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Kyrgyz Republic: Selected Issues

Author(s):
International Monetary Fund. Middle East and Central Asia Dept.
Published Date:
February 2016
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Impact of the Accession to the Eurasian Economic Union1

Following its accession to the Eurasian Economic Union (EEU), the Kyrgyz Republic could benefit from deeper integration across a broad range of areas, including an enhanced access to EEU markets, higher customs revenue, and more secure access to the Russian labor market. Given the current Kyrgyz trade structure, however, the initiatives pose a risk to divert trade and weaken the economic prospects, and the authorities have sought to mitigate trade diversion and adverse impacts. Reaping the full benefits of the EEU strengthens the case for upgrading technical standards and improving macroeconomic policies and undertaking structural reforms, so that the Kyrgyz economy can become more competitive not only within the EEU but also vis à vis non-EEU countries.

A. Background

1. In August 2015 the Kyrgyz Republic officially became a member of the Eurasian Economic Union (EEU), which comprises Russia, Kazakhstan, Belarus, and Armenia. The EEU is a customs union and “single economic space” that calls for free movement of goods, services, capital, and people within its borders. With a total GDP of nearly US$2.5 trillion in 2014, and more than 170 million people, EEU membership provides an opportunity for the Kyrgyz Republic to expand its exports and deepen integration, particularly with Russia.

2. The EEU can bring multiple benefits through a deeper integration across a broad range of areas. Greater diversification and larger markets would increase domestic competition, facilitate innovation, and contribute to building cross-border production chains. These, in turn, would increase exports outside the region and enhance job opportunities. The Kyrgyz Republic is a member of the Free Trade Agreement of Common Independent States (CIS FTA), however, the EEU membership is expected to eliminate the need for customs declarations and inspections, thus reducing nontariff barriers and delays. Strengthened financial linkages would provide better opportunities for consumption smoothing (trade finance) and efficient capital allocation (foreign direct investment). With a substantial number of migrants from the region seeking employment in the better-off economies, economic cooperation and integration could contribute to the reduction or removal of informal and institutional barriers to labor migration. Also economic cooperation could reinforce economic reforms towards greater unification of standards and political commitment to anti-corruption and good governance. In addition, the EEU membership can bring the Kyrgyz Republic financial assistance from the Eurasian Fund for Stabilization and Development for dealing with external shocks and implementing large investment projects. Although little progress has been made for integrating the financial sector and exchange rate policies, a single financial market is the ultimate goal, with mutual recognition of banking licenses as an early step and joint financial supervision targeted by 2025.

B. Fiscal impact

3. The government would benefit from higher customs revenue. The Kyrgyz Republic has secured 1.9 percent of the EEU common customs pool, which is expected to result in an increase in customs revenue annually (1.5 percentage points of GDP for 2016, according to the authorities’ estimates). In addition, the country would receive a small increase in tariff revenues (0.1 percent of GDP),2 since non-EEU common external tariffs (CET) are higher than the current preferential tariff (US$0.2 per kg of imported goods) between the Kyrgyz Republic and China, which accounted for 55 percent of Kyrgyz imports in 2014.

Imports by Countries

(Percent of total imports)

Source: IMF Direction of Trade Statistics.

4. The customs revenue structure is not expected to change. Joining the EEU is not expected to cause a significant change in tariff revenue from these countries, since goods traded among these countries are either not taxed at the border or are taxed at very low rates as a result of agreements among CIS countries. Under the current tariff regime, about 80 percent of the customs revenue is generated from imports from the rest of the world.

5. The positive effects on customs revenue would be partially offset by a VAT revenue loss because of a likely increase in administrative costs of revenue collection. Following accession to the EEU, collection of VAT and excises on EEU imports should be done on the basis of declaration of taxpayers rather than payments collected at border crossings. Therefore, the government shifted the responsibility of VAT and excise collections for imported goods from customs services to the state tax services. However, the Kyrgyz importers include many small traders, most of whom are unlikely to be registered VAT payers. This might result in loosing VAT or excise tax collection on EEU imports. The authorities estimate this revenue loss from small traders at approximately som 1 billion annually, which is about 2.5 percent of total VAT and excise collections.3 In addition, the accession to the EEU comes with the abolition of simplified customs procedures whereby several neighboring countries, including China, had their customs duties calculated based on the volume of trade rather than value. As a result, a potential under-reporting of the value of imports, if significant, could negatively affect revenues.

C. External trade impact

6. The transition from the current customs regime to the EEU would generally impose higher costs on Kyrgyz importers, which would, in turn, negatively affect exports. The weighted average EEU CET rate is higher (10.4 percent) than the current Kyrgyz weighted average tariff rate (5.1 percent). Both exports and imports are expected to decelerate as the transit trade declines due to higher external tariffs. An average 5 percentage points increase in import duties in excess of Kyrgyz WTO commitments may result in worsening terms of trade, estimated in the range of US$100 to US$300 million annually (1.5 to 4.5 percent of GDP).4 Export price competitiveness would be negatively affected as well. For instance, the higher CET would increase production costs of garments and textiles in the country, which employ 150,000 people and account for more than 15 percent of total exports, by 4 to 8 percent.5

Export Structure

(Percent of total exports)

Source: UN Comtrade Database.

Exports by Countries

(Percent of total exports)

Source: IMF Direction of Trade Statistics.

7. However, a gradual reduction in the EEU CET rates over the medium and longer term would mitigate such negative impact. The EEU CET rate schedule will decline over the medium term, reducing risks of trade diversion. With Russia’s accession to WTO, the average weighted tariff of the EEU CET rate would go down to 7.8 percent by 2017.6 Following its accession to WTO in June 2015, Kazakhstan is committed for lowering its tariff to an average of 6.1 percent, which would, in turn, require adequate downward adjustment to the EEU’s CET. Meanwhile, Kazakhstan’s WTO Accession is adding to challenges: the Kazakhstani government has recently requested the Eurasian Economic Commission (EEC) for CET exemptions of more than 3,000 goods to meet their WTO accession commitments. If the EEC accepts the request from Kazakhstan, the Kyrgyz Republic is expected to receive similar treatments.

8. By contrast, the benefits of removing non-tariff barriers in the EEU will take time to materialize. The EEU, which envisages free trade within the region, has made it more difficult for individual members to introduce unilateral nontariff measures for the regional trade. However, these benefits may be slow to materialize, given the lack of physical infrastructure and institutional capacity in member states. According to the 2015 World Bank Doing Business Report, the Kyrgyz Republic is ranked near the bottom globally with regard to trade across borders (183 out of 189 countries). This reflects exceedingly high intra-regional trade costs resulting from the geographic disadvantages, but also from cumbersome procedures and red tape in the processing of import and export documents. Meanwhile, uniform minimum health, safety, and quality standards on the intra-EEU trade are likely to restrict trades by increasing the cost and delays of obtaining certifications.

D. Other impact

9. The higher CET will negatively affect the local industry. Re-exports would be affected on account of an increase in input costs. As the re-export sector employs over 20 percent of the working population, the drop in re-exports is likely to have far-reaching repercussions throughout the economy. Also the high CET implies a rise of the consumer price inflation, because of a substantial import share of consumer goods.

Import Structure

(Percent of total imports)

Source: UN Comtrade Database.

10. The permanent opening of the Kazakh-Kyrgyz border would avert economic shocks. Temporary closure of this border in the past has resulted in a disruption of economic activity. In April 2010, The Kazakh border was unilaterally closed, which resulted according to the authorities,7 to a decline in exports of about US$0.4 billion (or 5 percent of the 2010 GDP), notably affecting the agricultural, clothing, and construction material industries.8

11. The sanctions and counter-sanctions between Russia and some other countries have presented an opportunity for the Kyrgyz agriculture sector. As a result, Kyrgyz exports of fruits and vegetables, dairy, and meats substantially increased. The EEU membership would give the Kyrgyz Republic much easier access to the Russian market than imports from other different regions.

12. The Kyrgyz labor is expected to have a more secure access to the Russian market. There are currently about one million Kyrgyz migrants in Russia, but only half of them have work permits. The EEU membership has simplified employment procedures, abolished mandatory quotas to the labor market, and improved social conditions for migrant workers and their families except for pension and health insurance. As a result, Kyrgyz labor migrants will no longer have to obtain work permits and do medical exams and language tests prior to seeking a job in any EEU member state. Since the country joined the EEU, the monthly flow of the Kyrgyz migrant workers to Russia has reportedly increased by about 20 percent (to 44 thousand people from 36 thousand people).

E. Authorities’ efforts to maximize the economic impact of the EEU

13. Ensuring macroeconomic stability is key to maximizing the positive effect of the EEU. While deeper economic and financial cooperation can yield substantial benefits, it also poses macroeconomic challenges and vulnerabilities. Limited trade diversification of exports and imports make the country particularly susceptible to sudden external shocks. Also an asymmetry in the economic size of the member states makes it more difficult for member countries to reap the full benefits of the customs union and enhanced economic integration. Kazakhstan’s GDP is about one-tenth of Russia’s, and the Kyrgyz Republic’ GDP is one-thirtieth of Kazakhstan’s. As a result, the Kyrgyz republic will be prone to more shocks, and sudden changes in the direction of capital flows may induce boom-bust cycles. In particular, exchange rate policy may become more challenging as integration with the EEU advances, particularly if more transactions are settled in rubles. Strengthening and modernizing macroeconomic frameworks and prudential regimes in tandem with increased openness and integration is important.

14. The Kyrgyz authorities have been identifying measures to mitigate short-term negative effects. During the accession negotiation, the government has secured transition periods to the EEU CET rates up to 2019 for about 1,500 products (including food products, cars, and machinery) out of about 6,400 commodities, for which the Kyrgyz’s current tariffs are lower. Also the government has been modernizing the existing test laboratories to meet the EEU sanitary and veterinary requirements. In connection with EEU membership, the Kyrgyz Republic has obtained a Russian grant of US$200 million to help it meet the EEU requirement of customs and border controls.

15. The US$1 billion Russia-Kyrgyz Development Fund (RKDF) is expected to mitigate the short-term negative impact of the EEU accession by contributing to growth. The priorities of the fund include infrastructure investment for the implementation of technical regulatory compliance in the agribusiness, garments and textile, and services sectors. The success of the fund will hinge on ensuring that it operates under a transparent and accountable governance framework in line with the international best practices. Also, clear delineation between the fund’s activities and public finances will be critical.

1

Prepared by SeokHyun Yoon.

2

IMF, Fiscal Affairs Department (2015), “Impact of Accession to the Eurasian Economic Union”.

3

Ibid.

4

Eurasian Development Bank Yearbook (2012), “Assessing the Economic Effect of Kyrgyzstan’s Accession to the Customs Union.”

5

World Bank (2015), Competitiveness of the Kyrgyz economy in the wake of accession to the Eurasian Customs Union: Select issues and opportunities.

6

The adjustment to CET is calculated as an average of the tariff rates of the member states on the basis of their share of the total EEU market.

7

Ministry of Economic Regulation (2012), “Economic Consequences of the Customs Union for the Kyrgyz Republic” as an USAID Regional Trade Liberalization and Customs Project.

8

Earlier this year, this border was also closed. As a result, hundreds of trucks transporting fuel to, and from, Kazakhstan and Russia were blocked at the Kyrgyz/Kazakh for several weeks. Reportedly, it made a significant disruption in economic activities.

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