Real Financial Linkages in the Kyrgyz Republic1
The financial sector in the Kyrgyz Republic has been in an expansionary phase since 2010, reflecting mostly the recovery from the 2008–09 global financial and 2010 domestic banking crises. The business cycle reached its peak in late 2013/early 2014 before the regional slowdown. The exchange rate appears to be a nexus between the real and financial sectors, and at the same time, a key source of vulnerabilities due to high dollarization. Addressing these vulnerabilities will require credible monetary and exchange rate policies aimed at the increasing confidence in the banking sector, as well as efforts aimed at deepening the domestic market.
1. The still underdeveloped financial system and frequent structural brakes, distort the analyses of linkages between the financial and real sectors of the economy. The level of credit-to-GDP was very low prior to the 2010 political crises and, at 21 percent of GDP as of August 2015, remains relatively low despite the recent credit boom. The correlation between credit and GDP growth is positive, having exhibited increasing strength after 2010. However, due to the 2005 and 2010 political upheavals, and the 2009 global financial crisis, it is difficult to find a statistically meaningful relationship between the business and financial cycles. In addition, the high presence of the informal economy—estimated between 24 and 40 percent—further blurs the trends in the business cycle. A weak interest rate channel also hampers the analysis.
Credit and Nongold GDP Growth
Sources: Authorities data and IMF staff calculations.
B. Trends in credit and business cycles
2. With data caveats in mind, the following trends in the credit and business cycle can be observed:
- The credit growth trend suggests that the financial cycle has been in an expansionary phase since 2010, reflecting mostly the recovery from the 2008–09 global financial and 2010 political/banking crises.2 Exchange rate volatility also affected the pace of growth of foreign currency loans, which accounted for about half of the overall credit growth. Demand for loans in foreign currency has significantly subsided with the recent sharp depreciation of the som, mostly as a reaction to the devaluation of the tenge. As of September 2015, foreign currency credit growth in dollar terms had fallen to below 1 percent, partly due to monetary policy tightening (via an increase in the policy rate and foreign exchange rate interventions as a sterilization tool). Also, macroprudential measures introduced in May 2015 may have also contributed to the slowdown in the pace of credit growth. That said, September credit growth, at 13 percent in the constant exchange rate, remains strong.
- The business cycle3 reached its peak in late 2013/early 2014, with nongold growth pace starting to slow down during 2014 as a result of adverse developments in the region. However, the strong credit growth of previous years, coupled with strong government investments, has prevented the nongold growth from contracting.
- The exchange rate appears to explain the nexus between the real and financial sectors. Given the high dollarization of the banking sector, the exchange rate movements strongly affect the demand for credits. In addition, the trade and construction sectors, both key drivers of the economy, are sensitive to exchange rate movements. Given the sharp depreciation of the som, NPLs have increased from 4.5 percent of total loans at the end of 2014 to 6.0 percent at end-September2015. In addition, the share of restructured loans at end-August reached 5 percent, as opposed to 2.2 percent at the end of 2014, when the share of prolonged loans stayed at around 3 percent of total loans. This explains why NPLs remain relatively low. The authorities’ stress test in August suggested that a 30 percent exchange rate depreciation would weaken the capital position of the banking sector.
- The link between credit and growth in the individual sectors of the economy is more pronounced than the link between overall credit and growth (Figure 1). In particular:(i) agriculture growth in 2015 has been strong, reaching 5.3 percent at end-August, partly due to a government subsidized lending program (credit to agriculture contributed, on average, about 9.5 percent to overall credit growth); (ii) trade sector growth has started to slow from 8.6 percent in 2014 to 4.5 percent (year-on-year) on average in 2015, while loans to trade started to slow at the same pace; and (iii) construction sector growth has shown signs of a slowdown in the first half of the year. Although intensive public investment kept construction growth at 8 percent, the majority of banks stopped or significantly downsized mortgage lending, in addition to cutting lending to construction.
Figure 1.Credit Trends and Structure by Sector
Sources: NBKR data and staff calcualtions.
Remittances, Mortgages and Construction Loans
Sources: The NBKR data and staff calculations.
C. What needs to be taken into account when analyzing real-financial linkages?
While gold and remittances are important for the Kyrgyz economy, their relevance to the financial sector is less so. Given limited sovereign-banking linkages and monetary policy traction, changes in financial sector policy have a limited effect.
3. Key factors to be considered in real financial linkages in the Kyrgyz Republic include:
- Remittances. Given their high share in the economy,4 a decline in remittances can significantly affect the real sector. A decrease in demand can result in a drop in growth prospects (while, conversely, a rise in demand will boost growth prospects). A remittance decline would decrease disposable income, and may indirectly affect the ability of clients to service their loans. In particular, remittances are important factors for servicing Microfinance Institution (MFIs) loans. While there is no evidence of problems in MFIs, their balance sheets may deteriorate if the slowdown in Russia, a key source of remittances, continues for a longer period. However, the majority of MFIs have stopped counting remittances as a source of income when providing loans. According to anecdotal information, remittances are commonly used for the purchase of real estate and their slowdown, therefore, decreased demand for property, as well as growth in the construction sector.
- Gold. While relevant for the economy as a source of budget and export revenues, gold does not have the same importance for other industries or the financial sector. Gold production has relatively few connected industries (even transportation is handled “in-house”). The whole output is exported, while the majority of investment and maintenance is mostly done via importing goods. Kumtor, an open-pit gold mine in the country’s north-east corner, has only recently started purchasing materials from the domestic market. However, the company’s financial flows are more relevant for the banking system than they are as a source of deposits and demand for loans from Kumtor employees.
- Weak sovereign banking linkages. Fiscal slippages and increases in public debt have an indirect impact on the financial sector through negative spillovers on overall macroeconomic stability. The stock of T-bills and T-bonds to GDP is about 3 percent, while banks’ gold constitutes about 1.3 percent of GDP. The scope for a sudden increase in domestic debt is limited due to a parliamentary-imposed ceiling. Thus, the risk of crowding out private sector credit is minimal, as is the risk of a spike in interest rates. However, fiscal slippages may destabilize the economy through inflationary pressures, weakening demand for credit.
- Limited traction of monetary policy. The policy rate is mostly impacting the interbank interest rate, with only marginal effects on deposits and lending rates. Due to weak interest rate channels, monetary policy is currently focused on controlling liquidity (for example, tightening the stance via decreasing the amount of som offered). This could, however, lead to a decrease in demand for the som.
D. Going forward: linkages between real and financial sector?
4. Medium-term growth projections forecast the strong credit growth of previous years to partly offset the negative spillovers from the region. Nongold growth is expected to moderate to 3 percent in 2015, and gradually pick up thereafter. While 2015 credit growth is expected to slow down relative to 2013–14 trends, it is expected to remain relatively strong in the period ahead. This is justified by: (i) an additional MFI in the process of obtaining a banking license; (ii) a new bank in the process of registration; and (iii) the onset of Russian-Kyrgyz Development Fund operations, which will be done via banks. These trends indicate that there is still demand for credit. However, in the case of the credit crunch during the next year, growth may slow slightly, especially in the trade and construction sectors. But strong government investments are another source of impetus for the economy, which can offset negative spillovers from the financial sector to the real sector.
5. Adverse risk from the slowing economy would mainly affect the financial sector via increasing exchange rate and concentration risks. As discussed, the authorities’ stress test results suggest a 30 percent depreciation would weaken the capital position of the banking sector. Moreover, given that the economy is not diversified and that the majority of lending is concentrated in a few industries, a risk of contagion between banks’ clients could be likely.
6. Spillovers from the financial sector to the economy are still limited, given the relatively small financial sector and high presence of cash in the financial system. In general, negative spillovers from the financial sector could result in higher volatility for both the exchange rate and inflation, hampering growth prospects. Problems in the financial sector would most likely result in a withdrawal of some deposits from banks and further increase dollarization, causing negative effects on credit growth. As a result, exchange rate pressures may rise, leading to inflationary pressures.5 Consequently, this would slow down the payment system and settlement of transactions between businesses. However unlikely it might be, a combination of all of these factors would hamper growth prospects.
E. What can be done from the policy side?
A stable macroeconomic environment with credible monetary and exchange rate policies is a precondition for addressing key vulnerabilities in the financial sector. They should be supplemented with macroprudential policy kits and efforts to deepen the domestic financial market.
7. To address risks stemming from exchange rate volatility, it is important to pursue a balanced set of monetary, exchange rate, and de-dollarization policies. The recent IMF working paper 6 and examples from other countries suggest that credible monetary and exchange rate frameworks, low inflation, and deep domestic financial markets are essential for the success of any de-dollarization policy. While the NBKR has successfully established a credible monetary framework, it should continue to increase its traction and pursue a flexible exchange rate policy. Such policies, together with a prudent fiscal policy, will create the foundations for a stable macroeconomic environment. Also, the NBKR’s macroprudential policies—aimed at making assets and liabilities in dollars more expensive than som assets and liabilities—are another step in the right direction. Measures to limit foreign currency lending to unhedged borrowers or a loan-to-deposit ratio for foreign exchange rate loans should be introduced when required. Strong banking supervision is needed to ensure that banking risks are properly monitored, so increasing the supervisory capacity and moving toward a risk-based supervision model is required.
8. In developing new de-dollarization policies, it is important to encourage market-based solutions as opposed to forced de-dollarization. De-dollarization measures that have failed in the past include the forced conversion of foreign currency deposits and the suspension of access to foreign currency deposits. Therefore, such measures should be avoided.
9. Developing a market for domestic securities would be a first step toward deepening domestic financial markets, and should be done in consultation with the Ministry of Finance and the NBKR. A deeper market for government securities would enable banks to increase intermediation between themselves, as it would create a higher volume of securities for collateral. In this context, the NBKR should allow its notes to be used as collateral for transaction purposes at the interbank market level. Moreover, hedging instruments and markets should be developed to enable clients to protect themselves against risks, particularly exchange rate risks.
10. Limiting concentration risks will require a mix of macroprudential measures in the short term and, in the medium term, macro-structural reforms for diversifying the wider economy. Macroprudential measures could involve debt-to-income ratio and increased provisioning loans to the most vulnerable sectors—mortgage, construction, and trade. While a diversified economy requires a complex set of policies, a combination of quality infrastructure, a stable and conducive business environment, and strong governance would be a good start.
Prepared by Dragana Ostojic.
The micro-finance institution FINCA obtained a license in March 2015, otherwise the peak would have happened in late 2014.
Approximated by the nongold growth trends.
With remittances accounting for 30 percent of GDP, the Kyrgyz Republic’s economy is one of the most remittance-dependent economies in the world.
Pass through from the exchange rate depreciation to inflation is estimated at 0.27.
S. Ben Naceur, A. Hosny, G, Hadijan “How to De-Dollarize Financial Systems in Central Asia”, IMF Working Paper 15/203, September 2015.