 32. The option of domestic self-sufficiency has an immediate appeal with a commodity of such importance to national food security as wheat. However, decisions on the r; erits of this approach must also take into account the costs and risks of alternative production and trade strategies. It is possible that a policy of self-sufficiency in grain may substitute production risks for market risks, and may substitute low-value grains for higher value alternative crops which would make a more efficient use of scarce factors of production. It is striking that grain production in Kyrgyz Republic is already highly dependent on imported inputs. The Ministry of Agriculture cost of production data indicate that 87% of grain costs in 1993 (up from 65.8% in 1991) were accounted for by material inputs, the Page 69 Krygyz Republic: External 7rade Policy majority of which were imported. Greater domestic production of wheat may therefcre not reduce import dependency as much as is hoped. What is critical is to develop multiple channels that can ensure a dependent supply of the necessary agricultural inputs. * ** *** ** **** SUMMARY OF RECOMMENDATIONS AND RECENT PROGRESS: * Encourage efficient domesti': grain production by liberalization of imports and exports and allowing producer prices to reach border levels. o Maintain links with current reliable grain suppliers such as Kazakhstan as well as develop additional links with other potential suppliers. Progres: Negotiations are underway with reliable grain suppliers. o Demonopolize the graii it -ide. To the extent external trading partners insist on centralized purchase, alicw private sector participation in prnoessing, marketing and distribution. Page 70 KAZAKHSTAN 4 r~ t - )S > olAboda g r z~~~~~~- - - ;- - l J VS O t OY -./z-- ' ,-. AAIS I, l -s r¢5< I~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~---- TIROO > ' ^ \/ SraO AAZ AK H S TAN ®