CIAO DATE: 03/04

The Kyrgyz Republic: Improve Governance and Expand Exports

Anders Åslund

May 2003

Carnegie Endowment for International Peace

Executive Summary

The Kyrgyz Republic has acquired a great position for achieving a breakthrough in reform and growth. The external terrorist threat has been removed with the defeat of the Taliban in Afghanistan and the arrival of Western troops in Kyrgyzstan. After the referendum on February 2, the domestic political situation has calmed down. Financial stability has never been greater thanks to new financial discipline, increasing state revenue collection and substantial debt relief through the Paris Club. Meanwhile, Kyrgyzstan's major export markets are thriving with high growth. Alas, the country saw no economic growth in the last year. While this shortfall can be explained by a landslide in the big gold mine and falling demand for Kyrgyz electricity because of ample rain in the neighboring countries, it illustrates the country's economic vulnerability.

The focus of economic policy should be economic growth. The GDP growth of recent years of slightly over 5 percent a year is not enough, but should rise to at least 7-8 percent a year and preferably 10 percent a year. Such a growth rate requires an annual expansion of exports of 10 percent or more, while exports have stated flat at the level of 1996. The key is to break through into the Kazakhstan market, and all efforts should be undertaken for that purpose. The main opportunity arises when Kazakhstan enters the WTO, but bilateral diplomacy, international support and business contacts must all be exploited

At the same time, supply must be released, by further improving the business climate. Although much has been done to rationalize contacts between the state and enterprises, corruption appears to have increased in the last few years. Some decisive measures are needed to improve governance. First, elementary discipline within the state administration must be imposed from above. Second, the continued "indicative" planning with physical plan indicators should be eliminated. Third, Kyrgyzstan has no need for four administrative levels. Three are enough, and the natural choice would be to eliminate the raion level. Fourth, the regional and local agricultural administration, which has outlived itself, should be abolished to facilitate the establishment of free intermediaries in agriculture. Some more mergers of duplicating state institutions appear appropriate, especially the establishment of a Ministry of Economic Development and Trade.

Since revenue collection has improved, the tax system can be further liberalized and streamlined. The special means should be the first taxes to go, and the income tax should be reduced to a flat 10 percent. The profit tax should be cut and eventually eliminated, while revenue collection from the big state enterprises should be improved and the customs cleaned up.

The banking system needs to be stimulated through the introduction of more legal security, more competition and deposit insurance. This is a suitable time for a reform of state salaries to raise them, differentiate them, make them more transparent and monetize remuneration. Meanwhile a new more liberal labor code should be adopted to raise legal employment and make the labor market more flexible. A pension reform with the introduction of private savings accounts can both increase social security and improve the financial system. The laudable education reform, aiming at cutting corruption and raising education standards, should proceed.

List of Contents

· Executive Summary
· Introduction
· No Growth in 2002 But Favorable Preconditions for Take-Off
· Kazakhstan: Key to Export Expansion
· The Dilemma of the Kyrgyz State
· Further Tax Reform
· A Shortage of Financing
· Time for Reform of State Salaries and Labor Market
· Pension Reform Is Needed
· Sensible Education Reforms Proceeding

Introduction
This report is a part of my ongoing work as an economic advisor to President Akaev since 1998, administered by the UNDP. It is based on observations from my visit in Kyrgyzstan from April 22 to May 2, 2003, and extensive reading of analytical reports before and after that trip. This report focuses on issues in economic policy that appear of particular importance at this time. The main tasks should be to expand exports, primarily by opening up the Kazakh market, and stimulating supply through further reforms in governance and taxation.

During this visit, I had the pleasure and benefit of one substantial meeting with President Askar Akaev. I had about 50 meetings, including Deputy Prime Minister for Economic Affairs and the President's Special Representative on Foreign Investments Djoomart Otorbaev, Minister of Labor and Social Protection Roza Aknazarova, Minister for Foreign Affairs Askar Aitmatov, Minister of Industry and External Trade Sadriddin Djinbekov, Minister of Interior Bakirdin Subanbekov, Chairwoman of the Supreme Court Nellya Beishenalieva, Governor of Osh oblast Naken Kasiev, Mayor of Osh Jantoro Satubaldiev, Deputy Head of the President's Administration Temirbek Akmataliev, State Secretary Osmonakun Ibraimov, Deputy Chief of Staff, Prime Minister's Office, Bekbolot Talgarbekov, Head Kubat Kanmetov and Deputy Head Leonid Komarover of the Economic Department of the President's Administration, Head Tsoi Man-Su of the Economic Policy and Forecast Department at the Prime Minister's Office, First Deputy Chairman of the National Bank Emil Abdumanapov, First Deputy Minister of Transportation Kubanychbek Mamaev, Deputy Minister of Finance and Head of the Committee on Revenues Shadiev, Director of Kyrgyzstandard Batyrbek Davlesov, Director of Kyrgyzalko Ulanbek Baiyizbekov, Deputy Chairman of the National Statistics Committee Djanbulat Baidjumanov, Director of the Investment Promotion Center Beyshenbek Bolotbekov, Deputies Marat Sultanov and Akylbek Japarov of the Legislative Assembly, many other government officials, numerous businessmen and journalists, US Ambassador John O'Keefe, representatives of the UNDP, the IMF, the World Bank, the Asian Development Bank, the EBRD, and USAID. Especially, I want to thank Kubat Kanmetov and Leonid Komarover of the Economic Department of the President's Administration and Jerzy Skuratowicz, David Akopyan and Aynur Muhamedgalieva from the UNDP for all their assistance. I also gave seminars at the Economic Department of the President's Administration, the Bishkek Business Club, the American University of Kyrgyzstan, the Slavonic University and the UNDP. Finally, I gave a press briefing at the UNDP.

I have drawn on studies from the Kyrgyz government and the organizations mentioned, especially the Comprehensive Development Framework of the Kyrgyz Republic to 2010 (CDF), the National Poverty Reduction Strategy (NPRS), the National Anti-Corruption Strategy of the Kyrgyz Government, the Matrix of Principal Measures to Attract Foreign Investment of the Council of the Promotion of Foreign Investment, the UNDP National Human Development Report for Kyrgyzstan 2002, UNDP Millenium Development Goals Progress Report for the Kyrgyz Republic, the IMF 2002 Article IV review under the Poverty Reduction and Growth Facility, the Memorandum of Economic Policies with the IMF, the EBRD Strategy for Kyrgyzstan 2002, TACIS/PROMA - National Business Opinion Survey of the Kyrgyz Republic, summer 2002, USAID/Pragma Corporation - Report on the Situation Facing the SME Sector in Kyrgyzstan, August 2001, and comments on the NPRS by Professor Marek Dabrowski.

No Growth in 2002 But Favorable Preconditions for Take-Off
After an average growth of about 5 percent a year from 1996 to 2001, the Kyrgyz Republic recorded a decline in GDP of 0.5 percent last year, and, industrial production fell by a devastating 13 percent. This can be explained by two factors. First, the big gold mine Kumtor suffered a major landslide early in 2002, which substantially reduced gold production. Second, because of ample rainfall, Uzbekistan and Kazakhstan demanded less electricity deliveries than in previous years. Although this drop was a case of bad luck, it shows the structural weakness of the Kyrgyz economy. Its dependence on one gold mine, owned by the state to two-thirds, and electricity owned entirely by the state. Industries that could be expected to develop are not taking off. The most glaring shortfall is in agriculture. Whereas agriculture has grown steadily by over 7 percent a year on average since 1996 and accounts for 36 percent of GNP, its share of exports vacillates around 10 percent without any tendency to rise. One obvious cause is protectionism directed against Kyrgyzstan's agriculture, but the absence of intermediaries and foodprocessing is striking. The one sector that really did well in 2002 was tourism.

While 2002 was a disappointment in terms of growth, four preconditions have been formed that could provide a basis for a substantial economic take-off. These four factors are the alleviation of external threats, domestic political stability, financial stability and splendid economic growth in the region. At the same time, many reforms either have been undertaken or are under way.

First, the external military terrorist threat that harassed Kyrgyzstan from 1999 to 2001 has been removed through the US-led war against the Taliban in Afghanistan and the military reduction of the Islamic Movement of Uzbekistan. With both US and Russian military bases in Kyrgyzstan, the country seems to have sufficient security guarantees. The external threat is gone.

Second, the police shooting five people in Aksy in March 2002 led to several months of domestic political unrest and the demise of the Kyrgyz government last May. The discussion over constitutional amendments also focused government attention on domestic politics. After the referendum on February 2, 2003, the domestic political situation appears to have stabilized, and parliamentary elections are scheduled for February 2005 and presidential elections for November 2005. This may give the government a political window of opportunity for one year to undertake essential reforms.

Third, the substantial macroeconomic improvement that occurred in 2001 was further reinforced in 2002. This success consists of three elements: expenditure control, increased fiscal revenues, and the Paris Club agreement on debt relief. Public expenditures have been brought under control, being reduced from 30.4 percent of GDP in 1999 to 23.7 percent of GDP in 2002. This has mainly been accomplished by cutting the public investment program (PIP), which peaked at 9.4 percent of GDP in 1999, to 5.1 percent of GDP in 2002. At the same time, revenue collection has improved considerably, as state revenues have increased from a low of 15.1 percent of GDP in 2000 to 19.1 percent of GDP in 2002, or by as much as 4 percent of GDP. As a result, the budget deficit has shrunk from 9.2 percent of GDP in 2000 to 5.6 percent of GDP in 2002. It is set to decline further because the PIP will shrink to 3 percent of GDP by 2006 at the insistence of the IMF, and revenue collection is likely to continue improving, while current expenditures as a share of GDP must not grow. Vital disbursements of salaries and pensions are being made.

For long after the Russian financial crisis in 1998, Kyrgyzstan was on the verge of external default. On March 7, 2002, however, Kyrgyzstan received substantial debt relief in the Paris Club. For the next three years, the country will have to pay only $6 million in debt service to the Paris Club rather than $101 million, according to the so-called Houston terms on benign rescheduling. As a result, Kyrgyzstan's external debt fell to 96 percent of GDP, if the commercial Kumtor debt is excluded. If Kyrgyzstan follows through with its fiscal policy and maintains its IMF conditions, one-third of the debt will be written off in 2005 in line with the Naples terms on debt relief. No other CIS country has received such favorable conditions from the Paris Club. One reason for this success was that Kyrgyzstan had undertaken such an impressive fiscal adjustment. The international financial institutions and other creditors had also realized the serious of the country's predicament. This agreement makes it all the more vital for the country to comply with the IMF programs not to miss the big debt write-off.

In the fall of 2002, Kyrgyzstan held a fundraising consultative-group meeting, which recorded pledges of grants and loans of no less than $700 million for the ensuing three years. Thus, Kyrgyzstan's external situation looks quite secure. The international currency reserves held by the National Bank of the Kyrgyz Republic (NBKR) have risen to four and a half months of imports. Although the money supply (M2) increased by 42 percent in 2002, inflation stopped at 2.3 percent, as the economy was remonetized. Even so, interest rates remain very high and decline only slowly, rendering the availability of finance and financial costs an ever greater concern of the business community. In relation to the US dollar, the som revalued by 5 percent in 2002 and so far by another 7 percent in 2003, but considering that the US dollar has been severely devalued, this is rather a devaluation in relation to a weighted basket of world currencies. Moreover, given that the Kyrgyz average salary is as low as $35 a month, revaluation is hardly a concern for the country's competitiveness. Because of the shortfall of gold and electricity exports, exports increased by only 2 percent, whereas imports surged by 23 percent, resulting in a large trade deficit. The foreign account was salvaged by Kyrgyzstan benefiting from sharply increased service exports, partly from the new military base, partly from increased tourism mainly at Issyk-Kul. Therefore, the current account deficit actually shrunk from 3.3 percent of GDP in 2001 to 2.8 percent of GDP in 2002, a respectable number.

The fourth positive factor for Kyrgyzstan's future growth is the very substantial growth of its three main export markets, Russia, Kazakhstan and China. For the last three years, Kazakhstan has had an average growth of 11 percent a year, which is likely to stay 9-10 percent a year for the next decade, given that its oil production is set to rise by 10-15 percent a year. Russia has entered a steady growth trajectory of an average of 6 percent for the last four years, and it is more likely to rise than to decline. China's growth lingers around 8 percent a year. The Kyrgyz Republic needs to jump on this growth bandwagon and reach a corresponding growth rate of about 8 percent a year.

The focus of economic policy should be to promote economic growth. The Kyrgyz Republic has maintained an average GDP growth of slightly over 5 percent a year from 1996 to 2001, interrupted by a fall of -0.5 percent last year. Yet, Kyrgyzstan's growth rate should rise to at least 7-8 percent a year, and preferably to 10 percent a year, the current Kazakh growth rate. The obvious reason for the shortfall is that exports have remained approximately stable at their 1996 level, while they should expand annually at 10 percent or more to generate the growth rate Kyrgyzstan can and should achieve. The prime task now is to expand exports, which requires greater access to the Kazakh market and better transit opportunities through Kazakhstan. The other lever to unleash great growth is a supply effect. Kyrgyzstan has undertaken so many substantial reforms that a limited number of additional reforms should produce a great supply effect. In particular, large enterprises that usually dominate exports must be allowed to grow stronger. Investment is no critical bottleneck. The issue is rather to utilize existing resources more efficiently through a further limitation of state intervention, together with a reinforcement of law and order.

In social reforms, Kyrgyzstan has been successful, with swiftly improving health indicators since the mid-1990s. The most striking successes have been recorded in the health care system, where Kyrgyzstan appears the leader in the CIS. Health care probably represents the most successful Kyrgyz reform by international comparison. The reforms currently under way in education could become similarly impressive. The social benefit system has been rationalized and reoriented to focus on those in deep poverty and those unable to work. The main priorities appear to be to improve the labor market, rendering the labor code more flexible to maximize legal employment, reducing the payroll tax, and rationalizing the state wage system. A pension reform needs to be undertaken, because the current pension system provides neither good protection nor the right incentives, and the payroll tax is too high, while long-term pension savings could help fix the financial system.

Kazakhstan: Key to Export Expansion
The main hurdle to Kyrgyzstan's economic development is access to export markets. Economic growth is closely correlated to the expansion of a country's export markets. Kyrgyzstan's four main export markets are Kazakhstan, Russia, Uzbekistan and China. Ideally, the country would grow in pace with its northern neighbor Kazakhstan at about 10 percent a year.

China is Kyrgyzstan's only neighbor that is also a member of the WTO. Their mutual trade has been rocky, but it amounted to 9 percent of Kyrgyzstan's exports in 2000 and it seems to be set for a rise. Given their geographical closeness, their complementarity, and market-oriented systems with limited protectionism, these two countries can and should trade much more with each other. The main problems are two. First, little traditional trade has existed, and businessmen in the two countries need time to come to know each other and find out what trade makes sense. The other problem is rudimentary infrastructure. An improvement of the two roads to China and the possible building of a railway to China should be priorities in the Public Investment Program. Trade policy is a subordinate concern.

Uzbekistan should be one of Kyrgyzstan's major trade partners, but Uzbekistan's trade is greatly encumbered, because it remains one of the few state-trading countries in the world. Kyrgyz exports to Uzbekistan have dwindled from 20 percent of its exports in 1996 to 10 percent in 2001. Kyrgyzstan can do little to boost trade with Uzbekistan until it has unified its exchange rate, which will require a major political transformation of the country. The persistence of multiple exchange rates and state-controlled prices in Uzbekistan means that decentralized trade is not possible with anybody. Illicit Uzbek exports to Kyrgyzstan of state-subsidized petrol, for instance, means that the Uzbek state subsidizes Kyrgyz consumers, while the Kyrgyz state loses tax revenues and Kyrgyz petrol suppliers rightly complain about unfair competition. For the time being, Kyrgyzstan is condemned to continue its hazardous negotiations at state level over electricity for gas, which is really determined by Uzbekistan's need for water.

Leaving the gold exports to Germany and Switzerland aside, Russia is Kyrgyzstan's largest export market. Even so, it purchased barely 14 percent of Kyrgyzstan's exports in 2001. With a similar degree of market reform, the Russian and Kyrgyz economic systems are quite compatible, with evident complementarities. Russia needs many agricultural products that Kyrgyzstan wants to export. Increasingly, viable old Soviet economic links are being re-established. Eastern Russia is a large bulk market, to which Kyrgyzstan can sell products without much refinement. Russia can be seen as an ally of Kyrgyzstan in the liberalization of trade through Kazakhstan, as it has an interest in receiving Kyrgyz exports, notably food in East Siberia. Kyrgyzstan could try to attract more Russian companies to invest by undertaking a debt-for-equity swap with its debt to Russia, as Armenia has successfully done. Russia is quite an open market with few quotas and low tariffs. The problem is rather that very expensive transit through Kazakhstan hampers Kyrgyz exports to Russia.

Kazakhstan would naturally be Kyrgyzstan's biggest trade partner, but its share of Kyrgyzstan's exports has declined steadily from 22 percent in 1996 to 8 percent in 2001, ending up as Kyrgyzstan's fifth export market. The halving occurred after Kazakhstan has imposed draconian protectionist measures on imports from Kyrgyzstan in 1999. Kyrgyz goods faced import tariffs of up to 200 percent or quotas. The cause was that Kyrgyzstan was forced to devalue in the fall of 1998 after the Russian financial crash, while Kazakhstan avoided devaluation for another half a year.

It is strange that Kyrgyzstan and Kazakhstan fail to trade with one another. Two nations could hardly be more similar. Their economic systems are very similar and the complementarities between the Kyrgyz and Kazakh economies are obvious. Kyrgyzstan enjoys a surplus of agricultural produce, while most of Kazakhstan's agriculture, save grain production, is lagging behind the country's economic development. It would be natural if food processing developed in Kyrgyzstan for exports to Kazakhstan. Kyrgyzstan has very attractive tourist spots with its mountains and Issyk-Kul, which are popular among Kazakhs living on the hot and dusty steppes. Kyrgyzstan has ample cheap hydropower and water, and Kazakhstan needs both. Several enterprises in Kyrgyzstan are designed for deliveries to Kazakhstan, for instance, a large cement factory in Kant just on the border to Kazakhstan. Kyrgyzstan is well suited to become a service provider for Central Asia in general and Kazakhstan in particular. Bishkek is developing into the capital of higher education in Central Asia.

Ironically, the main cause of Kazakhstan's ruthless protectionism against Kyrgyzstan is that the latter is too cheap. While the average wage in Kyrgyzstan is about $35 a month, it is almost five times higher in Kazakhstan at $160 a month. While standard trade theory suggests that a country would be able to export more if it devalues, the opposite is true of Kyrgyzstan because it arouses protectionism from Kazakhstan. Hence, Kyrgyz exports are completely inelastic, as a new IMF study evidences. Nor do imports depend on the exchange rate, as they are largely determined by the Public Investment Program. Hence, Kyrgyzstan does not suffer from a sharp revaluation of the Som, while an appreciation might help solve its trade problems with Kazakhstan, reducing Kazakh protectionist sentiments. Besides, higher Kyrgyz dollar wages would mitigate the large outflow of qualified labor to Russia and Kazakhstan.

Kyrgyzstan's problem with Kazakh protectionism is so great that Kyrgyzstan must use all the levers to solve it: the bilateral Kyrgyzstan-Kazakhstan commission, the WTO, Russia, the CIS, the Eurasian Economic Community, the US, the World Bank, public diplomacy, Russian businessmen and Kazakh businessmen.

1. First of all, Kyrgyzstan must publicly declare Kazakhstan's protectionism its greatest economic problem. Nobody will help you solving a problem, if you do not clarify how critical it is.

2. Kyrgyzstan has only rudimentary trade diplomacy. The new Ministry of Economic Development and Trade should focus on building a capacity of trade policy specialists and negotiators. International assistance can be mobilized from USAID or Switzerland for this purpose.

3. Kyrgyzstan's greatest opportunity to solve all its problems with Kazakhstan comes when Kazakhstan enters the WTO. As a member of the WTO, Kyrgyzstan can ultimatively demand that Kazakhstan comply with all WTO rules in relation to Kyrgyzstan. Kyrgyzstan can demand that Kazakhstan eliminate all trade barriers out of line with WTO regulations, notably its internal borders posts (GAI), discriminatory transit fees, discriminatory import tariffs, and discriminatory import quotas. Ninety percent of Kyrgyzstan's trade problems can be resolved in Kazakhstan's accession to the WTO.

4. Most problems in the CIS realm are solved through bilateral negotiations between their leaders. Bilateral Kyrgyz diplomacy with Kazakhstan must be intense and aim at resolving the trade problems. The natural forum for the resolution of these problems is the bilateral Kyrgyzstan-Kazakhstan commission. All personal and political contacts need to be utilized for this purpose.

5. The CIS and Eurasian Economic Community remain weak institutions, but Kyrgyzstan should try to mobilize them for their maximal usefulness. These institutions can be useful for bilateral trade relations as well. The most critical question is how to facilitate transit traffic through Kazakhstan, most of all to Russia.

6. Another strong lever Kyrgyzstan can utilize in its resolution of Kazakhstan's protectionism is Russia. Kyrgyzstan has wisely concluded trade deals with several Russian regions, concretizing their interest in purchases from Kyrgyzstan. Russia has an interest in better trade relations among the CIS countries, especially between two countries as friendly to it as Kyrgyzstan and Kazakhstan. Russia has many means to influence CIS member states.

7. Kyrgyzstan can mobilize various international organizations in its struggle. The IMF has just undertaken a small study on the effects of Kazakhstan's protectionism on Kyrgyzstan's economy, and they are devastating. The World Bank is about to undertake a study of trade problems in the Central Asian region.

8. Increasingly, major policy problems are being resolved under the pressure of big enterprises. Russian enterprises buy Kyrgyz companies exporting to Russia, and then they need to be able to transport through Kazakhstan. Russian enterprises also know how to break through into the Kazakh market, as the Russian juice and dairy company Wimm-Bill-Dann has shown, after having bought and modernized the dairy in Bishkek. Big serious Russian companies investing in Kyrgyzstan, can help resolve these trade problems.

9. Debt-equity swaps with Russian private enterprises can be a good means to attract large Russian companies to Kyrgyzstan, which will not only invest and develop production but also facilitate exports to both Kazakhstan and Russia.

10. Another useful lever might be big Kazakh companies. Kazkommertsbank has just bought one Kyrgyz bank, and Temir Bank is about to buy another. These big banks will have an interest in their clients having access to the Kazakh markets, and they can facilitate that. Kyrgyz authorities can discuss directly with some of the large financial-industrial groups, which dominate the Kazakh economy.

11. Kyrgyzstan can help Kazakhstan solve one of its greatest economic problems, namely overheating. For the last three years, Kazakhstan has had an average growth of 11 percent a year, and its growth is likely to stay almost that high for the foreseeable future. That implies substantial risks for bottlenecks for economic development, overheating and inflation. In 2001, Kazakh food prices rose by 17 percent, while Kyrgyz food prices fell by 4 percent because of a glut of food that could not be exported. Obviously, both the Kazakh national economy and its population would have been better off if Kyrgyzstan had been allowed to export its abundant food there.

By and large, small countries tend to pursue more liberal trade policies and are careful not to undertake retaliatory measures against bigger countries, because small countries are too weak to accomplish much in that way and would only harm themselves. Until the last year, Kyrgyzstan has shared this philosophy. Lately, however, Kyrgyzstan has undertaken protectionist measures against Kazakhstan in two cases. First, it introduced a temporary protective tariff on wheat last year, when the Kazakhs had a bumper harvest driving down the Kazakh wheat price to half that of Kyrgyzstan. In WTO terms, this could possibly be justified with state aid to agriculture in Kazakhstan, but should Kyrgyzstan really use 65 percent of its agricultural land for wheat? Recently, Kyrgyzstan tripled its excise tax on cigarettes imported from non-WTO countries other than Russia, that is, Kazakhstan and Uzbekistan. The reason is that both countries have closed their markets to Kyrgyz tobacco. However, then that should be used as the direct argument, and corresponding trade sanctions should be undertaken rather than excise taxes, which are not supposed to be trade-related. Kyrgyzstan cannot win its trade disputes with Kazakhstan, if it refuses to acknowledge them and face up to them. In general, Kyrgyzstan needs to appeal to the standards of the international trade system, holding on to high standards, low tariffs and an open economy.

The Dilemma of the Kyrgyz State
For many years, the Kyrgyz government has systematically tried to improve governance and reduce corruption. Numerous important measures have been undertaken. A large number of state agencies have been abolished or merged; severe restrictions have been introduced on government inspections of enterprises; many government procedures and taxation have been simplified; tax rates have been brought down; and a number of feedback mechanisms and checks have been introduced.

Even so, the results appear disappointing. In the EBRD and World Bank survey of business enterprises in 26 postcommunist countries, Kyrgyzstan stood out in several negative ways. It was the country with the highest bribe tax, 3.7 percent of sales in 2002. Moreover, it recorded an increase in the bribe tax of 50 percent over 1999, while the average for the postcommunist countries was a decrease in the bribe tax of 15 percent. Similarly, while Kyrgyz entrepreneurs reported 83 percent of their sales to the tax authorities in 1999, that share had dropped to 73 percent by 2002, that is, self-reported tax compliance fell sharply. Still, Kyrgyz businessmen reported a substantial improvement in overall business environment and the average time senior managers spent with public officials plummeted by half from 13 percent in 1999 to 7 percent in 2002. The worst problems they report are, in order, access to financing, taxation, corruption and quality of the judiciary.

This picture is reinforced by other enterprise surveys, of which several have been undertaken in the Kyrgyz Republic. TACIS/PROMA undertook a National Business Opinion Survey of the Kyrgyz Republic in the summer of 2002, questioning over 3,000 enterprises in the whole country. Forty-five percent of the businessmen thought that corruption in state agencies had increased, and only 4 percent thought that it had declined. Forty-eight percent reckoned that the number and complexity of licenses and certificates had increased, and 66 percent that their cost had increased. Only 27 percent considered that they could pay all taxes, and only 12 percent had used any external finance in the last three years. Yet, business confidence was high, with 48 percent of the businessmen expecting their firms to expand in the next two years, and 68 percent perceiving increased competition. Most firms are young, 66 percent being less than five years old. These observations are consistent with other surveys.

The number of agencies and officials who deal with each enterprise might have dwindled. If entrepreneurs complained a bout 10-20 harassing agencies a few years ago, they now complain mainly of about three, the Tax Inspection, the Customs and one more agency that varies. Yet, the remaining troublemakers demand more money than before. In spite of considerable tax reform, the real taxation remains excessive, prompting more tax evasion. Still, growth in the number of enterprises is evident and their output is expanding. A breakthrough might be within reach, but substantial measures are needed to achieve it. The current favorable situation offers a unique opportunity to undertake truly radical measures to put the situation right. Several years of substantial but gradual reforms have prepared the ground for a real breakthrough in governance improvement, which should result in a substantial supply effect on economic growth. However, the last years have also shown that half-measures or even rather substantial measures are not enough. Now, Kyrgyzstan has its best opportunity to jump to a higher growth trajectory.

The problems are profound and involve three competing views of the role of the Kyrgyz state. Officially, Kyrgyzstan embraces a liberal market economy based on private ownership and the rule of law. This is the dominant ideology incorporated into legislation. It argues that the state should set rules for private individuals and enterprises, which exercise their freedom of choice on equal conditions. However, in much of the state administration, a traditional ideology of socialist paternalism inherited from the Soviet Union persists. It insists that private businessmen cannot manage on their own. They need state help with advice, admonitions, regulations, inspections, planning, subsidies, subsidized credits and state enterprises. In surveys and interviews, entrepreneurs report a third type of state, a predatory state. Government officials do not care about the state interest at all but only about revenues they can extort from businessmen. This predatory activity appears pervasive. Officials earn money not only for themselves, but also for their superiors, and sometimes they justify their activity by some revenues going to the state. By all observations, this corruption is pervasive, systemic and involves high levels of power. An additional forceful external influence in the policy discussion is the IMF, which while adhering to the reformist view is dominated by a fiscal outlook.

These forces have left their mark on recent policy decisions or draft decisions. Reformers have pushed the extension of fixed taxes, the elimination of VAT on pharmaceuticals, the reduction on the excise tax on petrol, the merger of the tax and customs services, the reform of Kyrgyzstandart, the abolition of prior visas for Western visitors, the education reforms and the draft labor code. The statist or predatory proposals are also many. The Ministry of Tourism has argued for licenses for tourist enterprises, which would enhance its revenues and control. The Ministry of Transportation is advocating a three percent turnover tax on telecommunications services for an extrabudgetary fund, which would increase its resources. The Sanitary-Epidemic Inspection has wanted to extend its inspections to all enterprises. The Social Fund has abolished the ceiling on social tax contributions, which penalizes foreign investors and prompts large earners to escape into the underground. The IMF has insisted on the adoption of a new law on property tax and the introduction of VAT on big agricultural enterprises. Assessments of the current political balance vary, but a reasonable judgment is a stalemate. No breakthrough for reform is apparent, but reversals are limited.

These problems are not systemic but more a matter of political forces and will. Kyrgyzstan has introduced several good checks on the preparation of legislation within the government. First, the First Deputy Prime Minister serves also as Minister of Justice, which should make sure that legal considerations are taken fully into account. Second, the Deputy Prime Minister for Economy is requested to consider whether new legislative measures may harm investors. Third, the State Fund for the Support of Entrepreneurship is requested to review all legislative measures from the point of view of entrepreneurship, and it is also authorize or refute requests for inspections by various organs. These are quite impressive checks and they work, but if the government has the political will to overrule them it can. An elementary requirement would be that all ministers involved in economic decisionmaking at least in principle adhere to the idea of a free market economy. Issues such as comprehensive licensing of the introduction of new branch taxes leading to new extrabudgetary funds should not be allowed to enter the policy agenda. Bad policy proposals should be encountered with a political punishment of those who make them. Admittedly, other issues, most of all the tax questions, are spurious.

Apart from the policy issues, serious systemic issues persist. Most post-Soviet states have experienced a recovery of central state power in recent years, with Russia setting an example with its reimposition of a "vertical of power." Means used include a centralization of fiscal control, clearer subordination of state organs to the central bodies of government, deregulation, and strengthening of the judicial system. In Kyrgyzstan, such reforms have also been undertaken, but the inability of central state organs to impose elementary law remains a serious concern. No actor can turn to one specific body and receive any guarantee of escaping gross malfeasance from government bodies. While any individual case is difficult to judge, frequent contempt of law by local authorities is apparent. Even when the facts are made known to superior authorities, the culprits are not being punished. The control of the central state over local state organs must be reinforced. Decentralization based on democratic elections to local authorities (ail okomotu) must not be confused with the arbitrary exercise of power by representatives of the central state power. In fact, the elections mean that the ail okomotu are subject to some popular control, while the akims are not. The issue here is to impose elementary central state control of the obedience of the rule of law of state organs. The new Constitution may help in several regards. It has clarified the legal system considerably. The Supreme Court can make final judgements without having to refer a flawed decision back to the lower court that made the mistake. By allowing three supreme justices to pass judgments instead of the whole Supreme Court in session, the Constitution enhances the responsibility of individual judges, the capacity of the court and the quality of judgments.

Another trend in the CIS countries has been that big enterprises tend to become ever stronger and utilize state power to their benefit. Strangely, in Kyrgyzstan the opposite appears to be happening. Small enterprises have received more public policy attention than in any other CIS country, and they are thriving, while large enterprises appear to pay ever more progressive taxes the more successful they are, and are often broken by an excessive both formal and informal tax burden. Andrei Shleifer and Daniel Treisman call this problem "overgrazing." Uninhibited state organs gobble up the greenest pastures until nothing remains. In spite of the substantial merger of inspecting organs and the reduction of the number of inspections, the relatively few remaining control organs are neither disciplined nor interested in the survival of healthy enterprises, frequently taxing them till they die. Kyrgyzstan's key governance problem is, untypically, its defense of big private enterprises. Hopefully, the recent laudable merger of the two main revenue agencies, the State Tax Inspection and the State Customs Committee, will improve both revenue collection and governance. Revenue collection looks promising. Similarly, the establishment of a central unit for large taxpayers should facilitate the equalization of their tax payments, while also shielding them from intervention from other bodies, notably from local administrations.

A problem that tends to be overlooked but is profoundly harmful is that Kyrgyzstan continues with a system of physical planning. In 1996, Kyrgyzstan introduced "indicative planning." In fact, it was never indicative. The Ministry of Finance composed a list of some 15 physical indicators that were then passed on to the relevant branch ministries and on to governors and akims for plan fulfillment. The tax authorities also demand the fulfillment of production plans to get their planned revenues. Governors and akims are judged by their plan fulfillment, so they have urged enterprises and farms to fulfill the plans and apparently often falsify the results in agriculture. Apparently, akims tend to call all farmers in their raion for a weekly meeting, lecturing them on what, when and how to grow, although they have neither relevant knowledge nor take responsibility for their decisions. As private enterprises are so dependent on local authorities, they are almost forced to comply. One farmer who refused to comply with the akim's order reported 92 inspections in a year, while a similar farmer who submitted to the akim experienced only 10 inspections in the same year. Some enterprises have produced unprofitably for storage. Repeated imposed overproduction of some product have caused farms major losses. Naturally, this has hampered their independent development and willingness to invest. This state intervention has been particularly intrusive in agriculture. Governors and akims have often monopolized intermediation in agriculture to themselves, which explains the minimal intermediation in agriculture, the lack of accumulation of profits from agricultural trade, the minimal agricultural exports of the Kyrgyz Republic and the extraordinary dearth of food processing. Apart from filling no useful function, the "indicative planning" has seriously hampered the country's market economic development. It justifies any intervention by regional and local officials in private enterprises. Its severity is evident from newspaper notices about big enterprises requesting the authorities for alteration of their plan targets. It must be abolished. The department for planning at the Ministry of Finance must be eliminated, as well as the corresponding jobs at the Ministries of Industry and Agriculture. The usage of any physical plan indicators in relation to individual enterprises should be explicitly prohibited. The elimination of indicative planning requires the amendment of three laws that contain this task, namely the law on the government, the law on budget principles, and the law on local self-government.

The state agricultural administration is particularly badly implicated in this harmful intervention. First, all other branch administrations have been abolished at the regional, raion and local levels. The agricultural administration should no longer be excepted. Second, the agricultural administration in Kyrgyzstan is huge. During a recent visit to Ukraine, I learned that the whole state agricultural administration in the country employed about 7,500 people. At least a couple of years ago, it was slightly larger in Kyrgyzstan, although Ukraine has a ten times more people than Kyrgyzstan and is also a very agricultural land. Besides, the agricultural administration in Ukraine also seems superfluous and harmful. Third, this administration has caused Kyrgyz agriculture major damage by steering the choice and means of cultivation, barring traders and impeding food processing. Fourth, it is difficult to find relevant functions for the agricultural administration after land privatization. Land registration and social support are cared for by other state agencies. Over time, water management should be taken over by private Associations of Water Users. Veterinary services might stay with the Ministry of Agriculture. Remaining land sales and leases can be managed by the ail okmotu at the lowest level. Thus, the agricultural administration could be outright abolished at the raion and local levels.

Kyrgyzstan is a small country. Virtually all small countries and most big ones have three administrative levels, but Kyrgyzstan has four. This is untenable. The state level is of course necessary, and the lowest level appears to enjoy the greatest legitimacy, especially as the 460 ail okmotu were popularly elected last fall. Conversations with businessmen suggest that they deal with the governors and the ail okmotu, while they find little benefit even in talking to the akims, who cause a lot of trouble. The raions seem the most harmful, least legitimate, least useful and most Soviet level of power. The akims massive intervention in agriculture makes evident that they do not have any sensible function to fulfill. The evident conclusion is to merge the oblast and raion levels. Some argue for a new administrative unit called okrug. In practical terms, it could happen like this: The original Osh oblast has already been subdivided into four oblasts; a review could be undertaken of other oblasts, and a certain subdivision could be undertaken, while the raion level could be just abolished. In the two big cities Bishkek and Osh, the raions could be transformed into local authorities with elected heads, as is already the case in the countryside. The new constitution appears prepared for such a reorganization, as it mentions neither oblasts nor raions. The UNDP could play an important role in all this reorganization.

At the central government level, governance has greatly improved. It makes sense to have one first deputy prime minister with legal responsibility and one deputy prime minister for economic affairs. The number of ministries appears reasonable. Yet, the political responsibility for structural economic reform remains weak, with neither the Ministry of Finance nor the Ministry of Industry and Foreign Trade feeling responsible. A natural solution would be to form a Ministry of Economic Development and Trade as in Russia, which could take over several functions. First, it should have an overall responsibility for structural economic reform. Second, it should take over long-term and medium-term economic forecasts from the Ministry of Finance. They should be based on value indicators instead of physical indicators. Third, unnecessary branch organs should be abolished or merged into this new ministry. Such bodies are the old industrial departments of the Ministry of Industry and Foreign Trade. The State Committee on Tourism, Youth and Sport has just made clear that it has little reason to exist by lobbying hard for licensing of tourism enterprises. Fourth, the intensive stage of privatization has passed, and an independent institution for privatization no longer seems necessary. The Fund for State Property could suitably be merged with the new Ministry of Economic Development and Trade, which should be responsible for defending enterprise and investment climate, incorporating both the Council on Foreign Investment and the State Fund on Support for Entrepreneurship, which has little influence. Fifth, the Anti-Monopoly Committee appears to have disqualified itself, as in almost all CIS countries, by regulating the prices of relatively small enterprises, while not daring to regulate the big state monopolies for electricity and gas. It should be abolished, while the new ministry should regulate these two real natural monopolies. Sixth, a major task of the new ministry would be to develop Kyrgyzstan's foreign trade diplomacy, which remains rudimentary. Finally, the new Ministry of Economic Development and Trade could take over the responsibility for Kyrgyzstandart. Yet, the Ministry of Finance should be left with full financial responsibilities, including the PIP so that a new division between responsibility for revenues and expenditures does not emerge. Again, here the UNDP could play a role.

Laudably, President Akaev has named corruption a key problem and called for "a new comprehensive strategy to fight corruption," involving "administrative and judicial reform, accountablity and transparency of the public administration and responsibility of public officials at all levels." Many steps have already been undertaken such as economic deregulation, streamlining of bureaucratic procedures, the reduction of state interventions, reinforced treasury control and monetization of tax payments. The newly-established National Council for Good Governance is a natural body to lead this work. The state's declared aim is to turn the Kyrgyz Republic into a country of good governance is an eminent strategic goal. Corruption is a systemic issue, which must be fought with systemic reforms. It must also be fought with a firm hand from the top down. The worst corruption is usually at a high level, and it must be combat to render the struggle against corruption credible.

For a long time, the main reform consideration has been to adopt more legislation. At present, Kyrgyzstan has promulgated good reform laws in most areas. The task is being transformed from maximum change to optimal change. Good legislation can easily be made bad by hasty and partial changes. An unfortunate example is the excellent Tax Code of 1996, which has been amended repeatedly and thus weakened. Additional checks are needed to slow down the adoption of legal changes. That will also enhance businessmen's sense of institutional stability and the credibility of legislation. These considerations lead to the following recommendations.

1. The government needs to secure elementary vertical control within the state apparatus. Subordinate state officials should not be allowed to disobey both commands from senior officials and the laws. Disciplinary measures should be exerted against violations of discipline from the top to the bottom of the state administration. Law enforcement should make sure that the state administration obeys the law. To reinforce discipline, the subordination under more than one public agency should be avoided.

2. The National Council on Good Governance should be given a strong position to coordinate the reform of governance.

3. Indicative planning with physical indicators should be outrooted. No official should be allowed to demand that a private enterprise produces one thing or the other in any specific quantity without having concluded a commercial contract.

4. The agricultural administration at regional, raion and local level should be abolished, as it interferes in the free operation of private agricultural enterprises.

5. The number of administrative levels should be reduced from four to three, by abolishing the raion level which appears to have outlived itself. The oblasts could be further subdivided.

6. A new Ministry of Economic Development and Trade should be established out of the merger of the Ministry of Industry and Foreign Trade, the State Property Fund, the State Fund on Support for Entrepreneurship, the Anti-Monopoly Committee, the State Committee on Tourism, Youth and Sport, and Kyrgyzstandart. It should be responsible for structural economic policy, economic forecasting, trade policy, the promotion of entrepreneurship and foreign investment, the regulation of natural monopolies, privatization and state property management.

7. Three different agencies are preoccupied with the struggle against organized crime, while all have a solid reputation of corruption. It would be reasonable to reduce them to one. The National Security Service ought not to be involved in economic affairs, so its main directorate on the struggle against organized crime should be abolished. The Ministry of Interior is not renowned for any competence in this sphere, so its corresponding main directorate should also be abolished. That leaves the Financial Police at the Ministry of Finance as the most appropriate body for these tasks. With a new leadership and a new organization, it would also be a good time to purge this agency to improve its reputation

8. The powerful and arbitrary law enforcement organs should be kept out of enterprises. The police must not be allowed to carry out raids or arrests without court order. Prosecutors have no business to conduct enterprise inspections, as is now being done for the purpose of extortion. The investigation of economic crimes should be limited to one agency, the reformed Financial Police.

9. At present, land is registered by the State Land Register (Gosregister), while buildings are registered by Gosarkhistroi. It would be natural to merge these two agencies so that one agency registers both land and buildings.

10. No other fees or taxes beside those established by the parliament by law or the highest level of government should be allowed.

11. A moratorium on new licenses, fees and taxes should be imposed. Officials proposing such devices should be reprimanded politically.

12. The National Council should establish a telephone hotline to the central government level for complaints about public officials' violation of the law against any enterprise or individual.

13. Public control is vital to achieving a well-functioning public administration. Media that report on real misuse of public power must be given support and granted security.

14. The internet offers a new and unique opportunity to provide transparency. Much public information is already available on the net, such as statistics, legislation and budget outcomes, but the sphere of public availability should increase further.

15. Kyrgyzstan has strong NGOs and entrepreneurial organizations, which have a pretty clear idea about what is going on and a strong voice. It is vital that they feel encouraged to put forward justified complaints.

16. Finally, visa-free travel to Kyrgyzstan has become possible for citizens from 28 OECD nations and registration with OVIR been eliminated. Alas, the green corridor in the customs has effectively disappeared without any apparent official decision.

Further Tax Reforms
In the last two years, Kyrgyzstan has managed to raise tax revenues substantially because of improved collection. Most of the improvement has been accomplished by the State Tax Inspection. Kyrgyzalko has also greatly improved collection of alcohol excise taxes, with state revenues from excise taxes accounting for 1.4 percent of GDP in 2001. Kyrgyzenergo and the State Customs Committee, by contrast, show miserable collection performance. The increase in revenues offers opportunities for further tax reform.

An important structural change has occurred, the merger of the State Tax Inspection and the State Customs Committee into the Committee on Revenues, which has been fully subordinated to the Ministry of Finance. This should avert the competition over the same revenues between these two agencies and facilitate the administration of VAT. The opportunity should be taken to clean up the very corrupt customs. Preferably, the Social Fund collection should also be assumed by the Committee on Revenues, but at least the Committee on Revenues will be fully responsible for inspections for all these three agencies. The former Tax Police has become the Financial Police and should be devoted to other tasks than revenue inspection.

The tax changes in the last year have predominantly been positive. Several efforts have been undertaken to legalize revenues. Incentives rather than punitive actions have been used. Excise taxes on petrol have been harmonized with Kazakhstan, which has eliminated the market of smuggled petrol in northern Kyrgyzstan and enhanced revenue collection. VAT on medicine has been abolished for the same reason, rendering the vital sale of medicines legal and raising the quality medicine sold. The introduction of compulsory patenty (lump sum taxes) for casinos, saunas, discotheques and similar establishments has led to their legalization and additional state revenues. To limit conflicts between government agencies and enterprises, it would be sensible to extend these taxes further, for instance, to the tourist industry. The introduction of a property tax is commendable in principle. It is a also a fixed tax, and it adds a cost to holding property out of use. It should stimulate greater turnover of land and real estate, much of which is not being used, while providing local authorities with an independent tax base.

The introduction of value-added tax (VAT) on large farms is more disputable. In principle, VAT is better the more comprehensible it is, and it apears natural to start with the richest farms, but there are several unwarranted consequences. Because farms undertake few cash transactions, they have few receipts and can hardly deduct the VAT in their costs, implying that most of the 20 percent of VAT might amount to a turnover tax on them, which will be devastating. The idea behind the VAT on large farms is that they are very wealthy, but many of the largest farms are recomposed collective farms with hundreds of owners. Then, the introduction of VAT becomes a blow against the merger of micro farms, while such mergers are highly desirable for the development of agriculture. In case of negative consequences, the long-attempted rise in the fixed land taxes might be an alternative.

Although tax collection has improved, the problems with its procedures persist. The old system of inspecting each enterprise for an average of 7-10 days continues, though most inspectors appear to adhere to the banning of repeated inspections. As the revenue situation has stabilized, it should be possible to switch to sample inspections, which would encourage a more civilized relationship between taxpayers and inspectors.

The Committee on Revenues is introducing a controversial system with VAT invoices (schety-faktury). There are three problems with this system. First, the VAT forms have to be bought at a high price. Any compulsory state form should be free. Second, any lost form must be returned to the authorities under a complex procedure, making taxpayers liable to a great risk of new penalties. Third, taxpayers worry that the VAT invoices will lead to substantial bureaucracy. Besides, the actual benefit of the new system remains in doubt.

The most disappointing observation on the Kyrgyz tax system might be that the new information technology (IT) sector is widely to be considered to be mainly underground, while the IT sector is one of the most open and legal in countries such as Russia and Ukraine. The immediate causes appear to be high payroll taxes, high personal income taxes and a totally unjustified VAT on exports of services.

The collection of 13-14 percent of GDP should not have to be so complicated. Nominally, Kyrgyzstan's tax burden remains large, but a limited number of enterprises bear the brunt of the tax burden. A few large state enterprises should contribute more, and taxes for the rest of the economy should be fewer, simpler and lower. These considerations lead to the following recommendations.

1. Kyrgyzaltyn, as owner of two-thirds of Kumtor and thus the biggest contributor to GDP, should contribute substantially to state revenues with dividends, but contributes minimally. It should be transparently audited. This is also true of other big state enterprises.

2. Kyrgyzenergo is failing to collect revenue of considerable size. The reorganization of the electricity sector has made the failure evident. It is a management issue to make sure that electricity is being paid for in cash and in full. This would also amount to an improvement of state finances.

3. Complaints about patent corruption in the customs continue, while it collects an extremely small share of the potential customs revenues, as little as 0.38 percent of GDP in 2001, and they show no tendency to rise. The customs revenues should quintuple to about 2 percent of GDP, if law were obeyed. For years, the customs have resisted pre-loading inspection, which would diminish their opportunities for extortion. The absorption of the customs in the Committee on Revenues offers an excellent opportunity to clean them out. The customs should be the main target of law enforcement efforts to reduce corruption.

4. Compulsory tax inspection of each enterprise every year should be abandoned. The EBRD and World Bank enterprise survey, evidencing that enterprises have reduced their reporting from 83 percent of their actual sales to the tax authorities in 1999 to 73 percent by 2002, shows that they are counterproductive. About ten percent of all enterprises could be audited each year, to compare with about one percent in the US.

5. The system of the VAT forms must not involve undue costs for the forms, and corrupt penalties and inspections must not rise as a result.

6. Export of services should not be subject to VAT, because the idea of the VAT system is that exports should be free of taxes.

7. "Special means" and "paid services," contributed 1.5 percent of GDP in 2001. They have been centralized to the treasury, but these fees and penalties remain the most inefficient taxes possible. They are unpredictable and very labor-intensive both for the victims and the collecting agencies, being progressive taxes on successful entrepreneurs. They are largely used to finance state bureaucrats, and their expenditure might be as harmful as their collection. The state should make sure that it pays for all necessary costs of state agencies and prohibit the earning of "special means" by regulatory agencies and sheer administrative bodies.

8. The Kyrgyz intention was to cut the personal income tax to a flat 10 percent. Incredibly, the IMF insisted on it being raised to 20 percent for possibly three percent of those with the highest incomes. As a result, the income tax revenues appear to have stayed at 1.2 percent of GDP. The positive shock of a low stable income tax was averted. In addition, the credibility of the government's tax policy was sabotaged by this sudden reversal of important legislation. After all this damage for no good purpose, it would be reasonable for the IMF to accept a flat 10 percent personal income tax.

9. As soon as the revenue situation allows, the Social Fund tax should be reduced from a total of 33 percent of the payroll to 20 percent. This is Kyrgyzstan's highest tax, and it drives a lot of labor underground. As this tax is basically a fee for social insurance, it should be limited to a certain level of income. In the US, that level is indexed at about twice the average income. The logic is that those who earn a lot do not receive more social insurance benefits. It is regrettable that this ceiling on the Social Fund tax has been abolished recently, and it should be reintroduced. It is illogical and it is a severe deterrent against foreign investors and the entering of high earners to the official economy. Russia and Kazakhstan have introduced regressive social taxes, but the logic behind them is not obvious. A ceiling for social taxes appears more sensible.

10. Although the corporate profit tax is moderate at 20 percent, it is cumbersome. It is the main bone of contention between businessmen and tax inspectors, as it is the most difficult to assess. It taxes entrepreneurship and honesty. Besides, it reaps 1.3 percent of GDP in total revenues. As soon as the financial situation and the IMF allow, it should be phased out, as Ireland and Estonia have done, which will greatly improve the business environment. The biggest enterprises tend to be state owned, and they can be "taxed" by other means through the state insisting on dividends.

11. All sectoral taxes, such as the recently proposed telecommunications tax of 3 percent of sales must be avoided, and existing sectoral taxes should be eliminated. They tend to squeeze especially successful or honest industries. In particular, no new establishment of extrabudgetary funds should be permitted.

12. VAT refunds for exporters remain a problem as in all other CIS countries. The formation of the new Committee on Revenues and the introduction of a unified VAT card should facilitate these very important refunds, which stimulate exporters.

13. Simplified and fixed taxes, notably the land tax for agriculture and lump sum taxes (patenty) for small entrepreneurs, have worked excellently. Their proliferation bears witness to their effectiveness. It is good that the fixed property tax is now being added to them. Other activities that are difficult to tax should be added. They both contribute state revenues and transform much of the underground economy to official economy.

14. After having opposed an increase in the land tax for many years, the farmers are now up in arms against the introduction of VAT. The land tax contributes a handsome 1.4 percent of GDP, although much of it is paid by rather poor people. If the farmers really oppose VAT so strongly, they could be offered the alternative of a doubling of the land tax as a compromise solution, which indeed would add 1.4 percent of GDP or as much as the profit tax.

15. I have previously argued for the prospective elimination of the two turnover taxes, the road tax and the tax to the emergency fund, that are being paid on turnover, as they are cascading taxes and thus quite distortionary. However, they produce as large revenue stream as the profit tax at 1.3 percent of GDP, while they arouse far less controversy, offering the authorities few opportunities for dispute and extortion. Under the governance conditions existing in Kyrgyzstan, formally distortionary taxes appear preferable to taxes leaving the authorities with a great deal of discretion.

16. The establishment of a unit for large taxpayers at the Committee on Revenues is to be welcomed. On the one hand, it should make sure that the big enterprises really pay their taxes. At present, some big enterprises pay large taxes, while others pay little. On the other hand, it should be able to shield the big enterprises from undue meddling from local authorities.

17. People in Bishkek naturally compare their tax system with that in Kazakhstan. With its lesser natural endowment, Kyrgyzstan needs to offer an equal or more favorable tax system than Kazakhstan. Indeed, in the last year Kyrgyzstan has harmonized its petrol excise tax with Kazakhstan, while it has abolished VAT on medicine. Further harmonization with the Kazakh tax system is desirable. Kazakhstan has a regressive payroll tax peaking at 20 percent to compare with Kyrgyzstan's 33 percent. VAT in Kazakhstan is only 16 percent, while it is 20 percent in Kyrgyzstan.

A Shortage of Financing
All transition countries have poorly developed financial systems, little financial depth and weak banking systems. Thus, the problems in this sphere are standard and not very surprising. Kyrgyzstan undertook an early and substantial clean up of its banking system. It has a strong bank inspection and the bank system is well monitored. The bank system has stabilized with one or two banks having problem each year. All but two of the twenty banks are privatized.

But as time passes, the Kyrgyz bank system stands out as particularly small. The average interest rates for bank credits have remained very high, although they have fallen over time - on average 17 percent a year in foreign currency and 26 percent a year in som in January 2003. Many rates, however, are extremely high, and the demands for collateral are also extreme. These interest rates are much higher than in other transition countries with similar reforms, and bigger Kyrgyz businessmen tend to borrow in Russia or Kazakhstan if they can. The TACIS/PROMA survey of 3,000 Kyrgyz enterprises in the summer of 2002 showed that only 12 percent of them had used any kind of external finance in the last three years, and as few as 2 percent of them had used credit from commercial banks. The bulk of credits are actually micro-credits which have turned out to be a success. The UNDP plays an important role by being the second biggest provider of micro-credits. Commercial bank credits increased by 18 percent in 2002, but that is not all too much when the money supply expanded by 42 percent. The bank credits tend to be notoriously short of half a year or less.

Many measures are needed to improve the functioning of the Kyrgyz bank system. The security of the bank system and its capital needs to be further safeguarded. Hopefully, the streamlining of the court system that has been undertaken in the new Constitution can bring some benefits, but additional measures are also needed with regard to deposit insurance, bank bankruptcy law, pledge law, the collection of collateral. Another group of measures involves increasing the volume of capital and the competition among the banks. The most important action would be a pension reform with an element of private saving. A basis of the capital market is the land market that functions very poorly. Public funds should be distributed to the banks through tender rather than connections. Foreign banks are buying up Kyrgyz banks, and this trend should be encouraged, as long as law is abided. Most Kyrgyz banks are too small to survive on their own. They are small, cautious, inefficient and expensive. Therefore, mergers should be welcomed. Bank systems are tender flowers and take long time to develop, but several of these measures should be useful.

1. Improve the bank bankruptcy law (already drafted).

2. Adopt the new pledge law (already drafted).

3. Reinforce the control over court judgments by superior courts to check that court judgments are not being bought.

4. Render the collection of collateral more effective through an administrative review of the procedures.

5. Attract more funds to the banking system by introducing deposit insurance on individual accounts. In this way both substantial amounts of US dollars held in cash and annual transfers of perhaps $150 million from Kyrgyz working abroad could be attracted to the bank system. Much of this could be long money

6. The introduction of private pension insurance is the best solution of the problems of the bank system, as Kazakhstan has shown with its radical pension system in 1997. Today, Kazakhstan has the best bank system in the CIS, largely because of having undertaken the best pension reform.

7. Public funds that are being held in private commercial banks should be allocated through an open tender process.

8. Kyrgyzstan has already one Turkish-owned bank and one Russian-owned bank. It is a welcome sign that two Kazakh banks, Kazkommertsbank and Temir Bank have bought big banks in Kyrgyzstan. Foreign-owned banks are usually conduits of foreign direct investment, and they help raising the technical standard of the banking system, increasing competition and expanding the volume.

9. The banks cannot function much better than the land market, because land is essential as collateral. At present, the separate registration of land and buildings confuses, and the intrusive power of the city architects seems inappropriate and misdirected. Construction and land use in Bishkek is dictated by a general city plan from 1982, when virtually everything was different. This general city plan should be replaced, and the power of the city architects should be reduced to the reasonable, so that it does not block the usage of land. The underuse and misuse of land especially in Bishkek remain astounding.

10. Again, commercial bank credit cannot develop far without an increasing number of larger enterprises. The very small volume of the bank system relative to GDP may be a reflection of the paucity of large enterprises in Kyrgyzstan.

Interest rates must be driven down through competition and increased supply of capital. However high the interest rates may be, no regulation of them must be attempted, because that will only hamper the future development of the bank system and undermine the sense of security that is so vital for banking.

Time for Reform of State Salaries and Labor Market
In 1995, the Kyrgyz Republic adopted a new labor code, which was probably the least fortunate new law. Rather than abolishing old Soviet regulations, such as a severance pay for three months at lay-offs and great impediments to lay-offs, it largely maintained these problems. Today the labor code is not working, and a new draft labor code has therefore been drafted. It should answer to several needs. First of all, the labor code should make sure that the labor market works well, that is, allow for sufficient flexibility. It should keep costs of hiring and firing low, and bureaucratic impediments for such actions should be limited. Second, the labor code should secure workers' basic rights. If too may rights are "guaranteed," they will not be respected by employers, and workers will lose rather than benefit, while the labor market would suffer from excessive transaction costs and bureaucratization. One of workers' basic rights is to organize themselves in trade unions, but the interests of old Soviet-style trade unions must not be allowed to negate the real interests of workers.

There are two very different groups of labor codes in the world. One group is the West European-Soviet family of deeply bureaucratized labor codes. Several countries are trying to make their labor codes more flexible, but they are encountering severe resistance from their well-organized trade unions. The United Kingdom under Margaret Thatcher is one of the few examples of true success, though other countries such as the Netherlands have taken some steps. The average unemployment in the European Union is 8-9 percent of the labor force, and open unemployment has recently risen as high as to 19 percent in otherwise successful transition countries such as Poland and Slovakia. The other group is the East Asian and Anglo-American group of labor codes, characterized by flexibility and individualization of labor contracts. The model law among the latter is the New Zealand labor code. The latter group of countries have currently unemployment around 5 percent. In the course of transition, Estonia, Latvia and Kazakhstan have adopted labor codes inspired by New Zealand. Russia, by contrast, has failed to break through the vested interests of its old trade unions, and its new labor code stays in the West European-Soviet family of severe labor regulation. Looking upon transition countries at present, the choice of labor code corresponds to a choice of unemployment of around 8 percent or at least twice as much. Kyrgyzstan needs to take this action now, because later on it will be much more difficult to liberalize the labor market, as the discouraging examples of Germany, Italy, France and Poland show.

State salaries in Kyrgyzstan are characterized by multiple problems. First, they are very low. Second, they are too egalitarian, offering little incentives to qualified, hard-working and honest workers. Third, they are either unrelated to performance or too directly related to specific measures of performance, notably revenue collection, leading to the disregard of other aspects of work. Fourth, the salary system is non-transparent. Finally, all its shortcomings generate an outflow of qualified staff from the public sector and also the country and the corruption of many of those who remain. This appears a suitable time to sort out all these problems in connection with labor market reforms. The focus here is the actual state administration and the state regulatory agencies, not the state service sector of education and health care, though most of these principles would apply there also.

1. Kyrgyzstan should adopt its new liberalized labor code, but a further liberalization of the draft is vital. Especially, the severance pay should be reduced from two months to two weeks, as has become the liberal standard. Hiring and firing should be liberalized. Labor contracts should be individual. Such legislation would create more jobs, render jobs official and thus guarantee more actual rights to the workers.

2. In parallel, the minimum wage should bee raised from its current miserable level of Som 100 a month to perhaps Som 450 a month. The minimum wage would acquire the function of a social safety net, which is not the case today. To make this possible, the use of the minimum wage as a unit for all kinds social benefits and penalties should be ended. The combination of a higher minimum wage and the adoption of the labor code as a legislative package should make it politically possible to adopt both.

3. Today, state salaries consist of several monetary parts, a basic salary, additions, and bonuses, but civil servants tend to consider only the basic salary their "salary." As a result, they are denigrating themselves, underestimating their actual salary. The whole monetary part of the salary should be unified.

4. Apart from the monetary salary, civil servants enjoy a lot of benefits in kind. This is especially true of senior staff, the military and the police. As far as possible, these benefits should be transformed to money and be added to the salaries. This would make it clearer both to employers and employees how much employees actually earn, which would raise the self-respect of the employees and render the setting of salaries more rational and just. Various state agencies would be relieved of the costly administration of the purchasing of various benefits in kind. Both state and civil servants would benefit from this more rational usage of funds, and employees would enjoy a higher of wellbeing because of their greater freedom how to use their full actual salary by their choice.

5. Even if the whole salary is unified and monetized, public salaries are very low. The aim should be to raise them substantially, as state finances allow. It should be possible for all officials and inspectors to live on their official salaries. Otherwise, any attempt to reduce corruption lacks critical legitimacy. No responsible official should earn an official salary of less than $100 a month.

6. In particular, it is important that top officials earn substantial official salaries so that they can live comfortably without resorting to additional private incomes. Kazakhstan and Estonia have undertaken such salary reforms with very good outcomes. Apart from senior officials gaining more self-respect and becoming more focused on their work, the qualifications of officials on vital posts naturally rises. Characteristically, the Kyrgyz government has problems attracting qualified economists to the Ministry of Finance and experts on foreign trade policy. Moreover, many of the potential candidates, who have actually been trained, leave the country. As this involves a rather limited group of people, the costs of such salary rises would not be very large.

7. At the same time, salaries of higher officials must be individualized, as is usually the case in advanced civil services. Salaries should reflect merit rather than time of service, and they should also reflect the evaluation of skills in the private sector so that the state can attract qualified staff.

8. In parallel, all kinds of commissions and most private incomes on the side of public officials should be effectively prohibited. Any commission paid to officials who attract public revenues leads to their going out extorting money from businessmen and the public for any reason. This incentive must be avoided. Special means should be abolished in state administration and regulatory agencies, while they should be rendered official state incomes in real service providers, such as health care and education. The principle should be firm: a civil servant should own his or her whole salary from the state budget.

9. Considering to what an extent all regulatory and inspecting agencies indulge in unnecessary inspection aiming at extortion, it would be reasonable to reduce their staff by half over board. Any minor reduction of several percent is always defined away and thus ineffective. The central state administration, by contrast, has been trimmed down to such an extent that any general cut does not appear justified. Kyrgyz ministries now have a suitable number of staff. Also the oblast administration is quite limited.

10. To make such a cut in staff acceptable, all state agencies that face staff reductions should be entitled to keep their wage fund unaltered, so that they can redistribute the salaries of sacked staff to the remaining employees.

Pension Reform Needed Now
This appears an excellent time for pension reform. First, the Kyrgyz Republic has secured financial stability, facilitating a pension reform. Second, the payroll tax of 33 percent remains impermissible high and is a major force driving labor underground. Third, the pension system is both too expensive and provides insufficient protection for all, by spreading low pensions on far too many. Fourth, the pension system remains underfinanced, as collection is poor and some of it is not in cash, which is unacceptable. Fifth, it is both politically and administratively easier to undertake a pension reform now before the public pension system has grown too big and complex. Sixth, pension savings could provide critical help for the development of the Kyrgyz financial system. At present, the banks lack fixed long-term deposits, which private pension savings would provide, and over time they would lead to lower interest rates. Meanwhile, the real return on the private pension accounts will be very high because of the high interest rates on deposits in Kyrgyz banks.

The aim should be to introduce, beside a basic state pension, an element of a individual saving in the pension system for younger people, while the old state pension system for the existing pensioners and those about to retire within the next ten years. Several dangers persist that must be taken care of. First, any tampering with pensions tend to upset those who receive them or are soon to get them. This problem is taken care of by leaving the old system for the old, and the only issue is the cut-off age. Second, as substantial amounts of money are involved, there is one worry that the state budget will suffer badly, as happened in Kazakhstan. The response is a gradual introduction of personal savings accounts, and they will not account for the whole pension system as in Kazakhstan's system imported from Chile. Finally, the pension savings must be safe both from the state and private financial institutions. The response here is triple. The private pension money must be kept apart from the state Social Fund to avoid all possibilities of manipulations or suspicions. Any private bank receiving private pension savings should benefit from deposit insurance. Initially, pension savings should be restricted to the safest of investment, that is, bank saving. This reasoning leads to the following recommendations.

1. Kyrgyzstan should legislate a mixed pension system with a basic state pension paid out of the Social Fund and a private pension savings system to be introduced gradually for the young. The share of their payroll being paid into the private cumulative pension accounts should rise gradually over several years up to something like 10 percent of their payroll. Then, pensions become real savings, and people have an incentive to pay their pension insurance contributions.

2. The private pension savings must be kept in individual accounts in private institutions according to the pension holders' choice. The state Social Fund or any state institutions must not be allowed to hold this money.

3. A precondition for such a pension reform is that deposit insurance is being introduced in private banks that could hold pension accounts. The banks should be obligate to provide the account holders with a quarterly statement of the value of their pension account, as is customary in the West.

4. Because of vagaries on the financial market, private pension accounts should only be held by banks to begin with. As the financial market develops, this condition should be relinquished.

5. The aim should be to reduce the total social tax/contribution on the payroll from the present 33 percent to a flat rate of 20 percent. An indexed ceiling on the income liable to a contribution should exist. In the US, it is about twice the average income, which seems a reasonable level.

6. At present, the World Bank is resisting any substantial pension reform in Kyrgyzstan. Then, it is obviously not a suitable agency for this task, and the country should look for another provider for technical assistance. The Asian Development Bank is a possibility, but a positive attitude to private accounts must be ascertained.

Sensible Education Reforms Proceeding
Kyrgyzstan greatest asset is its outstanding human capital. It has quite a good education system and a decent level of expenditures on education as a share of GDP. In recent years, the number of universities and their students has increased sharply. A few good private universities have opened up and contributed to raising standards. Kyrgyzstan has managed to improve higher education more than other countries in the region, with the American University in Kyrgyzstan probably being the best university in Central Asia and the Slavonic University the second best.

Yet, the education system suffers from several systemic shortcomings. First, the higher education system is considered seriously corrupt, undermining its quality. Second, teachers' salaries are very low, and they are too many. Third, the education system is not transparent and the students do not know what they get in advance. Fourth, primary and secondary education are seriously underfunded, especially in the countryside. Fortunately, the Ministry of Education is pursuing heroic reforms to alleviate all these problems.

1. The key to higher education standards is independent national testing that is now being undertaken. It should go a long way to solve the problems of standards.

2. Private university financing should be brought into the open in transparent budgets. As tuition fees are paid in any case, officially or unofficially, they can as well be made fully official and be put into the universities' official budgets.

3. Public financing of higher education should be based on test results and directed to the best institutions, while the worst would not get any financing.

4. State certification should disqualify the worst institutions from calling themselves higher education, and they should be liquidated as such. Currently, some students are learning after graduation that their degrees are of little or no value, as the purchasing of degrees is considered pervasive at their institutes.

5. When private university financing is being brought into the open, it should be used to raise the salaries of most university professors and lecturers.

6. Overall, education financing should be reoriented from higher education primarily to middle education but also to primary education. The state should provide a normative equal amount of financing for each child of a certain grade. Money should first of all go to teachers, who are very poorly paid, and to textbooks.

7. Given the shortage of financing for education, the teacher-pupil-ratios need to be reconsidered. South Korea has a teacher-pupil-ratio of 1-27, which does not stop it from having an excellent education system. The best way of saving money in the school system is to raise this ratio, while the teachers should be paid more in salary.