Report No. 29150-KG Kyrgyz Republic Country Economic...

Report No. 29150-KG

Kyrgyz Republic Country Economic Memorandum An Integrated Strategy for Growth and Trade (In Two Volumes) Volume II June 1, 2004

Poverty Reduction and Economic Management Unit Europe and Central Asia Region

Document of the World Bank

CURRENCY AND EQUIVALENT UNITS (as of June 1, 2004)

Currency Unit = KGS Som US$1 = 43.85 Som

1 KGS Som = US$0.02

WEIGHTS AND MEASURES Metric System

ACRONYMS

CIS – Commonwealth of Independent States EA – East Asia EBRD – European Bank for Reconstruction and Development EU – European Union FDI – Foreign Direct Investment GDP – Gross Domestic Product IFIs – International Finance Institutions KAFC – Kyrgyz Financial Agriculture Corporation LAC – Latin American Countries MSMEs – Micro, Small, and Medium Enterprises NBKR – National Bank of Kyrgyz Republic NSC – National Statistics Committee OECD – Organisation for Economic Cooperation and Development RCA – Revealed Comparative Advantage Index REER – Real Effective Exchange Rate RULC – Relative Unit Labor Cost SA – South Asia SCD – State Customs Department SITC – Standard International Trade Classification SMEs – Small and Medium Enterprises UN COMTRADE – United Nations Statistical Division Commodity Trade VAT – Value Added Tax

Vice President : Shigeo Katsu Country Director : Dennis de Tray

Sector Director : Cheryl W. Gray Sector Manager : Samuel Otoo

Task Leader : Sebnem Akkaya

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TABLE OF CONTENTS

I. TRADE PERFORMANCE................................................................................................... 1 1. Introduction ........................................................................................................................ 1 2. The Kyrgyz Republic’s Integration into the Global Economy............................................ 1 3. Origins and Destinations.................................................................................................... 3 4. Specialization and Concentration of Exports and Import Composition............................. 6 5. Factor Content of Exports .................................................................................................. 9 6. International Competitiveness.......................................................................................... 10

II. FINANCIAL SERVICES AND TRADE FINANCE.................................................... 13 1. Introduction ...................................................................................................................... 13 2. Support to Trade............................................................................................................... 14 3. Access to Finance ............................................................................................................. 16 4. Government’s Policy Reform Agenda .............................................................................. 19 5. Conclusion and Recommendations................................................................................... 19

III. VALUE CHAIN ANALYSIS.......................................................................................... 24

A. MARKET OVERVIEW....................................................................................................... 24

B. CHANNEL MAPPING METHODOLOGY ...................................................................... 26 1. Creating a Product Value Chain...................................................................................... 27 2. Value Chain Analysis ....................................................................................................... 27

C. COTTON INDUSTRY IN THE KYRGYZ REPUBLIC .................................................. 28 1. Market Segmentation........................................................................................................ 29 2. Cotton Farming ................................................................................................................ 33

2.1. Cotton Value Chain ................................................................................................... 33 2.1.1 Harvesting............................................................................................................ 33 2.1.2 Fertilizing ............................................................................................................ 34 2.1.3 Cultivation ........................................................................................................... 34 2.1.4 Summary.............................................................................................................. 35

3. Cotton Ginning ................................................................................................................. 38 3.1. Cotton Ginning Value Chain ..................................................................................... 39

3.1.1 Cleaning/Drying ................................................................................................. 39 3.1.2 Ginning................................................................................................................ 39 3.1.3 VAT.................................................................................................................... 40 3.1.3 VAT.................................................................................................................... 41

3.2. Seed Oil Processing....................................................................................................... 41 3.3. Other Operational Issues .............................................................................................. 41

Weak Backward and Forward Linkage Mechanisms .................................................... 41 Undocumented Costs..................................................................................................... 41 Transport ...................................................................................................................... 42

4. Yarn Production ............................................................................................................... 43 4.1. Yarn Value Chain ...................................................................................................... 43

5. Textile Product: Terry Cloth Towel ................................................................................. 44 5.1. Terry Cloth Towel Value Chain ................................................................................ 46

6. Factors Inhibiting the Development of the Cotton and Textile Exports ....................... 4847

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D. WOOL INDUSTRY IN THE KYRGYZ REPUBLIC .................................................. 5150 1. Market Segmentation.................................................................................................... 5150

1.1 The Formal Market................................................................................................. 5150 1.2. The Informal Market ............................................................................................. 5251 1.3 Semi-Processed Hides: Secondary Product ........................................................... 5453

2. Sheep Farming: Background....................................................................................... 5453 2.1 Sheep Farming: Production System ...................................................................... 5554 2.2 Sheep Farming Value Chain................................................................................... 5554

2.1.1 Feed and Fodder .............................................................................................. 5655 2.1.2 Pasture Lease ................................................................................................... 5655 2.1.3 Veterinary Services ......................................................................................... 5655 2.1.4 Summary.......................................................................................................... 5756

3. Sheep Hide Value Chain............................................................................................... 5857 4. Worsted Yarn Value Chain........................................................................................... 6059

4.1.1 Raw Material ................................................................................................... 6059 4.1.2 Dyeing ............................................................................................................. 6160 4.1.3 Spinning........................................................................................................... 6160 4.1.4 Opportunity Cost of Informal Sector............................................................... 6160 Opportunity Costs Associated with Sales of Worsted Yarn through the Informal Sector................................................................................................................................... 6362

5. Wool Coat Production.................................................................................................. 6463 5.1 Wool Coat Value Chain.......................................................................................... 6463

5.1.1 Production and Packaging ............................................................................... 6665 5.1.2 Taxes ............................................................................................................... 6665 5.1.3 Office Expenses............................................................................................... 6665

5.2 Need for Market Support Infrastructure ................................................................. 6766 6. Summary....................................................................................................................... 6766

E. DAIRY INDUSTRY IN THE KYRGYZ REPUBLIC ................................................ 7170 1. Dairy Value Chain........................................................................................................ 7170

1.1 Collection and Delivery Costs................................................................................ 7271 2. Animal Husbandry........................................................................................................ 7372 3. Butter Value Chain ....................................................................................................... 7574 4. Ice Cream Value Chain ................................................................................................ 7675 5. Non-Tariff Barriers ...................................................................................................... 7776 6. Distribution and Logistics Support .............................................................................. 7877 7. Administrative Barriers Faced by Dairy Processors ................................................... 7978

7.1 Medium Size Dairy Processor ................................................................................ 8079 7.2 Sources of Administrative Barriers ........................................................................ 8281 7.3 Cost of Administrative Barriers on the Competitiveness of the Dairy Industry..... 8483

8. Summary....................................................................................................................... 8584

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Tables

Table 1.1: Selected Indicators, Country Groups Selected as Comparators for the Kyrgyz Republic................................................................................................................................... 3

Table 1.2: Kyrgyz Republic–Non-gold Exports by Destination, 1999-2002 ................................. 4 Table 1.3: Composition and Destination of Kyrgyz Non-Gold Exports ........................................ 6 Table 1.4: Export Concentration Index, 1997 and 1999................................................................. 7 Table 1.5: CIS Countries–Revealed Comparative Advantage ....................................................... 9 Table 1.6: Kyrgyz Republic: Exports by Factor Intensity, 1999-2002......................................... 10 Table 2.1: Depth of the Kyrgyz Banking Sector, 2002 ................................................................ 15 Table 2.2: Interest Rates in the Kyrgyz Banking Sector, 1998-2003 ........................................... 15 Table 3.1: Livestock Count in 2000 (x1000)................................................................................ 25 Table 3.2: Large Joint Ventures in Agriculture Industry.............................................................. 26 Table 3.3: An Example of a Value Chain for Coffee ................................................................... 27 Table 3.4: Cotton Production Statistics for Kyrgyzstan (1990–2001) ......................................... 28 Table 3.5: Central Asia. Selected Indicators of Cotton Exports (2001) ....................................... 29 Table 3.6: Comparative Supply/Demand for Nitrogen ................................................................ 35 Table 3.7: Comparative Supply/Demand for Phosphates............................................................. 35 Table 3.8: Drying/Cleaning Cost.................................................................................................. 39 Table 3.9: Ginning Cost Breakdown ............................................................................................ 40 Table 3.10: Yarn Production Value Chain for Kyrgyzstan .......................................................... 44 Table 3.11: Value Chain Breakdown for Sheep Farming ........................................................ 5756 Table 3.12: Administrative Costs Associated with Importing Chemicals................................ 5958 Table 3.13: Opportunity Costs Associated with the Brokerage System................................... 6362 Table 3.14: Opportunity Cost of the Informal Market on Public Sector Revenue ................... 6362 Table 3.15: Transaction Margins for Wool Half Coats ............................................................ 6867 Table 3.16: Butter Production Value Chain ............................................................................. 7574 Table 3.17: Administrative Costs Associated with the Production of Ice Cream .................... 7776 Table 3.18: Administrative Interventions Faced by Dairy Processors ..................................... 7978 Table 3.19: Administrative Interventions Faced by Medium Size Dairy Processor ................ 8079 Table 3.20: Legal Matrix Summary Sheet, Dairy Industry ...................................................... 8382 Table 3.21: Impact of Administrative Barriers on Production Cost/Litre of Milk ................... 8584 Table 3.22: Factors Inhibiting the Growth and Competitiveness of Value Added Dairy Products

........................................................................................................................................... 8584 Figures

Figure 1.1 : Kyrgyz Republic: Trade Performance, 1993-2003 ………………………………… 2 Figure 2.1 : Change in Bank Lending Maturity ………………………………………………... 15 Figure 3.1: Cotton Production in Kyrgyzstan (1990-2001) ……………………………………. 28 Boxes

Box 1.1: Quality of Trade Statistics ............................................................................................... 2 Box 1.2 How did Kyrgyz Exports Responded to Growing External Demand from Neighboring

Russia and Kazakhstan? …....……………………………………………………………… 12 Box 2.1: Increasing Banking Sectors Intermediation Capacity: A Matter of Skills and Knowledge

............................................................................................................................................... 17 Box 3.1: Summary of Barriers to Growth, Cotton Value Chain .................................................. 36 Box 3.2: Summary of Barriers to Growth, Cotton Ginning Value Chain .................................... 42 Box 3.3: Summary of Barriers to Growth, Cotton Yarn Value Chain ......................................... 45 Box 3.4: Summary of Barriers to Growth, Terry Cloth Towel Value Chain ............................... 48

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Box 3.5: Factors Inhibiting Growth and Competitiveness of Value-Added Cotton and Textile Industries ............................................................................................................................... 50

Box 3.6: Summary of Barriers to Growth, Sheep Farming Value Chain ..................................... 58 Box 3.7: Summary of Barriers to Growth, Sheep Hide Value Chain........................................... 60 Box 3.8: Summary of Barriers to Growth, Worsted Yarn Value Chain....................................... 63 Box 3.9: Summary of Barriers to Growth, Wool Coat Value Chain........................................... 68 Box 3.10: Factors Inhibiting Growth and Competitiveness of Value Added Wool Industry....... 69 Box 3.11: Summary of Barriers to Growth, Dairy Value Chain .................................................. 75 Box 3.12: Summary of Barriers to Growth, Butter Value Chain ................................................. 76 Box 3.13: Summary of Barriers to Growth, Ice Cream Value Chain........................................... 77 Diagrams

Diagram 3.1: Market Segmentation of the Cotton Industry in Kyrgyzstan ……………………. 32 Diagram 3.2: Cotton Production Value Chain for Kyrgyzstan ………………………………... 37 Diagram 3.3: Cotton Ginning Value Chain for Kyrgyzstan …………………………………… 40 Diagram 3.4: Yarn Production Value Chain for Kyrgyzstan ………………………………….. 44 Diagram 3.5: Terry Cloth Towel Value Chain for Kyrgyzstan …………………………………47 Diagram 3.6: Market Segmentation of the Wool Industry in the Kyrgyz Republic …………… 52 Diagram 3.7: Sheep Farming Value Chain ……………………………………………….. ….. 57 Diagram 3.8: Sheep Hide Value Chain ………………………………………………………. 59 Diagram 3.9: Worsted Yarn Value Chain ………………………………………………... …... 62 Diagram 3.10: Wool Coat Value Chain ………………………………………………………. 65 Diagram 3.11: Key Factors Inhibiting Competitiveness of the Wool Industry in Kyrgyzstan ... 67 Diagram 3.12: Value Chain for a Small and Medium Dairy Farm in Kyrgyzstan …………….. 69 Diagram 3.13: Random Traffic Police Inspections during Delivery of Milk from Rural Farm to Bishkek Processing Facility ……………………………………………………….. 71 Diagram 3.14: Butter Value Chain for Kyrgyzstan …………………………………………… 72 Diagram 3.15: Ice Cream Value Chain for Kyrgyzstan ……………………………………….. 73

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I. TRADE PERFORMANCE

1. Introduction

1. The Kyrgyz Republic's domestic market is small. Accelerating economic growth through capitalizing on growing external demand in the region and through increasing the Kyrgyz export offer outside the region are among the greatest challenges facing the Kyrgyz Republic in the period ahead. This section examines developments in Kyrgyz merchandize trade over the past decade with a view to highlighting weaknesses that need to be addressed through measures discussed extensively elsewhere in this Report. The section starts with reviewing Kyrgyz trade and analyzing trade openness. It then analyses the changes in trade origins and destination; specialization and concentration of exports; and the factor content of exports. The section concludes with brief analysis of recent developments in export markets and regional demand.

2. The following are the highlights from the analyses of the Kyrgyz trade performance over the last decade:

Integration of the Kyrgyz Republic into the world trade remains overly limited; The apparent reorientation of the

geography of Kyrgyz exports from the CIS countries towards the non-CIS destination was explained by, and large, gold exports; Complementarity of export and import

profiles of the Kyrgyz Republic and its main regional export markets, such as Russia and Kazakhstan, has declined; Despite some increase in CIS-destined

non-gold exports, Kyrgyz exporters have failed to fully capitalize on a growing regional demand; Kyrgyz exports have become increasingly

concentrated, compared also to other countries with large share of extractive-industry exports, which makes the exports vulnerable to changes in external

conditions, such as commodity prices and regional demand for water/electricity; Kyrgyz exports are predominantly natural

resource intensive (i.e., about 80 percent of Kyrgyz exports), in terms of factor content; Exports from the Kyrgyz Republic, that

were quite undiversified to begin with, have shifted further away from manufactures towards agricultural and industrial raw materials and have lost their revealed comparative advantage in a number of food and light industry products; Some non-traditional product groups, in

particular dairy products, have demonstrated strong growth and regional expansion.

2. The Kyrgyz Republic’s Integration into the Global Economy

3. During the 1990s, total trade in goods and services averaged 85 percent of GDP. Trade turnover increased during 1997-1999, mainly on the account of import expansion and gold exports, while Kyrgyz non-gold exports contracted as a share of GDP during the same period. Trade turnover as well as trade deficits have declined temporarily during 1999-2001 following a considerable import contraction, which has been reversed since then (see Figure 1.1). This, in combination with declining gold and power exports, resulted in increase in current account deficit to about 4 percent of GDP in 2002 despite strong performance of non-gold exports. With continued import growth and weak non-gold export performance, what keeps the current account deficit under 4 percent of GDP today is strong gold export performance—which won’t be long lasting as the largest gold reserves are expected to be depleted by 2008.

2

Figure 1.1: Kyrgyz Republic: Trade Performance, 1993-2003

Source: Staff estimates based on the official data.

Box 1.1: Quality of Trade Statistics

Official trade data are collected by the State Customs Department (SCD) and reported by the National Statistics Committee (NSC). The National Bank of Kyrgyz Republic (NBKR) adjusts NSC data for some shuttle trade. However, despite those adjustments the authorities data differ markedly from partner data reported by the UN COMTRADE database, which is partially due to the smuggling of imports and underreporting of exports. It is notable that the trade data has improved over time, however given the poor quality of the past statistics, it is difficult to accurately analyze the past trends. Nevertheless, a few points can be made on relative levels.

4. The openness of the economy—measured by the ratio of trade to GDP—compares the Kyrgyz Republic favorably both to the land-locked country group and the low-income countries. However, an empirical analyses of openness1 suggests that the trade realization ratio (actual trade/predicted by the model) for the Kyrgyz Republic is: (i) less than what it should be, based on its size and income level; and (ii) below that of the other CIS countries’ ratio2 (except of Armenia, Georgia, and Uzbekistan). This divergence is due to a combination of domestic and external trade barriers (see discussions on this elsewhere in this Report). 1 See Freinkman, Polyakov and Revenco, “Trade Performance and Regional Integration of the CIS Countries,” 2004. 2 Since the CIS countries as a group have on average been more open than any other regional country groups (except for Eastern Asia) it is useful comparing the Kyrgyz Rep to other CIS countries.

5. Measured on a per capita basis, total exports—at their 2002 level of US$98.5—compare favorably to a group of countries that are similar in terms of land-locked status, resource endowments, and the level of economic development.3 This is less the case for non-gold exports per capita, which have declined over the decade and at current US$65 level, while still comparable to poor land-locked countries, remain below the average for low-income countries. When compared within Central Asia (per capita exports of US$280), however, the Kyrgyz exports display a very low per capita levels (Table 1.1).

3 Per capita GDP is used as a proxy for the level of economic development.

-600-400-200

0200400600800

1,0001,200

93 94 95 96 97 98 99 00 01 02 03

Trade Balance

Non-gold exports GNFS

Exports GNFSImports GNFS

3

Table 1.1: Selected Indicators, Country Groups Selected as Comparators for the Kyrgyz Republic

6. Trade in services remained on an average at about 15 percent of GDP over the period 1996-2003. Services exports started to recover in late 1990s after an almost total collapse following the dissolution of the Soviet Union and grew fast over the past two years, mainly following the establishment of the international coalition military base in 2002.4 In GDP terms, services exports increased to about 8 percent in 2002-2003 from an average of 5 percent during the period 1998-2001. At the same time, services imports declined to about 8 percent of GDP in 2002-2003 from an average 10 percent during the period 1998-2001. This decline in services imports mirrored goods import contraction of 1999-2001 (see para. 3 above) and occurred mainly in railroad transport and government services. Main services exports presently comprise transport (30 percent), travel (17 percent), and business services (15 percent). Main categories of services imports include

4 Establishment of the US Army military base in Kyrgyzstan following the US attack on Afghanistan in the fall of 2001 generated demand for various types of services, including transportation and travel.

transport (32 percent) and business services (28 percent).

3. Origins and Destinations

7. The integration of the Kyrgyz Republic into the global economy and its geographical diversification of trade remains limited. While, on aggregate, there has been a major reorientation of the geography of Kyrgyz exports away from the CIS countries and towards the non-CIS markets since 1997, this has been almost entirely accounted for gold exports, which represents 40 percent of total exports at present. Given the exchange/trade commodity feature of gold, analysis of non-gold export destination is more relevant for revealing the trends in geographical diversification of trade.

8. The pattern of non-gold production and non-gold trade in the Kyrgyz Republic still bear many features from the Soviet era when the Kyrgyz Republic was overtrading with the other republics of Soviet Union and under-trading with the rest of the world. Despite some reorientation of non-gold trade flows away from traditional partners in the CIS towards new markets, the pattern of such

Exports

to GDP

Ratio PrimarGoods

Kyrgyz Republic 2002 0.30 69.8 30.2

Landlocked countries average 0.17 60.4 33.7Low income countries average 0.24 55.2 43.8Middle income countries average 0.26 43.4 70.0

High income countries 0.41 25.7 74.3Central Asian Countries 0.37 .. ..

102

Population

(million) Capita ($)

GDP

($ million)

Export Share (%)

No. of

Products

Exported

Exports

Per

5.0

6.6

1,632

1,594

99

22.5 9,044 95 ..44,128 738 ..

7041

Source: Export Profiles of Small Land-Locked Countries by Francis NG and Alexander Yeats, Based on partner’simport data drawn from UN COMTRADE statistics (1999 data), data for KR is provided by Kyrgyz authorities(2002).

Note: Land-locked countries represent 16 land-locked countries selected based on the following criteria: relatively smallpopulation and market size, relatively limited natural resource endowments, and relatively remote location from major OECDmarkets. High income countries include both OECD and non OECD countries, but exclude the USA and Japan.

Manufactures

11.2 8,440 280 ..16.5 342,418 8581 ..

15.4

4

trade flows remain unstable (see Table 1.2). Overall, the number of trading partners of the Kyrgyz Republic increased from 38 in 1992 to 56 in 2002, but trade with only 38 of them

exceeds US$1 million (less than 0.1 percent of total trade).

Table 1.2: Kyrgyz Republic–Non-gold Exports by Destination, 1999-2002 (as share of total)

Source: Official data.

9. Measured by estimates using the gravity model—a tool which helps analyze potential and realized trade flows5—the Kyrgyz Republic’s exports to the CIS (mainly Russia, Kazakhstan, Uzbekistan, and Tajikistan) are larger than predicted by the model. This can be partly explained by historical ties, geographical proximity to the CIS countries and remoteness from other parts of the world, existing transport, power and irrigation infrastructure, and common use of the Russian language, which facilitates operation of Kyrgyz trade agents in the CIS markets.

10. Trade intensity6 between the Kyrgyz Republic and its traditional CIS partners has,

5 Recently applied in the paper on the CIS trade by Freinkman, Polyakov and Revenco. 6 Trade intensity index (I ij ) measures the extent to which country j’s share of i’s total exports is large or

however, considerably declined over the past decade. For instance, total trade with Russia, Kazakhstan, Tajikistan and Uzbekistan, although about 30 times more intense than the average, is almost twice less than what it was in early 1990s. This decline is partly explained by diminishing complementarity7 small in relation to j’s share in world

trade:w

j

i

ijij

mm

xxI = , where X ij is country i’s exports

to country j. If trade is not geographically biased, the ratio will be equal to 1. The larger the ratio the larger will be the trade intensity index suggesting to the possible trade diversion. 7 Trade complementarity index shows how well the export profile of one country matches the import profile of the other country. The index of trade complementarily between two countries K and J (Ckj) is defined as:

∑ ÷−−= )2(100 ijkj xmC ik . The index is zero

when no good exported by one country is imported by the other, and 100 when the export-import shares exactly match.

1999 2000 2001 2002 2003

Total CIS 67.7 67.1 67.0 52.3 62.6 Russia 26.1 21.1 25.6 24.8 30.2 Kazakhstan 16.6 10.8 15.5 11.4 17.8 Tajikistan 3.5 2.4 2.7 3.2 5.9 Uzbekistan 17.2 28.9 19.1 8.6 5.1 Ukraine 0.5 0.4 1.2 1.3 1.7 Belorussia 1.8 1.0 1.3 0.4 0.5 Other CIS 1.9 2.5 1.7 2.6 1.6

Total Non-CIS 32.3 32.9 33.0 47.7 37.4 United Arab Emirates 0.4 0.5 0.2 0.3 0.0 Switzerland 0.1 0.2 0.2 0.1 0.0 Canada 0.1 0.0 0.5 1.5 9.6 China 9.4 11.4 7.7 12.7 7.3 Turkey 1.7 2.3 5.5 5.1 3.4 USA 0.4 0.9 2.8 11.2 2.0 Germany 1.5 1.3 1.2 0.5 0.9 United Kingdom 0.4 2.0 1.8 0.3 0.0 Other 18.2 14.2 13.1 15.7 13.4

5

between the export and import profiles of the Kyrgyz Republic and its main trade partners (see Part V, part B of this section for a more detailed analysis).

11. As noted above, with the initiation of the gold exports, some non-CIS trading partners have emerged, e.g., Switzerland, Germany and United Arab Emirates. Another notable aspect of the Kyrgyz non-CIS trade is the growing importance of exports to the United States (8 percent of merchandise exports in 2002, compared to less than 2 percent during the 1990s). This is, however, driven largely by the presence of the international coalition military base in the Kyrgyz Republic, with re-export of fuel accounting for much of the increase.8

12. Table 1.3 provides detailed presentation of Kyrgyz exports by composition and destination. Overall, exports to CIS countries (mainly Russia, Kazakhstan, Uzbekistan, Tajikistan and lately Azerbaijan) are concentrated in raw materials, such as cotton and tobacco, electric current, and some specific food products like fruits and vegetables (mainly apples, beans and onions, dairy products and sugar). In manufacturing sector, exports to CIS are concentrated in textile yarn and fabric, non-metallic mineral manufactures, metal manufactures, filament lamps, road vehicles and vehicle spear parts. Exports to non-CIS countries are much less diversified, consisting of gold, cotton, wool, hides and skins, leather, scrap metal, and inorganic chemicals.

13. Geography of import markets shows more diversification than exports. The Kyrgyz imports have traditionally been originated mainly from Russia, Kazakhstan and Uzbekistan, but Chinese and Turkish goods have become competitive since mid 1990s, following liberalization of trade.9 Imports 8 Kyrgyz trade statistics do not allow to differentiate between gross and net exports. 9 In 1995 Russian and Kazakh goods share in domestic absorption represented about 7 percent, followed by Uzbek goods at 5 percent. In the aftermath of the regional financial crisis, Russian goods have gained an additional share of Kyrgyz market but later have

from the OECD countries have been predominantly related to goods and services procured in the context of the public investment projects, FDIs in selected sectors (mainly gold mining) and humanitarian assistance.

returned to their 1995 level. Performance of Kazakh imports was the opposite. During the regional crisis they have lost the market share, but have regained it in late 1990s and have registered higher import shares than in 1995. Uzbek goods seem to loose the market share in Kyrgyz republic over the period 1995-2002. Chinese consumer goods imports have somewhat substituted Turkish goods, with the share of the former declining from 2 to 1 percent and the share of the later increasing from less than 1 to 3.5 percent of domestic absorption.

6

Table 1.3: Composition and Destination of Kyrgyz Non-Gold Exports

Source: Staff calculations based on the official data.

4. Specialization and Concentration of Exports and Import Composition

14. The Kyrgyz economy is driven by extractive industry and primary agriculture, with higher value added activities remaining at their infancy. Consequently, Kyrgyz exports consist mainly of natural resource-based products, with a large share of metal, minerals and agro products exported in crude or semi-processed form.

15. Kyrgyz exports have become increasingly concentrated over time, compared also to other countries with large share of extracting exports. Besides the principal export item gold (which currently accounts for about 40 percent of total exports),10 exports are concentrated around few items—cotton, electric current (bartered for natural gas and coal) and tobacco. This makes exports vulnerable to changes in external conditions, such as commodity prices and regional demand for water/electricity. In 10 Reserves of Kumor gold deposit, that have been exploited since 1995, are expected to run out by 2008. Smaller deposits, namely the Jeeroy, which is one forth of the size of Kumtor and Taly-Bulak, one half of the size of Jeeroy, are planned to start production in 2005 and 2006 respectively.

addition, like other countries with heavy reliance on depletable resources, the Kyrgyz Republic’s export offer, if remain unchanged, will exposed it to risk of erosion of external payments position and increased vulnerability to external shocks once these resources are depleted.

16. The estimates made based on Hirschmann index11—a common measure of trade concentration—further highlights the concentration of Kyrgyz exports. The index increased from 0.118 in 1995 to 0.468 in 2001,12 mainly reflecting the concentration of exports around one major export commodity, i.e., gold, since 1997. Nevertheless, the index 11 Hirschmann index values range from zero to unity, with higher numbers corresponding to greater

concentration

n

nXx

H i

i

i 11

12

−

−

=∑

where xi is

the export value of commodity i, X is the value of total exports, and n is the number of products at the 3-digit SITC level (239 product groups). 12 The Hirschmann index was estimated at 0.339 in 2002, reflecting low gold production following the accident at the Kumtor gold mine.

Rus Kaz Uzb Taj Azer Turkmen Afg Canad Belg ChinaCzech Rep.

Romenia

Latvia Hungary Turkey Netherl France

USA

02 Dairy - x - - - - x - - - - - - - -05 Fruits and Vegetables x x x - x - - - - - - - x - -06 Sugar,sugar preparations x x x x - - x - - - - - - - -11 Mineral water - - x - - - - - - - - - - -12 Tobacco and tobacco manufact. x - - - - - - - - - - - - - -21 Hides,skins and furskins,raw - - - - - - - - - x - - x - -26 Textile fibres x - - - - - - - - x x x x - -27 Crude fertilizers and crude materia - - x - - - - - - - - - - - -28 Metalliferous ores and metal scrap - - - - - - - - - x - - - - -35 Electric current - x x x - - - - - - - - - - -52 Inorganic chemicals x - - - - - - x - x - - x x x61 Leather - - - - - - - - - x - - - - -65 Textile yarn,fabrics,made-upart.,re x x - x - - - - - - - - - - -66 Non-metallic mineral manufactures,n x x x x - x x - - - - - - - -68 Non-ferrous metals - - - - - - - - - x - - - - -6924 Manufactures of metal,n.e.s. x x - - - - x - - - - - - - -7643 Radio/tv transmit. Equ - - - - - x - - - - - - x - -77 Electrical machinery,apparatus & ap x x x x x x x - - - x - - x -78 Road vehicles (incl. air cushion ve x x x - - - x x x x - - x - -84 Articles of apparel and clothing ac x - - x - - - - - - - - - - -8931 Plastic boxes/lids - x - - - - - - - - - - - - -

7

shows an increase from as low as 0.118 in 1995 to 0.279 in 2000, when evaluated for non-gold exports as well—reflecting the concentration of non-gold exports around power, cotton and tobacco. Table 1.4 presents

the Hirschmann index for some comparator CIS countries, which points to the highest concentration of exports in the Kyrgyz Republic.

Table 1.4: Export Concentration Index, 1997 and 1999

17. Kyrgyz exports have not shown any considerable diversification either. The number of items exported, currently at about 130 items (>US$ 100, 000) according to SITC 4 digit classification, is and has historically been high, compared to other landlocked countries. However only 20 exceed the value of US$1 million (i.e., less than 0.2 percent of total exports).

18. Leaving gold aside, the top three export product categories—electric current, cotton and tobacco—have been stable in post-independence era. Other major exports currently include hides, metal scrap (aluminum and lead), inorganic chemicals, vegetable and fruits (beans and edible nuts), sugar and some manufactured goods, and machinery and transport equipment (such as filament lamps, motor vehicle parts and semi-trailer tractors, asbestos and rolled glass sheets, and metal tanks).

19. The export shares of main non-gold product groups (by SITC classification) have shown the following pattern over the last decade:

Net reduction in export shares of food and live animals—mostly accounted by meat and meat products, cereals and cereal preparations, sugar, vegetables and fruit;

Net reduction in export shares of chemicals— mostly accounted by organic chemicals exports;13

Net reduction in export shares of manufactured goods—mostly accounted by textile yarn and fabrics, non-metallic mineral manufactures, iron and steel and non-ferrous metals;14

Net increase in export share of tobacco;

Net increase in export share of crude materials—mostly accounted by cotton, hides an metal scrap);

Net increase in export share of power—mostly accounted by electric current; and

13 The inorganic chemicals exports have remained at their previous levels. 14 Some insignificant increase in the leather exports has occurred in 2002.

No. of Items exported

Concentration index

No. of Items exported Concentration index

Armenia 93 0.237 80 0.349Moldova 123 0.307 97 0.250Kyrgyz Republic 160 0.162 147 0.412Latvia 192 0.162 188 0.211Estonia 207 0.092 201 0.124Lithuania 213 0.122 210 0.113Russia 224 0.270 222 0.261

1997 1999

Source: National Statistics Department of the KR; WB staff calculations; TDS for Armenia.

8

Net increase in export share of machinery and equipment—with the decline in exports of general industrial machinery and equipment and specialized machinery compensated by the increase in exports of road vehicles.15

20. Although the initial change in export composition reflected structural changes in the economy triggered by the break-up of the Soviet Union, the prolonged shift from production of higher value added to lower value added activities reflect, as discussed extensively in this Report, poor implementation track record of second generation structural reforms and weaknesses in the micro-level business climate, repressing the growth of formal private sector activity.

21. Presently, there are only few products in which the Kyrgyz Republic has a strong revealed comparative advantage (see Table 1.5). Based on an estimated Revealed Comparative Advantage Index (RCA),16 these goods are concentrated in non-manufacturing groups: primary agricultural goods (cotton, tobacco, hides and skins), power and gold. As shown in Table 1.5, the most notable trend in the Kyrgyz RCA over the years has been the decline in industrial trade, including food and light industry and other manufacturing trade.

22. Concerning the composition of imports, the imports of consumption goods, although expanded dramatically in late 1990s

15 The fact that the export of electric lamps has remained stable has also contributed to the stability of the share of this export group in the total non-gold exports. 16 The index for country i good j is RCAij = (Xij /Xit)/( Xwj /Xwt)*100 where w=world and t=total for all goods. The Revealed Comparative Advantage index (RCA) compares the composition of exports of a country with the composition of total world exports. An RCA index higher than one indicates that a country has a strong revealed comparative advantage in the export of the product. An RCA index lower than one indicates that the country has a comparative disadvantage in that product. An RCA index equal to one indicates that the country has neither advantage nor disadvantage

(reaching 14 percent in 2000), have remained broadly unchanged at about 12-13 percent of domestic absorption. Energy imports have declined from above 11 percent to about 9 percent of domestic absorption. Investment goods imports grew during 1995-1999 (reaching 11.2 percent of domestic demand), but declined thereafter (to 6 percent currently), following the reduction of externally financed public investment projects and Kumtor gold-mine related imports. Intermediate goods imports grew insignificantly, while the raw materials imports declined to less than 3 percent of domestic absorption, reflecting the downsizing of industrial, especially manufacturing, production. In sum, today imports are highly consumption driven (cumulative level of consumption goods and energy imports is above 60 percent of total goods imports); reflecting the increasing dominance of low-value added activity, imported inputs are extremely low.

9

Table 1.5: CIS Countries–Revealed Comparative Advantage

Note: Countries with export specialization index lower than the KR are shown in italics. Source: Staff calculations based on the official data.

5. Factor Content of Exports

23. As demonstrated above, Kyrgyz exports—led by exports of gold, power, cotton and tobacco—are predominantly natural resource intensive (about 80 percent of Kyrgyz exports).17 Labor intensive exports—both unskilled and skilled (each about 5 percent of total exports)—as well as capital intensive exports (9 percent of total exports) are quite suppressed (see Table 1.6).

24. In addition to the high share of gold, power, cotton and tobacco exports, other top products in the natural resource based category are hides, leather and metal scrap. Those exports however, bear a temporary nature and mainly result from the dismantling of the pre-independence fixed assets and infrastructure (in case of metal scrap) or reflect the weaknesses in the value chain of exports (in case of hides and leather) which encourages exporting unprocessed hides and leather rather than engaging in the higher levels of processing (see Volume II, Value Chain analyses). Exports of goods with high weight-to-value ratios, like construction materials (e.g., cement, asbestos) will be difficult to expand outside the region due to the cost effectiveness reasons.

17 The share of NRI exports was estimated at about 76 percent in 2002 reflecting the temporary reduction in gold exports due to the accident at the Kumtor gold mine.

25. In terms of total volumes, export performance has improved only for the natural resource intensive group of products, while the other three groups (i.e., skilled and unskilled labor and capital intensive) have remained broadly unchanged over the past three years.

26. The aggregated annual export volume of both unskilled and skilled labor intensive products is about US$50 million (i.e., about 10 percent of total trade). These exports grouped around few major items like metal tanks < 300 liters (SITC 6924), semi-trailer tractors (SITC 7832), used trucks (SITC 7833), motor vehicle parts (SITC 7843) and plastic boxes for packaging and transportation (SITC 8931).

27. The technology intensive (or capital intensive) goods include two major products, i.e., inorganic chemicals and electric filament lamps (SITC 77821), and they constitute less than 10 percent of total trade.

Gained RCA

Fruit and vegetables Geo, Mold, Tajik, Uzbek Live animals Dairy products Belarus, Mold., Ukr.Sugar Moldova, Ukraine. Meat and meat prep. Moldova, Ukraine. Leather manuf. Geo, Mold, Ukr.Cotton Tajikistan, Turkm and Uzb. Cereal and cereal prep. Kazakh, Mold, Ukraine.Tobacco Moldova. Beverages Arm, Geo, Moldova.Hides and skins Armenia, Georgia, Moldova. Oil seeds Mold, Ukr, Uzbek.Electric current Arm, Azerb, Tajik, Uzbek Animal oil/fat Animal oil/fatInorganic chemicals Ukraine. Non-ferrous metals Kazakhstan, Tajikistan.Gold Uzbekistan. Chemical ind. (organic) Azerbaijan.

Textile yarn, fabrics Belarus, Uzbekistan.Non-metallic mineral Armenia.

Current RCA Foregone RCA

10

Table 1.6: Kyrgyz Republic: Exports by Factor Intensity, 1999-2002

Source: Staff calculations based on the official data.

6. International Competitiveness

28. This section examines some aspects of developments in international competitiveness of the Kyrgyz Republic over the period 1995-2002 by analyzing the evolution of the Kyrgyz Republic’s export and import market shares. Although the literature on competitiveness suggests that the international competitiveness might be assessed by analyzing market share gains (or losses), in the case of the Kyrgyz Republic, this type of analysis may not prove too revealing, due to the fact its trade with its regional partners is hampered in part by trade barriers. Therefore other measures of competitiveness, like the evolution of the real effective exchange rate (REER), and relative unit labor costs (RULC) are also analyzed in Volume I, Chapter IV of this Report.

Development in Export Market Shares

29. As demonstrated above, the geographical destination of Kyrgyz non-gold exports18 remained broadly unchanged,19 but Kyrgyz exports have experienced a net loss of their regional market shares since mid-1990s. Retaining the existing export market shares in the partner countries would have required an increase in volumes and values of exports to these countries as the Kyrgyz Republic’s main 18 In order to assess the evolution of export market shares, trade in certain inelastic goods, like gold, should be netted out from the total export figures. 19 The share of five largest importers of Kyrgyz goods, i.e., Kazakhstan, Russia, Tajikistan, Uzbekistan, and China represented about 65–70 percent of total non-gold exports in 2002.

export partners had experienced quite a dynamic economic growth and import expansion during 1995-2002, despite a temporary slow down associated with the regional financial crisis. In the event, exactly the opposite has happened, with both the volumes and values of Kyrgyz exports to the major export markets dropping significantly during the same period—e.g., total value of exports to the five major export destinations dropped by about US$122 million between 1995 and 2002. A significant loss in market shares has occurred in Uzbekistan and Kazakhstan. The share of Kyrgyz goods in total Uzbek imports has declined from more than 2 percent in mid 1990s to about 1 percent in early 2000s and in total Kazakh imports from 1.3 percent to 0.4 percent respectively.

30. A similar pattern is observed vis-à-vis big and growing trading partners’ markets, such as Russia and China. Given the large total import volumes of Russia and China, the share of Kyrgyz exports in these countries’ total imports has been marginal, albeit being very important for the Kyrgyz economy―these shares are down to 0.13 percent from about 0.2 percent for Russia, and down to 0.02 percent from about 0.05 percent for China during the period 1995-2002.

1999 2000 2001 2002 1999 2000 2001 2002

Total (excl. gold and electricity) 453.8 504.5 473.2 460.5 100.0 100.0 100.0 100.0Natural Resource NRI (1) 367.7 415.3 381.8 350.5 81.0 82.3 80.7 76.1Unskilled Labor UNLI (2) 25.2 24.8 25.7 35.3 5.6 4.9 5.4 7.7Technology (Capital gds) TI (3) 39.1 44.0 42.3 49.6 8.6 8.7 8.9 10.8Human Capital (HCI) (4) 21.8 20.4 23.4 25.1 4.8 4.0 4.9 5.4

(in US$ mn) (as share of total)

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External Demand

31. Geographical location and associated high cost of transportation to the world’s major trade markets is generally claimed as a reason constraining export promotion in the Kyrgyz Republic. However, the fact that the Kyrgyz Republic have missed opportunities provided by the growing income/demand in neighbors and actually lost its market share to a wide-range of other countries20—not only in the region but also outside the region (e.g., EU, LAC, EA, SA and Africa)—reveals deeper problems than those related to location (see Box 1.2).

32. Conditions in the closer regional markets therefore are of utmost importance in determining the prospects for broadening the production base and export offer. What follows highlights the future prospects of external demand in the region and the challenges that the Kyrgyz exporters will face in the period ahead in the regional markets. 33. The Kyrgyz Republic, is neighboring or is situated in a relatively close proximity and has traditional economic and social links to two resource rich countries, Russia and Kazakhstan. Imports are an important component of consumption (and investment) in both countries, accounting for about 25-30 percent of GDP. Both countries have been growing steadily since late 1990s—real growth averaged 6 percent in Russia and 8 percent in Kazakhstan during 1999-2002. Import growth resumed with one-year lag and averaged 17 percent in Russia and 15 percent in Kazakhstan during the period 2000-2002. The medium-term economic forecasting projections estimate the real GDP growth to be above 5 percent for Russia and around 6 percent for Kazakhstan, and import growth to be at about 7 percent for Russia and 5 percent for Kazakhstan.

20 Kyrgyz non-gold exports have lost market shares in the main trading partners’ markets, such as Russia and Kazakhstan, during the period when these countries experienced quite dynamic economic growth (6-8 percent, respectively) and import expansion (17-15 percent, respectively). See Box 2 for details.

34. Similarly, China, another neighbor with growing economy, is expected to continue to grew in the period ahead—China has been growing at the average rate of 9 percent, with import growth averaging at 16 percent over the past decade; medium term growth in China is forecasted at 7 percent and imports’ growth at 8 percent.

35. In principal, increase in income of the neighboring trade partners would have lead to increase in the Kyrgyz Republic’s net exports, unless exported goods are inferior. Present Kyrgyz export offer, has not been favoring demand on Kyrgyz exports, as consumer’s preferences have been increasingly shifting towards sophisticated and high quality products. For instance, expansion of Russia’s and Kazakh imports was lead by growth of demand for food products and manufactures, while the Kyrgyz Republic’s exports were mainly focused in agricultural materials, textile fibers, ores, minerals and metals and energy. Hence, as discussed above, the trade complementarity between the Kyrgyz Republic and both countries has declined, reducing the prospects for expansion of trade.

36. The fact that the Kyrgyz Republic’s trade partners have not yet fully liberalized their trade regime, however, suggests that their current trade pattern will continue to evolve in the future. This both provides opportunities for the Kyrgyz economy and increases challenges it needs to face due to the following: (i) the ongoing trade liberalization process in the region is bringing increasing global supply, so the Kyrgyz Republic has to face tougher competition; (ii) rise in external demand will be mostly stimulating imports of superior goods,21 so the Kyrgyz Republic’s current mostly inferior export offer has to diversify; and (iii) external demand for food (e.g., meat, cereals, dairy products, fruits and vegetables) will be growing, however, export earnings from primary or semi-processed agricultural products, with low value-added, will be low, (the unit costs of such exported items have been on the decline). 21 Manufactures are more likely to be superior goods than agricultural commodities or raw materials.

Box 1.2: How did Kyrgyz Exports Responded to Growing External Demand from Neighboring Russia and Kazakhstan

This Box presents the evolution of selected Russian and Kazakh imports, with likely-to-continuestrong upward trend, as well as Kyrgyz exports to both markets, with potentially strong spill-overeffects on the supply-side of the Kyrgyz economy.

Meat and meat preparations: Meat and meat product imports doubled in both Russia andKazakhstan. Kyrgyz exports of this group of products declined in Russia and grew only marginally inKazakhstan. Overall, Kyrgyz exports lost their respective, albeit low, market shares in both countries.Russian imports of meat and meat preparations shifted toward countries specialized and highlycompetitive in meat exports like Brazil, United States, some EU countries, Ukraine and China, whileKazakh imports of meat originate predominantly from Russia and US. It is notable that along withthe Kyrgyz Republic, the majority of the CIS also lost their shares in Russia market.

Dairy products and eggs: Dairy products and eggs imports increased by more than 60 percent inboth Russia and Kazakhstan and re-oriented toward the EU, Ukraine and New Zealand. In addition,Russia is the main exporter of this group of products to Kazakhstan. The Kyrgyz Republic has shownconsiderable improvement in this highly competitive market with its exports quadrupling to bothcountries, albeit from a very low base. It is notable that Kyrgyz exports of dairy products nowcapture about 5 percent of Kazakh dairy imports market. Other CIS countries (excluding Russia andUkraine) have performed quite poorly.

Vegetables and fruits: Vegetables and fruits imports increased by about 45 percent in Russia and 15percent in Kazakhstan. They also showed growing geographical diversification (e.g., Ecuador,Uzbekistan, EU, China, Morocco). Kyrgyz exports have lost their market share in both countriesalthough Kazakhstan continues to be a main export partner for the Kyrgyz Republic in this export-line. On the contrary, many other CIS countries have capitalized on growing demand in Russia andKazakhstan and increased their export market shares in both countries.

Textile yarn: Imports of textile yarn and fabrics grew by about 30 percent in Russia and 40 percentin Kazakhstan. Kyrgyz exports to Russia decline by over 60 percent. It lost its market share to highlycompetitive growing exporters such as China, Korea and Turkey, which also import to Kazakhstanalong with Russia. Kyrgyz exports to Kazakhstan, however, almost doubled resulting in aggregategain of the market share for this product. CIS countries lost their respective market shares in bothRussia and Kazakhstan

Selected Indicators, 1999-2002

1999 2000 2001 2002Total imports Russia (US$ mn) 39,537.0 44,862.0 53,764.0 60,966.0 share of Kyrgyz exports 0.2 0.1 0.1 0.1

Kazakhstan 5,648.2 6,848.2 8,223.9 8,886.4 share of Kyrgyz exports 0.8 0.5 0.5 0.4

Kyrgyz exports To Russia 15.3 12.7 13.4 17.3 To Kazakhstan 9.7 6.5 8.1 8.0

(as share of total Kyrgyz exports)

Source: Official statistics.

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13

II. FINANCIAL SERVICES AND TRADE FINANCE

1. Introduction

37. The provision of financial services is essential for the functioning of a modern market-based economy and for stimulating economic growth and integration. Financial services are especially important to facilitate trade and intermediation, where there is need for diversified services and instruments to increase flows and improve certainty of payments across borders and in different currencies. The contribution of the Kyrgyz financial system to economic development and trade during the last decade of transition has been limited. The core financial system was created between 1992 and 1993, with the establishment of the National Bank of the Kyrgyz Republic (NBKR) and the two-tier banking system.

38. The system suffered a financial crisis in 1995 as hyperinflation and the drop in the industrial output triggered large losses in the portfolios of banks. To address the effects of the crises, the Government and the NBKR embarked in an ambitious reform program, which included bank consolidation and privatization, enhancement of the supervision functions of the NBKR, and development of the legal and regulatory framework supporting intermediation. The reform brought positive effects as economic growth resumed and inflation stabilized. The NBKR enhanced its supervision functions and closed a number of insolvent banks. The Parliament passed a number of laws and legislations supporting banking and private sector intermediation.

39. The Kyrgyz Republic suffered a new setback on the aftermath of the Russian financial crisis in 1998, which brought macroeconomic instability, high inflation and devaluation, and bankruptcy of the largest industrial conglomerate and four of the largest banks in the country. The Government and the NBKR addressed the crises by tightening monetary and fiscal policies, and fostering the financial sector reform agenda. The NBKR phased-in increased minimum capital requirements in an attempt to consolidate the

system and phase out undercapitalized banks. At the same time, it enhanced supervision and resolution.22

40. The financial and banking system has now started to stabilize and show decisive signs of improvement. Nevertheless, it still remains small, fragile, and under-developed, with depositors confidence yet to be established. It is dominated by commercial banks, which account for US$271 million or 14 percent of GDP in total assets, and by two non-bank financial institutions engaged in microfinance and rural lending. While the leasing sector is growing fast, other financial services such as insurance, pensions and capital markets are at their early stage of development.23

41. This section elaborates on the financial and banking sector’s performance, support to trade promotion and the economy at large, and constraints the sector face in intermediation. It concludes with brief review of the Government’s and the NBKR’s response to address weaknesses in the legal and technical infrastructure supporting intermediation, and reform priorities in financial and banking sector that will facilitate growth of trade and businesses.

22 Since 1998, the NBKR has revoked the licenses of 9 commercial banks, and narrowed the licenses of two others. 23 The enactment of the Law on Leasing and subsequent amendments to the tax code in June 2003 laid ground for the development of the Leasing sector. As of the end of 2003, there were two leasing companies in the country, and four commercial banks engaged in leasing transactions, with total US$0.98 million leasing contracts signed so far. To facilitate further the development of the Leasing sector, the authorities are currently considering to allow accelerated depreciation for leasing.

14

2. Support to Trade

42. Trade finance in The Kyrgyz Republic has not yet developed to its potential due to the underdevelopment of the financial, banking, and enterprise sector. The most developed trade finance products are provided by banks in the form of working capital loans for import/export activities and letters of credit. Leasing, which is a growing sector in The Kyrgyz Republic, is mostly provided directly by banks.24 More developed trade services, such as performance guarantees and bonds, import/export insurance, and the like, are not yet developed. Most of the long-term working capital loans are extended by the commercial banks under donors’ and IFIs’ credit lines, and by the Kyrgyz Financial Agriculture Corporation (KAFC), a specialized non-bank financial institution, which provides credit services to the agriculture sector. One of these credit lines is specialized in trade finance services, providing funding and bank confirmations for letters of credit and other specialized trade financing services (see Attachment 1 for a list of current credit lines and trade facilities).

43. According to the NBKR, as of the end of 2003, bank loans for trade amounts to som 409 million (US$9.7 million equivalent), suggesting that the contribution of banks to businesses, and trade seems meagerly low at 0.5 percent of GDP (compared to the share of trade to GDP of about 65.5 percent in 2003). This is in line with the relatively limited intermediation role that banks and other intermediaries play in the Kyrgyz Republic. In addition to the small disposable income and low savings rate in the economy, this is attributable to the following factors:

lack of trust in banks, due to the aforementioned two banking crises and several bankruptcies, which characterizes

24 Due to the underdevelopment of the financial sector in The Kyrgyz Republic, banks are taking the lead in the leasing sector. This somehow differs from experiences in more developed countries, where banks either set up separate operations under their ownership, or provide direct funding to leasing intermediaries.

the transition path from a socially planned system to an open market economy;

small deposit base and lack of long-term funding, limiting the capacity of banks to develop their product base and, hence, to expand their outreach, to improve their technology, and to lower intermediation costs;

underdeveloped capacity in banks, financial intermediaries, and businesses in coping with the challenges of a market economy, which has made traditional bank lending and intermediation a relatively risky and unprofitable business;

delays in the development of a sound framework for intermediation, including supervision, property and creditors’ rights, accounting and auditing, which have contributed to high lending risks, forcing banks into collateral-based crediting.

44. Against this background, there are some early signs of positive trends in the above outlined picture, thanks to the improved macroeconomic conditions. Bank funding and depositors’ confidence are improving, with bank’s deposit base steadily increasing over the last three years—e.g., M2-to-GDP increased from 8 percent in 2000 to 11 percent in 2002 and 17 percent in 2003. Nevertheless, deposits to money supply decreased to 36 percent in 2003 from 46 percent in 1999, indicating that banks are not yet fully capturing the effects of improved macroeconomic conditions and growth (see Table 2.1).

Table 2.1: Depth of the Kyrgyz Banking Sector, 2002

Table 2.2: Interest Rates in the Kyrgyz Banking Sector, 1998-2003

Source: The NBKR Bulletin (November 2003).

% of GDP - end 2002 Kyrgyz CSI E. Europe South EE EU

Credits to Private Sector 4.1% 11.7% 32.0% 27.6% 108.6%

Demand Deposits 1.1% 3.4% 14.5% 6.7% 28.0%

Time & Savings Deposits 4.4% 8.6% 28.2% 25.6% 24.0%

Capitalization 2.8% 5.0% 8.6% 9.3% 15.5%


Figure 2.1: Change in Bank Lending Maturity

Lending Rates 1998 1999 2000 2001 2002 2003 (III)0 to 3 months (in Soms) 60.1 57.6 39.4 41.0 25.0 27.3 3 to 12 months (in Soms) 75.0 62.0 46.1 43.0 29.0 28.1 0 to 3 months (in US$) 43.7 30.9 29.6 21.4 19.0 21.9 3 to 12 months (in US$) 44.1 34.3 32.2 21.8 22.0 22.6 Deposit Rates (Savings) 0 to 3 months (in Soms) 43.7 35.6 17.3 11.1 6.2 7.3 3 to 12 months (in Soms) 44.1 43.3 24.8 16.6 8.6 9.1 0 to 3 months (in US$) 12.0 10.3 5.8 4.7 4.2 3.7 3 to 12 months (in US$) 18.4 12.0 8.7 8.7 7.6 7.7 Margins (Real) 0 to 3 in Soms (0.4) (17.9) 12.4 26.2 16.5 17.4 3 to 6 in Soms 14.0 (21.1) 11.7 22.7 18.1 16.4 0 to 3 in US$ 14.9 (19.3) 14.2 12.9 12.5 15.7 3 to 6 in US$ 8.9 (17.6) 13.9 9.4 12.1 12.3

15


1999 to 2003 - Percent of total loans

0% 10% 20% 30% 40% 50% 60% 70%

M2x to GDP Loans > 1 year (Som) Loans > 1 year (US$) Loans > 1 year (Tot)

16

3. Access to Finance

45. Despite some improvements, the credit and deposit base of the Kyrgyz banking sector remains among the smallest both in the CIS and compared to more developed European transition economies. This suggests that the bank’s contribution to the economy and growth is inadequate, with the increasing deposit base of the banks has yet to translate into increase in lending. Despite a steady increase in the share of liquid assets—cash and cash equivalent, correspondent accounts and Government securities—in total assets of the banking sector (from 40 percent to 65 percent) over the last few years, on average, only about 40 percent of the banks’ funding base25 has been reinvested into loans over the same period. Basically, as the Kyrgyz economy gains strength, banks manage to attract additional funding resources, but these resources remain un-invested into loans, which could be reinvested into the economy, de facto immobilizing national savings.

46. Furthermore, growth in the monetary and deposit base is not translating into longer maturities of loans, which would have otherwise indicated further deepening of the intermediation by banks. The banking sector balance sheet shows that 57 percent of banks’ portfolios have maturities less than one year. Long-term lending is mostly denominated in hard currencies and almost entirely extended under IFI’s credit lines—which, in general, have low disbursement rates.

47. The weaknesses in the intermediation functions of banks seem to be explained by combination of factors, including: (i) inadequate banking and technical skills; (ii) high risk profile of the Kyrgyz enterprises (see para.13); and (iii) high overhead costs resulting from deficiencies in legal and regulatory environment for intermediation. These factors, in turn, explain high reliance by businesses on own funds and low capital investments. Table 2.2 and Figure 2.1

25 Roughly calculated as banks’ credit portfolio divided by net capital plus deposits net of reserve requirements.

demonstrate trends in costs of financing for businesses in the Kyrgyz Republic.

48. Interest margins in the Kyrgyz Republic seem extremely high for allowing banks to efficiently intermediate deposits. Furthermore, despite significant decline in nominal interest rates,26 and the increase in funding base, interest margins remains fairly high.

49. High real margins in an expanding and more stable economy are clear symptoms of lack of capacity and skills in the banking and enterprise sector. The banking sector has remained fragmented and underdeveloped, with only few banks displaying relatively more developed technology, management, and skills. But most banks, especially the small ones, provide basic banking services, such as savings, working capital and investment loans, money transfers and foreign exchange. Credit decisions are based more on the knowledge of the client and the value of the collateral (sometimes 150/200 percent of the value of loans) rather than the cash generating capacity of borrowers (see Box 2.1). Excessive reliance in collateralized lending is becoming particularly detrimental to borrowers and banks as weaknesses in the judiciary and in the legal framework for creditor and property rights are making collateralized lending expensive and inefficient.27

26 Nominal margins are the simple difference between weighted average nominal lending and deposit rates. 27 Very few banks are now offering more sophisticated products such as mortgage and home improvement loans, overdraft facilities, leasing, trade, financing, etc.

17

Box 2.1: Increasing Banking Sectors Intermediation Capacity: A Matter of Skills and Knowledge

A symptomatic example of the lack of banking skills and the incapacity of banks to support and meet the demand of businesses was experienced during two separate interviews. The interviewee is involved in construction and metal works. The company has more than fifty employees and a turn-over of more than half million US dollars. It operates throughout the region, especially in Kazakhstan, where it bids on large construction contracts. The company had won a contract in Kazakhstan and thus need ed raw materials and new equipments. They decided to import the raw materials from Russia and purchase new machinery from Western Europe.

They contacted their bank for letters of credit and working capital financing for these purposes. The bank offered four-months worth of working capital loan and letter of credit, but were informed that payment to the supplier would be on 4-month installment basis starting from the effective delivery of the equipment and the raw materials. This type of arrangement was clearly unsuitable for the enterprise. Russian suppliers would require advance payments, often in cash. In addition, the bank could have negotiated a leasing agreement (the entrepreneur was unaware of leasing) to buy the equipment.

Lastly, the interviewee reported that it finally obtained a US$5,000 loan for six months from another bank, which could have offered a larger loan against collateral and adequate documentation. This demonstrates another common problem, an information gap between the banking and enterprise sector, especially given the disproportion between the enterprise’ turnover and the loan it obtained, and the lost opportunity for the bank to establish a stable relationship with a promising client.

50. Limited number of projects eligible for bank credits and limited investment alternatives for banks and other intermediaries also constitute a problem. The small and medium enterprise sector does not have sophisticated financial and accounting capacity, generally lacking basic skills in marketing, product development, business and strategy planning.28 Lack of transparency is still a major issue in the Kyrgyz business sector, and partly in the banking sector. Among the factors behind this are unclear ownerships and titles, absence of internationally-based accounting and auditing standards/practices, as well as administrative barriers, with the latter contributing to informalization of the economy. Informality and untransparent enterprises cannot help bankers in establishing stable and fruitful business relationships with their clients, which, in turn, limits enterprises’ ability to access finance.

51. Administrative barriers continue to impede development of businesses and the private sector at large.29 Despite recent improvements, licensing, certification, and 28 See Chapter IV, vol 1, for details. 29 See Chapter III, vol 1, for details.

registration requirements in the Kyrgyz Republic remain cumbersome. This not only diminishes the investment perspectives of enterprises, shortening their investment and production horizon, but it also contributes to high risks and, hence, high interest margins in the economy. Small businesses, and banks are also indirectly suffering from the absence of formal market structures and business services, capable of creating demand for small services. All these weaknesses in the business sector explains, to a certain extent, why intermediation remains costly and inefficient.

52. To address some of these shortcomings, banks are progressively downscaling their portfolios by refocusing on micro and small enterprises, and retail banking, especially under donor and other IFI programs. This has been a natural phenomena in other transition economies, where smaller banks tend to disintermediate from large industrial productions towards medium size businesses. This is a shift in the right direction for Kyrgyz banks, as micro, small, and medium enterprises (MSMEs) are eventually expected to have become the major contributors to the economy. Refocusing on MSMEs would help banks to: (i) streamline their credit processes; (ii) lower

18

intermediation costs; (iii) become more efficient; and (iv) disentangle from collateral-based lending.

53. There also exist a number of weaknesses and gaps in the technical and legal infrastructure supporting intermediation, which pose clear constraints for banks and other intermediaries to lower intermediation costs and to effectively support the economy and private sector. The NBKR and the Government have devoted much efforts to develop a framework conducive to private sector development and foreign entry. The privatization process has made a significant progress, including in the banking sector with only two state-owned banks operating presently. There are no formal restrictions on foreign transactions, and in foreign investors’ ability to invest in the banking and private sector.30 However, the infrastructure for banking and intermediation is still deficient in some of its crucial elements. The collateral registry, for example, is automated and well-functioning, but not easily accessible. The credit information bureau, which is critical in facilitating retail and small scale banking, is not functioning and the payments system is not developed enough to support modern banking.31

54. Gaps in the laws and a corrupted weak judiciary are impeding the NBKR to fully enforce banking supervision and resolution.32 A weak judiciary is also weakening the framework for contract and property rights, thus, providing incentives for unsound banking practices. Court 30 As a result of these efforts foreign banks are starting to enter the Kyrgyz system. Between 2002 and 2003, three Kazakh banks acquired Kyrgyz banks and started operations. As a result of these entries, there are now five banks in the country with foreign investors as major shareholders. Other foreign investors are mostly IFIs. 31 The Government and the NBKR have started a payments system modernization program, which consists of enhancing the core infrastructure for large and small payments. The program is supported by a IDA-funded project 32 In few cases, the NBKR has tried to close unsound, mismanaged or insolvent banks, but courts reversed NBKR’s decisions challenging its authority over banking matters.

proceedings, for example, are too long and decisions are unpredictable—it takes sometimes 15 hearings for a bank to repossess a collateral. Under these circumstances, banks have little tools to ensure the value of their collateralized assets and to enforce the contracts, which increases transaction costs. Moreover, unpredictability of court decisions and lengthy proceedings create incentives for malpractices and mismanagement, such as extending loan maturities, rollovers, settlement with partial repayments, etc.

55. The accounting reform is yet to be completed and auditing system needs to be further developed. Speedy progress in converting to internationally based accounting is critical for the Kyrgyz Republic. The framework for property and creditor rights is also deficient. In May 2003, the Parliament passed a new amendment to the Banking Law, which reinforces the NBKR’s exclusive authority over banking issues. But for this to work, there still is a need to provide additional tools to the NBKR in the area of information disclosure and coordination between the NBKR and the other regulatory and enforcement agencies, including external auditors.33

56. The insurance sector and the capital market oversight are not consistent with the needs of the private sector. The insurance sector is extremely small with 15 private insurance companies and one state-owned insurance company. The sector is regulated and supervised by the Ministry of Finance,34 but supervision is opaque and weak. 33 Banks have adopted IAS-based accounting since January 2001 under the instruction of the NBKR. However, the enterprise sector still does not use IAS-based accounting, and the auditing profession is not yet developed to acceptable standards. Under these circumstances, financial information is generally not available and/or reliable. 34 The only relatively active insurance companies are the London-Bishkek Insurance Company, which provides a full range of insurance products to businesses, and two other insurance companies, though they are mostly engaged in life insurance. London-Bishkek insures only foreign owned companies and has a total turnover in premiums of US$300 thousand, approximately. Ninety-five percent of its portfolio is reinsured in London.

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Basically, insurance companies are licensed, but not supervised with anecdotal evidence signaling to abuses in this sector. The capital market is developed, but lacks liquidity and is not transparent due to insufficient financial information and disclosure.

4. Government’s Policy Reform Agenda

57. The NBKR and the Government are now planning to modernize the payments system, which will help banks provide more diversified, efficient, and reliable services. The NBKR, with the support of the World Bank, is initiating the Payments System Modernization Program. Under this program, the NBKR will develop a “real-time gross settlement system”―an automated bulk clearing system for recurrent payments such as utilities, salaries and pensions, and a bank-shared card clearing system for card transactions. An efficient and effective payments system would reduce transaction costs for banks with positive spillover effects in terms of lending and interest margins. Moreover, a modern payments system could also help banks in focusing on retail banking operations such as overdrafts under salary schemes, utility payments, etc. This could improve the flow of financial information throughout the system and improve crediting and risk management.35

58. The Government macroeconomic stabilization program, pursuing fiscal discipline, price stability and gradual reduction in the external debt, is achieving tangible results, including a likely further debt relief under the Paris-Club umbrella. The Government is also trying to address structural reforms in the public administration and the private sector, with the goal of addressing accountability, transparency, and 35 Experiences in other developing countries showed that efficient retail banks were able to expand their lending operations and become more profitable institutions integrating the cash payments system with the credit information database. Credit decisions on small and medium loans were basically based on automated risk-scoring systems, which integrated and processed financial information from credit cards, bank deposits, utility payments, etc.

governance. One of the main goals is to remove administrative barriers to businesses, streamlining the procedures for registration, certification, licensing and inspections. In addition to this, the Government intends to reform the standards and accreditation infrastructure and the standards regulatory regime. Clearly progress in these fronts are critical to address many of the obstacles to development of the banking sector into a much needed effective intermediary in the Kyrgyz Republic.

5. Conclusion and Recommendations

59. The financial and banking sector in the Kyrgyz Republic is steadily improving since the Russian crisis of 1998, especially in terms of stabilization, capitalization, assets quality, and overall intermediation. Nevertheless, despite these improvements, banks and non-bank financial institutions are still lacking behind in the delivery of financial resources and services necessary to support private sector, economic growth, and trade integration.

60. There are a number of factors affecting financial and banking sector intermediation, including high transaction costs, a narrow range of products, and serious weaknesses in the technical, legal and regulatory framework, including weak and unprepared judiciary. Delays in the implementation of the accounting reforms, and overall lack of transparency and enforcement are additional impediments. Furthermore, formidable weaknesses in Kyrgyz investment climate is de facto inflating intermediation and transactions costs—with businesses discouraged from entering into the formal market and banks encountering problems in identifying bankable projects.

61. As discussed above and elsewhere in this Report extensively, there are critical issues related to weak institutional-capacity and skills both in the enterprise and banking sector. This combined with weaknesses and corruption in the judiciary hamper bank supervision and resolution, contract

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enforcement, creditor rights, and collateral repossession. These weaknesses constrain banking sector’s and other financial intermediaries’ ability to provide much needed efficient and effective support to enterprises that will help them grow. They also generate large overhead costs for the financial and enterprise sector.

62. Trade finance in the Kyrgyz Republic should be addressed within the comprehensive reform of the financial, banking, and enterprise sectors, with reforms focusing on enhancement of the technical and legal infrastructure for intermediation, capacity building, and consolidation. In this context, the following measures should be given consideration:

Further reform of the banking sector through enhancement of the payments system infrastructure, development of a credit information bureau, and strengthening supervision and resolution; Continued reform of the accounting

system to expedite full conversion to IAS-based accounting in the enterprise sector,

including training of accountants and auditors; Addressing weaknesses in the judiciary

and corruption (including law enforcement) and in corporate governance in both financial and enterprise sector (with emphasis on improved transparency); Eliminating administrative barriers to

businesses and the private sector, and developing legal and regulatory framework supporting intermediation (including through the enactment of the new Collateral Law) and a sound framework for bankruptcy, insolvency, and creditor rights; and Exploring possibility for establishment of

a trade finance agency, regionally-based and privately-owned, which could provide funding, technical assistance, and training services to banks, non-bank financial intermediaries, and entrepreneurs on trade finance products and services.

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Attachment 1

EBRD Micro and Small Enterprise Finance. This facility was implemented in 2002, in coordination with the IFC, the Swiss Cooperation Office, USAID and TACIS, restructured an existing credit line into a new US$15.3 million revolving facility under which four36 local banks extend US dollar-denominated working capital and investment loans to small and medium entrepreneurs. Interest rates are technically ”market-based”. Terms of the loans vary between one-to-36 months, depending on the size of the subprojects. Maximum loan size is US$100,000. IPC International, an international NGO with worldwide experience in microfinance and SME finance, implements the EBRD’s credit line. IPC works as an Apex Unit under the above facility providing training and advisory services to the participating banks in the area of credit evaluation, risk, and portfolio management. Although the credit line is not fully disbursed yet, banks’ lending is definitively improving as well as the overall technical capacity of the participating banks. As of the end of 2003, more than 2,500 loans were disbursed under this facility for an average loan of US$800 and total portfolio of US$2 million, approximately.

Trade Facilitation Program. This program is the Kyrgyz branch of a regional program, which covers 26 of EBRD’s countries of operations. Under this program, the EBRD provides a wide range of trade finance products directly to importers/exporters or through the commercial banking system. These products include: (i) EBRD guarantees; (ii) direct financing of banks in the form of revolving pre-export finance advances; and (iii) direct financing to enterprises in the form of pre-export finance and/or working capital loans. Domestic and foreign banks eligible under the facility can also join as confirming banks. The most commonly used trade finance products in The Kyrgyz Republic are Letters of Credit (LCs), stand-by LCs, advance payments bonds, other forms of payments guarantees, bid and performance bonds. As of June 2003, four domestic banks were extended US$1 million line of credit for LCs and stand-by LCs. All participating banks have already exhausted their respective lines.

Kyrgyz Agriculture Financial Corporation

KAFC was established in December 1996 with the support of the World Bank. KAFC is a fully state-owned joint stock company engaged in rural lending to agro-businesses and individual farmers. The KAFC receives support from a number of different donors, including IFAD, the Asian Development Bank, and other bilateral agencies. KAFC has been a successful organization since its inception. In few years KAFC has become the largest non-bank financial institution in the region with the largest number of clients (about 43,000). KAFC has a large credit portfolio, approximately US$21.7 million (12.8 percent of the whole banking sector). It operates through a relatively large branch network mostly inherited from the bankrupted Agroprom Bank and comprises 11 branches and 43 representative offices. KAFC lends mostly to small and micro entrepreneurs and agro-businesses in the rural areas―the average loan size is, in fact, around US$1.3 thousand. KAFC is now considering its transformation into a rural bank. Discussions about this option are ongoing between the Government and the IFIs, as KAFC transformation into a bank without careful planning represents a risk for the whole financial system. KAFC is currently receiving technical assistance from an international adviser to develop a feasibility study and strategy plan.

FINCA - Foundation for International Communities Assistance

FINCA was established in 1995 with the support of USAID as a profit organization engaged in developing a village-banking program. It is now supported by the International Financial Corporation (IFC). During these

36 As of the end of June 2003, participating banks were Inexim Bank, AKB The Kyrgyz Republic, Kazkomerts The Kyrgyz Republic, and Demir Bank.

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last 8 years, FINCA has been growing fast. It has now five regional and seven satellite offices, and about 320 employees. FINCA’s outstanding portfolio is about US$5 million (3.6 percent of the whole banking sector). FINCA has almost 25,000 active clients, among the poorest in the country. Average loans, in fact, range between US$194 for group lending and US$447 for individual lending. Group lending represents about 80 percent of the whole portfolio. The average loan size of the whole loan portfolio is US$281. With the support by the IFC, FINCA is considering for the transformation into a microfinance company.37

Bai Tushum Financial Foundation (BTFF)

BTFF was created in 2000, by ACDI/VOCA and Swiss Caritas as a non-profit and non-deposit taker credit institution. It provides financing mostly to farmers and tourist operators. It has four branches and total outstanding assets of US$2.3 million as of the end of 2002. Loan terms range from one month to one-and-half year. Interest rates are about 35 percent on annual basis. Lending is mostly collateralized. KFW is implementing a bilateral agreement between the German Government and the Kyrgyz Republic providing financial support to SMEs. The Ministry of Finance (MoF) of the Kyrgyz Republic is the beneficiary of the loan. Loans are provided through AKB The Kyrgyz Republic Bank to enterprises for their investment and working capital needs. Loan amounts range between Euro 35 thousand to Euro 600 thousand, with maturities up to five years. Interest rate is extremely competitive, 11 percent on annual basis. All loans are collateralized, with collateral requirements of 120 percent of the loan amount.

Mercy Corps International (MCI)

MCI provides credits under two different programs: the women’s microcredit program and the SME line. Loans are provided for trade and other commercial activities, including services. Total outstanding portfolio of MCI was about US$1.2 million as of the end of 2002. Loan terms are up to 24 months, and interest rates range between 20-28 percent. Average loan size is small, around US$1,000.

Asian Development Bank (ADB)

As of the end of 2002, there were 333 registered credit unions in the country serving 29,000 members with a portfolio of some US$7.8 million outstanding. Credit unions were established with the support of the Asian Development Bank (ADB). They provide small loans to their members, but also member-only saving services. The credit unions are organized under the Financial Company for the Support and Development of Credit Unions (FCCU), basically an Apex Unit established to perform supervision and treasury management operations. The ADB is now planning to reform the credit union universe and most probably the NBKR will become the sole supervisor of these entities.

37 In July 2002, the Parliament passed a new law on Microfinance companies. According to the law, the NBKR would be responsible for the supervision of microfinance companies willing to apply for a deposit taking license. In December 2002, the NBKR issued the implementing regulations establishing the supervision and licensing requirements for microfinance companies.

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IFC - Leasing A promising and developing sector is leasing. With the support of the IFC, the Kyrgyz authorities adopted a new legislation in 2002 to regulate the leasing contract. Following this new legislation, the Parliament amended the tax code in July 2003 to enable leasing companies to dilute VAT payments throughout the life of the leasing contract, thus, creating a level playing field for leasing companies and banks over these type of contracts. There is need now to further allow banks and leasing companies to benefit from accelerated depreciation of the leased equipment and machinery. As of the end of 2003, there are now two leasing companies and credit unions extending leasing in the poorest regions of the country. These companies and the credit unions have already signed about 200 leasing contracts for about US$0.25 million, approximately. Four banks are now financing leases―Demir Bank, EnergoBank, Ineximbank, and Kyrgyz Investment Credit Bank. Inexinbank has already financed about US$0.2 million for 10 leasing contracts. KICB has financed one contract for total US$0.3 million.

Additionally, IFC is planning to develop a regional Central Asia Leasing Facility to provide lines of credit to support leasing transactions.

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III. VALUE CHAIN ANALYSIS

A. MARKET OVERVIEW

63. The Kyrgyz Republic’s principal exports include non-ferrous metals, minerals, woolen goods, agricultural products, electrical energy, and engineered products. Its principal trading partners are Switzerland (in gold exports), Russia, China, Kazakhstan, and Uzbekistan. The economy is predominately driven by the extractive industry; agriculture, and a relatively small manufacturing industry.

64. The agricultural sector contributes nearly 40 percent to the country’s GDP and employs about half of total registered employment. Following the break-up of state-owned enterprises, the agricultural sector has increasingly moved away from large scale collective farming to smaller subsistence level family farming. Specifically, 40 percent of agricultural output is produced by private farmers and 54 percent by household farms.

65. Principal crops grown in Kyrgyzstan include cotton, tobacco, vegetables, sugar beets, oilseed crops, fruits, and various grains. It is estimated that only 7 percent or 14,000 km² of the 198,000 km² of land available in Kyrgyzstan is suitable for arable agriculture. Of the arable land, only 7,320–8,372 km² is utilized for irrigated crops.

66. In the past decade, the production of wheat has grown from 193,582 hectares in 1990 to nearly 482,717 hectares in 2001. While the total area of wheat farmed has increased, the yield rate for irrigated wheat production declined from 3.5-4 tons/hectare to about 2 tons/hectare during the same period. The principal reasons given by the Government for this decline include the lack of cash among small farmers, particularly the lack of cash to purchase fertilizers, agricultural chemicals and high quality seeds, as well as the use of aging equipment.

67. Cash crop production has also increased. Much of the increase in hectares farmed can be attributed to at least two factors.

(i) replacement of fodder crops like lucerne, sainfoin and barley, which supported the livestock industry, to cash crops to support the immediate nutritional requirements of household farmers.

(ii) increase in the number of small cash crop farmers.

68. As a part of its effort to stimulate the development of the cotton sector, the Kyrgyz Government has set aside 30,000 hectares (i.e., about 4 percent of total arable land) for cotton production. This resulted in production of nearly 75,700 tons of cotton in 2002. Nearly 80 percent of the cotton is grown by private farmers, which generates as much as 5 percent of the total value of the country’s exports. While per hectare yield rates are relatively high, the full potential of the cotton industry is dampened by high production costs, including for access to fertilizers and crop protection chemicals.

69. Tobacco is also an important cash crop for the Kyrgyz agricultural sector. The majority of tobacco continues to be grown by state owned enterprises, which produced 24,000 tons of green leaf tobacco in 2001. This was low compared to the 44,000 tons the previous year--principally due to the fact that the company was unable to sell the harvest. In recent months, the Kyrgyz Government has announced that it would sell substantial amounts of cured tobacco to the Russian Defense Department and provided some subsidies for the purchase of the high quality seeds. The problem continues to be the limited volume of local value-added production activities in the tobacco industry.

70. The livestock sector is an important activity for the Kyrgyz economy and contributes over 40 percent of the gross value of agricultural output. At the same time, however, the composition of the livestock market has shifted from fleece wool producing sheep to cattle and fat tail sheep,

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principally raised for meat. The fat tail sheep survives in poorer pastures and on low quality fodder, but produces coarse and colored wool.

71. The carrying capacity of the grazing land is approximately 7,000,000 sheep

equivalent, which is substantially less than the total number of livestock accounted for in 2000 which raises the issue of the limited capacity in development of wool production.

Table 3.1: Livestock Count in 2000 (x1000)

Sheep Goat Cattle Yaks Horses Sheep Equivalent

Total Sheep and Sheep Equivalent

3,263.8 542.7 511.5 16.9 349.8 5,154.7 8,418.5 Source: Staff estimates based on official data.

72. The decline in the number of sheep raised in the Kyrgyz Republic, which in turn affected the wool industry, can be attributed to a number of factors including:

decline in international wool prices decline in wool quality increase in the number of breeding ewes

and young females slaughtered for meat improvement in the market distribution of

meat lack of cash leading families to sell

livestock for meat lack of financing to purchase feed and

proper animal care summer pastures far from settlements; limited development of community sheep

herding changes in social-economic conditions

bringing a shift in preference away from sheep to cattle and horses, and shortage of good winter pasture.

Value Adding Agricultural Industries: Cotton and Wool

73. Currently there are approximately 14 cotton processing plants operating in Kyrgyzstan with a total processing capacity of nearly 337,000 tons. The total cotton production in the country was about 100,000 tons in 2000, which suggests that the industry faces a substantial problem with capacity under utilization. The largest plant has a processing capacity of nearly 90,000

tons/year.38 A number of large joint ventures have increased in the market in recent years (see Table 3.2).

74. It is estimated that there are over 70 enterprises operating in the garment sector in the Kyrgyz Republic producing ready-made garments ranging from light clothes, coats, jackets, raincoats and military uniforms, largely serving the domestic market.

75. As mentioned earlier, the nature of the livestock industry has changed in the Kyrgyz Republic, which in turn has negatively affected wool production and consequently value added textiles. This is explained by both market as well as policy based problems, which is discussed in the rest of this section

38 These include public companies like JSC Ak-Attyn (90,000 tons/yr); CJSC Kyrgyzshlopok (70,000 tons/yr); JSC Ak-Bula (30,000 tons/yr); as well as a private company Doma-Ata (30,000 tons/yr).

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Table 3.2: Large Joint Ventures in Agriculture Industry

Kaiset Spinning Factory British-Kyrgyz investment of $10 million Production capacity of 3,500 ton of yarn/year Largest wool processing plant in Central Asia Exports to Turkey, Russia, Kazakhstan, and Uzbekistan

Teviz Kyrgyzstan Kyrgyz-Portuguese joint venture Investment of $1.65 million Production capacity of 500 tons of cotton yarn/year Sale volume: $1 million Employment level: 100 workers

Glaeser Dunay-Naryn Kyrgyz-German joint venture in Jalal-Abad Production capacity: 15,000 metric tons of raw cotton processed/year

Tian Shan Panda Krygyz-Chinese JV Focus on animal skin processing and leather

Aida Kyrgyz-American-British JV Wool and leather processing

Ak-Maral Kyrygz-American-Kazakh JV Animal skin and leather products Jackets and footwear Supply to Italy, South Korea, India, and Pakistan

B. CHANNEL MAPPING METHODOLOGY

76. Channel mapping is a process of tracing a product flow through an entire channel from the point of product concept to the point of consumption. This process highlights the underlying patterns of inputs, constraints and competitive advantage that a producer has. It also traces the path of all value adding and non-value adding activities associated with the production of a good and approximates costs involved at each stage.

77. Channel mapping methodology provides the opportunity to benchmark both one producer against another, and production activities across regions and countries. At the same time, this methodology provides a tool for measuring and quantifying the cost of administrative distortions that hinder the competitiveness of products and industries. Channel mapping can also be used as an effective tool to identify discrete areas for policy reform.

78. One of the principal applications of channel mapping is in value chain analysis. Value chain analysis provides a detailed breakdown of each stage of production, estimates the cost at each stage, and calculates the relative significance of these costs to the overall value of an end product. In this context, the notion of competitiveness is introduced, which has at least two implications. First, competitiveness is defined with respect to the identification of production and process inefficiencies. Specifically, a value chain analysis provides a snapshot picture of distribution of costs across the entire production and process. Disproportionate distribution of resources across a value chain signals the need for further analysis, particularly as inefficiencies in production and process along a value chain will have the largest impact on the final price of a good in question.

79. Second, competitiveness can be measured in a value chain analysis by

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benchmarking the distribution of resources across a value chain against similar operations within and outside the country. In this context, the strengths and weaknesses of supply chain linkages would, in turn, affect the ability of enterprises to deliver goods at a competitive price.

80. While more traditional methods of product and market analysis isolate operational costs along various stages of production, a value chain analysis is a much more comprehensive tool, particularly as it takes into account an entire spectrum of activities and inputs associated with a product. Although value chain analysis is usually employed at a product level, output from such an analysis provides useful indicative data on production and operational costs associated with a specific market.

1. Creating a Product Value Chain

81. An important point of departure for conducting value chain analysis is to understand how to break down and categorize

various activities associated with the production of the good to be analyzed. Creating a value chain requires products to be defined and categorized according to various production processes and procedures that capture all value adding and non-value adding activities associated with a final product. Depending on the complexity of the product and the level of detail required for analysis, the number of categories along a value chain can range from as few as 5 to as many as 25 or more categories of activities. For instance, a value chain for coffee has 9 process categories clustered under three major value adding activities, namely land preparation, fertilizing, and plant maintenance. A sample of the process segmentation along a coffee value chain is presented below. Each of the process segmentations represents important value adding and non-value adding activities relevant for tracing a product from its very beginning until it reaches the final consumer.

Table 3.3: An Example of a Value Chain for Coffee

Farming Host-Harvest Transport/Shipping/Customs Clearance

Land preparation Fertilizer/manure Pesticides Plant maintenance Harvesting

Transport to processor Drying Hulling & grading Bagging

Fumigation Phytosanitary certification Transportation Port charges THC Customs clearance Shipping Bank interest Misc.

2. Value Chain Analysis

82. The principal challenge for developing credible industry and product level market analysis in any country is the absence of reliable baseline data. As a result, much of the raw data required to analyze industries and markets must be compiled through individual in-depth firm level interviews (the use of surveys fail to provide the necessary

information, as most interviewees are unwilling to put down on paper sensitive production data). Consequently, the value chain analysis offers indicative data for various product groups and industries, which may require further work if a larger sample size of firms need to be analyzed for

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preparing a representative analysis of a particular product or product group.

83. To ensure that the value chain analysis is adjusted for any uncharacteristic

data, additional emphasis is usually given to cross-checking a particular firm-level data against data for other similar enterprises producing similar products.

C. COTTON INDUSTRY IN THE KYRGYZ REPUBLIC 84. Over 100 countries export cotton valued at $7.1 billion, of which 85 are developing countries. According to the Cotlook Index, between 1997 and 2002, world prices have declined by approximately 50 percent. The Kyrgyz Republic, which is a minor player in the global cotton industry, produces approximately 98,200 tons of cotton annually. Of this, over 60 percent is exported, and the remaining 40 percent is consumed by

the domestic market in the textile and garments sectors.

85. As Table 3.4 and Figure 3.1 below indicate, the cotton industry has made a gradual recovery since 1994 in terms of production, yield per hectare, as well as an average price. More importantly, as shown in Figure 3.1, since 1997-1998, production has gradually shifted away from state to private farms, with the latter accounting for early 80 percent of production at present.

Table 3.4: Cotton Production Statistics for Kyrgyzstan (1990–2001)

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001Cotton production (x1,000 tons) 80.9 63.4 52.4 49.2 53.5 74.5 73.1 62.4 77.8 86.9 87.9 98.2 State Farm 80.9 62.4 50.2 45.9 52.0 54.2 38.4 31.3 28.5 19.8 28.5 19.8 Private Farm ... 1.0 2.2 3.3 1.5 20.3 34.7 31.1 49.3 67.1 59.4 78.4Cotton yield/ha (x100 kg) 27.3 24.5 24.4 24.2 20.2 22.4 23.1 25.1 24.6 25.1 26.0 25.9Average price/kg 0.01 0.01 0.27 2.17 4.01 5.19 5.89 6.84 6.43 7.18 14.1 13.44Source: Official statistics.

Figure 3.1: Cotton Production in Kyrgyzstan (1990-2001)

0.0

50.0

100.0

150.0

200.0

250.0

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

Years

Stat

isca

l Tre

nds

Average price/kg

Cotton yield/ha(x100 kg)

Private Farm

State Farm

Cotton production(x1,000 tons)


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86. Export of cotton represents approximately 15.2 percent of the US$178 million in agricultural exports from Kyrgyzstan. Compared to regional competitors, such as Tajikistan, Uzbekistan and Turkmenistan; share of Kyrgyz cotton exports in total agricultural exports are relatively small. Similarly, relative share of Kyrgyz cotton exports in regional exports of cotton is rather small (see Table 3.5).

87. Nevertheless, the Kyrgyz Republic is regarded to produce a higher quality cotton compared to its regional competitors. On the other hand, as discussed below, it has substantial idle processing capacity.

Therefore, collaboration with cotton producing countries in the region to utilize the existing excess processing capacity can potentially generate value added production activities.

88. It should be noted that the statistics presented in this analysis do not reflect the informal trading between countries. Reportedly, a substantial amount of cotton enters the Kyrgyz market from neighboring Uzbekistan informally. This is largely explained by the relatively much lower, state-dictated purchasing price of cotton in Uzbekistan compared to what Uzbek farmers can command in the Kyrgyz market.

Table 3.5: Central Asia. Selected Indicators of Cotton Exports (2001)

Cotton Export

(US$ million)Total Ag Exports

(US$ million)% of Total

Ag Exports% of Regional

Exports Kyrgyzstan 27 178 15.2% 2.4% Kazakhstan 80 703 11.4% 7.1% Tajikistan 82 113 72.6% 7.2% Uzbekistan 840 988 85.0% 74.1% Turkmenistan 105 142 73.9% 9.3% TOTAL 1,134 2,124 53.4% 100.0% Source: FAOSTAT.

1. Market Segmentation

89. The Kyrgyz market produces about 100,000 ton of cotton through a range of private and state owned cotton farms that average in size from as little as 0.5 hectare family farms to 20 hectare farms. It is estimated that there are 14 cotton private processing facilities in the country with an installed capacity of over 337,000 tons, but this does not account for the growing number of small/micro processing units that have emerged in the past several years.39

90. The market is segmented into 4 areas, including cotton farming; ginning; yarn/fabric manufacturing; and finished goods manufacturing.

39 Some estimates suggest that accounting for small and medium (but not micro ginneries) there are at least 30 ginneries in operation today.

91. There are at least three ways in which transactions take place between farmers and ginneries (refer to Diagram 3.1).

Contract processing: Farmers take raw cotton to a ginnery to have it cleaned and processed. As working capital is not readily available, cotton processors are often unable to purchase and stockpile cotton as farmers want cash for their harvest. Consequently, many ginneries are left doing contract processing rather than purchasing raw cotton from farmers.

Contract farming: Ginneries with access to financing tend to contract directly with farmers for their harvest. Before independence, such arrangements were made through a type of an out grower scheme in which the processor provided seed, fertilizer, and chemicals to farmers

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in exchange for a 100 percent off take agreement of the farmer’s harvest. As financing has become scarce, this type of arrangement has become increasingly rare.

Broker: A broker (either hired directly by a ginnery or as an independent broker) negotiates purchases from cotton farmers. Such brokers have proven useful, particularly when purchasing cotton from small family farms.

92. In addition to these three sources, ginneries also acquire contraband cotton from Uzbekistan. It is estimated that over 25 percent of all cotton processed by ginneries in the country are smuggled Uzbek cotton.

93. Nearly all of the ginneries operate with equipment from the 1960s and are generally in need of substantial technical upgrading or replacement.40 The same applies to equipment used to press cotton seeds. It is estimated that the total cotton processing capacity in the country (excluding micro ginneries) is approximately 337,000 tons, which is more than 3 times the amount of the cotton grown in the country, even when 25,000–30,000 tons of illegal cotton from Uzbekistan is accounted for.

94. In addition to processing cotton, some ginneries also offer seed pressing, seed trading and production of animal fodder from waste leftover after pressing cotton seeds. Most of the transactions, including processing and selling of goods, are barter transactions.

Seed trade: Seeds remaining from the cleaning process are usually sold back to the farmer, leaving a small local market for cotton seeds.

Seed oil: After deducting seeds for the following season, excess seeds are either sold as seeds or pressed. A number of ginneries offer seed pressing services. Here again, charges associated with

40 Both foreign and local investors have tended to invest little in upgrading current equipment, particularly as the opportunity costs are high given adequate local and regional demand for medium grade cotton.

pressing seeds are paid in either cotton oil or raw cotton. Unrefined cotton oil has found demand in both local and regional markets.

Animal fodder: Waste derived from pressing cotton seeds is usually sold as animal fodder. In most cases, waste is sold to local sheep farmers or used for private consumption.

95. Once cotton is processed, lint cotton is packed into bales and sold through at least three different channels.

Contract processing: Farmers that pay for contract processing sell their cleaned cotton directly to yarn or cloth manufacturers.

Direct sales to yarn and fabric manufacturers: Ginneries with adequate working capital that can purchase raw cotton will sell lint cotton directly to yarn and cloth manufacturers.

Exports: Many medium and large ginneries have offshore purchasing contracts from countries such as Bulgaria, Turkey, United States, Italy, France, Japan and elsewhere.

96. Many of the former state-owned enterprises were integrated factories where lint cotton was first processed into yarn and later woven or knitted into cotton fabric under a single roof. These enterprises are largely sitting idle today. The market has become segmented into different specializations breaking with the fully integrated production modality of the former Soviet era. The government’s privatization strategy has so far been privatization of the entire integrated facility, rather than segments of the production line. Nevertheless, the results so far are poor, given the high indebtedness of most of these former state-owned enterprises.

97. Yarn producers must also compete with contraband Uzbek yarn that enters the Kyrgyz market. According to one textile manufacturer, Uzbek yarn sell for at least 13 percent less than Kyrgyz yarn in the wholesale market. Although Uzbek yarn is

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of lower quality, textiles and garments targeted towards the lower end of the market, particularly in the local market, utilize the Uzbek yarn principally to compete with contraband finished products coming into the market from several origins.

98. Finished textile and garments are sold through three principal channels: local wholesale/retail markets; government contracts; and through export agents. As is evident from the volume of raw cotton versus the processing capacity available in the country, demand for yarn and textile fabric far exceeds the demand by the textile and garment industries. Although the quality of cotton fiber has declined in the past several years, the quality of lint cotton is considered relatively high in the international market.41

Consequently, demand for finished goods directed towards export markets, particularly from regional markets, has been strong, but the quantity of cotton available through the local market has dampened potential growth.

99. Smaller finished goods producers tend to gravitate towards having their own retail stalls to sell their finished products to avoid paying wholesale/retail margins. Government contracts continue to be a large percentage of sales for former state-owned enterprises. Nevertheless, cash payments by government clients, such as the military, have often been either delayed or absent. Instead, payments are often bartered against electricity or tax liabilities. Much of the export in cotton-based products are small or of a one-off custom orders nature.

41 Principally due to poor farming practices, use of poor seed varieties, and high input costs.

Contraband Cotton fromUzbekistan

Source: G

Contraband Yarn fromUzbekistan

Cotton Farm

Cotton G

Finished GoProduce

Yarn Producers

Diagram 3.

lobal Development Solution

32

er

innery

Broker

ods r

Exports

Government Contract

Local Wholesale/Retail Market

Custom order

Wholesale Agent

Seed Trade

Seed Oil

Animal Fodder

Local Market

Regional Market

Local Sheep Farm

Use in Own Farm Fabric

Producers

1: Market Segmentation of the Cotton Industry in Kyrgyzstan

s, LLC™.

33

2. Cotton Farming

100. Cotton is one of many cash crops grown in the Kyrgyz Republic, with cotton, textiles and garment industries playing an important role in the Kyrgyz economy, particularly before the collapse of the Soviet Union. “Kyrgyzski 3” with a staple length of approximately 34 mm is a key cotton variety grown in the Kyrgyz Republic.

101. Most of the cotton grown in the country relies on rain fed irrigation, but also on furrow irrigation where depending on the availability of water, farms may irrigate 4–6 times per season. Cotton is principally grown in the southwestern part of the country, particularly in Osh, Batken and Jalal Abad Oblasts. Average yield rate per hectare range from 2.2–3.2 tons, but some farmers are now using high yielding fertilizers which can improve yields to 3-3.5 tons per hectare.42

102. Crop pests and diseases including thrips and Verticillium wilt continue to be a problem for cotton farmers, particularly as farmers are only able to acquire 40–50 percent of their pesticides and insecticides needs necessary for proper treatment of cotton plants. As most cotton farmers do not have access to working capital, agricultural chemicals are acquired through a barter system.

103. Some medium and large commercial farmers able to access working capital are also using plastic sheets to cover their fields during the early phase of planting to help shorten the growing season, as well as to ward off insects and reduce pesticide use, particularly during the early planting period. While 55 kg of plastic sheet, at a cost of nearly 2,000 som/ha is required, such techniques can yield as much as 5 tons of cotton per hectare. The use of this technique helps to reduce both the level weeding required43 and pesticide use. An

42 High yielding fertilizers are produced by Bayer and available principally to farmers with access to working capital. 43 With this technique, weeding is only required 2-3 times per season using 2 workers for 4 days. Such workers are paid approximately 350 som/ha.

additional benefit to this technique is that the first harvest occurs 20 days earlier than the use of conventional farming methods.

104. As the number of farms utilizing this technique is relatively small, a typical farm located in the Osh Oblast—with an average yield per hectare of approximately 2.45 tons/ha—was selected for the purpose of the value chain analysis presented in this section. That being said, however, farming with the use of plastic sheets would serve as a useful benchmark and best practice model in the analysis.

2.1. Cotton Value Chain

105. The cotton value chain is broken down into 11 categories of activities:

Land preparation Planting Seed Thinning Cultivating Weeding Spraying Fertilizer Harvest Social Fund, and Land tax

106. The value chain analysis revealed that cotton production cost per hectare for an average farmer producing 2.45 tons/ha is approximately US$406.88 (see Diagram 2).44

The principal cost components include harvesting US$87.8/ha (21.6%), fertilizer US$60.37/ha (14.8%), and cultivating US$50.28/ha (12.4%). A detailed analysis of the cotton value chain is presented below.

2.1.1 Harvesting

107. As suggested by the value chain analysis, harvesting constitutes over 21.6 44 Comparative cost of producing cotton:

Cost/ton-US$ Kyrgyzstan $166.07 Kenya $321.68 Cambodia $345.83 China $591.13

34

percent of the value added (US$87.8/ha) of which 83 percent goes to wage payments. Interviews with farmers suggest that hand picking as opposed to mechanical harvesting yields better quality cotton. As cheap illegal labor from Uzbekistan is available in the vicinity of Osh, particularly during the 3-4 month peak season, Kyrgyz farmers tend to rely on migrant farmers for harvesting. Generally, Uzbek laborers are paid at a fairly low 1 som for every kg of cotton harvested. Adult laborers are able to harvest on average between 50 to 60 kg of cotton per day.45

2.1.2 Fertilizing

108. Approximately 14.8 percent of value added activity in cotton production is comprised of fertilizing, which amounts to 2,355 som. Of this amount, 9 percent is in the fuel cost associated with equipment operation for fertilizing, while the remaining 91 percent is spent on imported fertilizer. More specifically, nitrogen is the prinicipal fertilizer used by farmers, costing on average 6 som/kg. Most of the fertilizer used by cotton farmers enters the market through Uzbekistan and Russia―principally through informal market channels (see fertilizer supply/demand–Tables 3.6 and 3.7).

109. Ironically, the same fertilizer can be purchased during off-peak season for 4 som/kg, but most farmers do not have adequate cash flow to purchase inputs during off season, and thus must pay a premium during the peak season.

110. As most farmers lack cash to purchase fertilizer, purchases are made through barter trade where raw cotton is the principal form of payment. According to interviews, a ton of medium to high grade fertlizer commands approximately 700 kg of raw cotton. This suggests that the barter price of fertilizer is approximately 9.7 som/kg as opposed to the cash price which is 6 som/kg—a 62 percent mark up!

45 The absence of illegal labor from Uzbekistan can dramatically increase the cost of cotton farming in the Kyrgyz Republic.

111. Taking into account that a hectare of cotton requires at least 360 kg of nitrogen, this suggests that poorer farmers must pay an additional 1,340 som/ha to acquire fertilizer through barter trade when compared to competitors in the market, who are able to purchase the same fertilizer at a cash price of 6 som/kg.

112. It should be noted that nearly 50 percent of the fertilizer used by the cotton industry in Kyrgyz Republic is contraband fertilizer. With an average use of 360 kg/ha of fertilizer, this amounts to approximately 7.2 million kg of fertilizer entering in illegally. Assuming a price of 6 som/kg of fertilizer, this amounts to nearly 42 million som of contraband fertilizer just for the cotton industry. This, in turn, translates into approximately 8.64 million som per year in forgone VAT.

113. Discussions with farmers did not reveal any problem with fake fertilizer or poor quality fertilizer in the market, but the issue of diluted pesticides appears to be a problem, particularly pescticides imported from Uzbekistan, where the concentration level is 50 percent of the prescribed strength.

2.1.3 Cultivation

114. The third area of highest value added activity is cultivation, where a total of 620 som/ha is spent on cultivating and 416 som on irrigation. The first cultivation is generally done by hand, costing up to 500 som/ha, with 5 subsequent cultivations done mechanically. Reliance on cheap illegal Uzbek labor seems to be high at this sage as well.

35

Table 3.6: Comparative Supply/Demand for Nitrogen

Nitrogen (tons) Production Export Consumption Import

Kazakhstan 7,616 4,390 42,000 52,100 Kygyzstan 0 0 7,000 7,000 Uzbekistan 573,000 50,700 559,000 0


Table 3.7: Comparative Supply/Demand for Phosphates

Phosphates (tons) Production Export Consumption Import

Kazakhstan 16,295 11,220 5,500 2,100 Kygyzstan 0 0 0 0 Uzbekistan 132,600 6,300 0 0


2.1.4 Summary

115. Per hectare cost of cotton production in the Kyrgyz Republic comes well within a range of costs associated with the production of cotton in other parts of the world. With this said, however, a number of issues stand out that need to be addressed in order to help reduce the cost of production further. The key issue is the availability of working capital (bridge financing) for farmers to acquire farming inputs. Issues related to the purchase of inputs fall into two categories: first, to help reduce the cost of inputs such as fertilizer where the barter price is substantially higher than the cash prices; and, secondly, to help farmers introduce new farming techniques, such as the use of plastic sheets to increase yield per hectare.

116. Taking into account the limited prime cotton growing land available, changing farming technique to improve yield per hectare is vital to strengthening the entire cotton-to-finished goods value chain. Given the relatively low ceiling of total cotton production potential within the country, cotton processing facilities will continue to face under capital utilization, an issue, which among others, can also be adressed by exploring opportunities with cotton producing

countries in the region ways of better utilizing excess processing capacity.46

117. Field interviews suggest that a number of cotton grower associations are forming as a way of organizing growers to help deliver training and to improve price negotiations between farmers and ginneries. At the same time, however, consideration must be given to exploring how such associations can be used as a vehicle to facilitate bulk purchases of farming inputs, as well as to develop a self financing facility to help bridge the working capital gap that cotton farmers face.47

46 It is estimated that Uzbekistan, for instance, has approximately 128 ginneries of various sizes and quality in operation today. 47 Examples would include consolidating output and the development of infrastructure to disseminate information, training and working capital finance.

36

Box 3.1: Summary of Barriers to Growth, Cotton Value Chain

Issue Areas Barriers to Growth

Financial Lack of access to working capital which results in: • low yield per hectare due to reduced fertilizer use; • paying a higher price for fertilizer as bulk purchase is not possible; and • no opportunity to improve farming practices such as the use of plastic

sheets to reduce farming costs while improving yield.

Market Barter price of fertilizer is set high, so farmers use less fertilizer than required, which in turn results in lower yield.

Inputs Use of illegal labour from Uzbekistan artificially reduces the overall cost of production.

37

Land Preparation

11.8%

Planting

7.0%

Seed

7.9%

Thinning

5.8%

Cultivating

12.4%

Weeding

5.8%

Labour

51%

Inputs

49%

Cultivation: 620 som/ha First cultivation: 500 som/ha 5 mechanical cultivations: 120 som/haWater: 416 som

Illegal Laborers fro Uzbek cotton p Adults: 50 – 6 Child: 20 kg/d

Diagram 3.2: Cotton Production Value Chain for Kyrgyzstan

Acmain

Spraying

9.8%

Fertilizer

14.8%

Harvest

21.6%

Social Fund 1.6%

Land Tax

1.6%

Labor

83%

Inputs

17%

Labor

5%

Fertilizing

95%

Fertilizer application Nitrogen: 6 som/kg Application: 360kg/ha Per ha cost: 2,160/ha

Fertilizing: 2,355 som Fuel: 195 som (9%)

Fertilizer: 2,116som (91%)

Total Labor: 3000 som/ha Cotton pickers: 2,800 som/ha Loaders/security: 200 som/ha Hand picked cotton is considered higherquality than mechanical harvesting

m Uzbekistan icker: 1 som/kg of cotton 0 kg/day ay

pproximately 43.2 million som ofontraband fertilizer (approximately 7.2illion tons) from Uzbekistan, Russia,

nd Kazakhstan used by the cottondustry

38

3. Cotton Ginning

118. Ginneries of varying sizes are currently operating in Kyrgyzstan. With the exception of one large former state owned ginnery, which exports 100 percent of its output, most ginneries, including micro ginneries, cater to local farmers.48 Ginneries have at least two modes of operation. The first mode is to contract processing where ginneries receive a fee for processing farmer’s cotton. The second is where ginneries purchase cotton either directly or through brokers, which in turn is exported as lint cotton or sold to local yarn and fabric manufacturers.

119. In most instances, the lack of working capital, particularly among micro ginneries, has forced ginneries into contract processing. On the other hand, as noted above, there exist a large ginning overcapacity, particularly in the Osh region, where the capacity exceeds the supply of raw cotton by a factor of three.

120. The ginning equipment is mostly outdated and under disrepair. Consequently, the conversion ratio from raw to lint cotton is relatively low, ranging between 33-45 percent, where 1 ton of raw cotton would yield between 330–450 kg of lint cotton—for this value chain analysis, an average conversion ratio of 35 percent was used.49

121. Large ginneries source raw cotton from over a thousand farmers using brokers as agents. According to interviews, farmers, both Kyrgyz and Uzbek, are leasing land at a cost of 8,000–10,000 som/ha/year for irrigated land and 3,000–5,000 som/ha/year for non-irrigated land to grow cotton to supplement the output of cotton from the limited family farmer.50

48 Major cotton processors include: CJSC “Kyrgyzhlopok” (70,000 tons/year); JSC “Ak-Altyn” (90,000 tons/year); JSC “Ak-Bula” (30,000 tons/year); and JSC “Doma-Ata” (30,000 tons/year). 49 The conversion ratio is approximately the same as in Kenya and Cambodia, for example, but both countries face substantial inefficiencies in the ginner sector. 50 Land acquired under the land redistribution scheme does not provide adequate land to make cotton farming

122. Since most ginneries do not have adequate working capital, raw cotton is usually not purchased in large-volumes in the market. Generally, however, farmers bring on average 3-4 tons of seed cotton for contract processing, and pay ginneries anywhere from 5.2-5.4 som/kg of lint cotton. In most instances, seeds resulting from the ginning process are either taken back by farmers or pressed for seed oil whenever a seed press is available.

123. According to interviews, ginneries use a cotton grading scale, which ranges from 1-4 with the 1 being the highest quality. Principally, cotton grown in Osh and Jalal Abad (constituting 80-85 percent of total production), particularly those which are hand picked, fall into the grade 1-2. Each grade scale commands a 10-15 percent difference in prices.

124. While the quality of raw cotton has remained relatively stable over the years, given the aging and poor quality of the equipment used for ginning, the quality of lint cotton has been declining. The decline in cotton quality is reflected in the length of the cotton fiber, which in the past was 34 mm, and now is approximately 32 mm.

financially viable to support a minimum livelihood for farmers.

39

3.1. Cotton Ginning Value Chain

125. The cotton ginning value chain was divided into 7 categories, with the first three categories of activity are of value-adding nature. They include the following:

Drying/cleaning Ginning Cleaning/packing Profits Emergency fund Social fund, and VAT

126. Based on a conversion ratio of 35 percent, processing 1 ton of raw cotton (yielding 350 kg of lint cotton) costs approximately 1,889 som (US$46.09). Major cost factors include drying/cleaning (25 percent); ginning (23 percent); and VAT (17 percent) (see Diagram 3.3).

3.1.1 Cleaning/Drying

127. Once raw cotton is brought to the ginnery, it is first washed and dried using a large tumbler which can process anywhere from 10-35 tons of raw cotton per hour. The principal costs associated with this stage of value adding are electricity (55.9 percent), maintenance (21 percent), labor (16.9 percent), and overhead (6.2 percent).

Source: Staff estimates based on interviews.

128. Cleaning and drying cotton requires substantial fuel and electricity. As the breakdown of the value chain suggests, the principal cost at this stage is electricity, with

ginneries paying between 0.85-1.2 som/Kwh. This translates to an electricity cost of approximately 263 som/ton of raw cotton processed. Similarly, 72 percent of maintenance costs reflect fuel used to operate the cleaning and drying units. Interviews with ginneries suggest that there are no major problems associated with accessing fuel and electricity, but power outages often results in equipment damage as well as work stoppage.

3.1.2 Ginning

129. Ginning equipment is old and requires frequent repair.51 It is estimated that ginning costs are approximately 439 som/ton of raw cotton. Of this total, about 26 percent is accounted by spare parts, 16 percent by fuel and 17 percent for electricity. As is evident from the Table 3.9, ginning equipment requires constant repair, in which spare parts are either custom made or some major parts must be imported. One of the principal problems emphasized by ginneries is the lack of trained workers, particularly qualified mechanics and engineers for operations and maintenance of ginneries. Due to low wages at home—on average less than US$100/month—ginneries have difficulty attracting and retaining qualified technical staff, with many technically skilled Kyrgyz workers are seeking job opportunities outside the country.52

51 The opportunity cost of new investments is high, as there is inadequate demand for medium grade cotton in the regional market. Also with international cotton prices on the decline, rationale for making additional investment to replace equipment is weak. 52 The movement of workers is particularly high to Northern Russia where opportunities for work in construction and mining is available at about US$300-500 wage/month.

Table 3.8: Drying/Cleaning Cost (som/ton)

Drying/

Cleaning% of Total

Labour 226.8 16.9%Electricity 752.22 55.9%Overhead 83.754 6.2%Maintenance Spare parts 40.5 3.0% Fuel 204.93 15.2% Material costs 16.2 1.2% Labour 21.06 1.6%Total 1345.464 100.0%

40

Table 3.9: Ginning Cost Breakdown (som/ton)

Ginning % of Total Labour 151.2 12.0%Electricity 214.92 17.1%Overhead 83.754 6.7%Maintenance Spare parts 324 25.8% Fuel 204.93 16.3% Material costs 129.6 10.3% Labour 147.42 11.7%Total 1,255.824 100.0%

Drying/ Cleaning

25%

Ginning

23%

Cleaning/ Packing

16%

Profits

13%

Emergency Fund

1%

Social

5%

Labor

16.9%

Electricity

55.9%

Overhead

6.2%

Maintenance/ operation

21%

Labor

12%

Electricity

17.1%

Overhead

6.7%

Mainte

64.2

Electricity Costs: 0.85 - 1.2 som/kwh

High total electricity cost due to the use of outdated equipment

Spare Parts

25.8%

Fuel

16.3%

n

72% of the cost ofmaintenance reflectsfuel costs

Fund

VAT

17%

nance

%

Material Costs

10.3%

Labor

11.3%

Diagram 3.3: Cotton Ginning Value Chain for Kyrgyzsta

Outdated ginning equipment requires frequent maintenance using imported parts and inefficient electricity consumption

41

3.1.3 VAT

130. As is evident from the value chain analysis, VAT weighs in relatively high within the costs associated with cotton ginning. Interviews also suggested that there are cases, when companies producing only for outside markets asked to pay VAT—for instance a large former state-owned enterprise, which exports 100 percent of the lint cotton it produces, reports such a case; in another case, one exporter was assessed a VAT of 120 million som even though 100 percent of its cotton production was exported, which eventually costed time and administrative fees to the company in the process of settling the case in the court.

131. Ginneries also report that the VAT-threshold below which producers are exempt from VAT, has both positive and negative aspects: it discourages growth of small-firms and encourages medium-scale enterprises to operate in the informal market to keep revenues below the threshold, but it also attracts entry and investment into the industry.

3.2. Seed Oil Processing

132. According to interviews with those working in ginneries, only a handful of seed pressing equipment is currently in operation in the Kyrgyz Republic. Most equipment is originally from Ukraine and dates from the 1960s.

133. While most farmers elect to take the seeds back for their own use or for sale to other farmers, farmers with access to oil presses contract ginneries to produce oil at a cost ranging from 5-19 som/kg of oil. Barter system is usually the mode of payment for the required fees. Generally, 30 percent of the oil is kept by farmers with the remainder being transferred to the processor to cover costs.

3.3. Other Operational Issues

Weak Backward and Forward Linkage Mechanisms

134. As with the case of cotton farmers, access to working capital is crucial for improving value-adding transactions between cotton farmers and processors. As ginneries are unable to purchase large volume of raw cotton from farmers, the process of consolidating and transferring available lint cotton to the next stage of value added activity—principally the production of yarn and cloth—is missing. This leads to at least two market weaknesses:

135. First, as individual farmers must sell a small volume of lint cotton to cloth and yarn producers or use lint cotton to barter for other goods, farmers tend to have less leverage negotiating their price with yarn and fabric manufacturers. Secondly, as yarn and fabric manufacturers must purchase from individual farmers or through a broker, the administrative costs associated with the transaction is high.

136. In this context, relying on ginneries to consolidate the stock of available cotton from the farming sector would help ease and minimize transaction costs down the supply chain, while producing farmers with a greater opportunity to retain value from their harvest. This, of course, will require the availability of working capital, which is beyond the reach of many ginneries, with interest rates ranging from 45-55 percent and with collateral requirements of about 130 percent.

Undocumented Costs

137. Small and micro ginneries report very little difficulty associated with public sector interventions. However, experience of large former state-owned ginneries seems to be somewhat different. Reportedly, various local and regional interest groups, including the fire department, police, and other public sector entities have been demanding ‘sponsorship payment’ of between 2-3 million som per year.

42

Transport 53

53 According to interviews, trucking from processing facility to the rail yard is approximately 3 som/ton/km. While there are occasional road block by the traffic police, such events are considered minor in the overall cost of processing.

138. Export-oriented cotton is generally transported through the rail system. Rail is considered a much more efficient means of getting goods out of the Kyrgyz Republic, particularly to Russia via Kazakhstan, as rail cargo does not face the same ‘security’ charges assessed by individual oblasts in Kazakhstan. At the same time, however, interviews revealed that rail freight transport

also possess a costly challenge. A manager of one ginnery reported difficulties with access to railroad wagons. A more in-depth analysis of this issue is beyond the scope of this study, but as the Kyrgyz Republic looks to expand its exports, reportedly-monopolistic behavior in the railroad wagon sector can become a critical bottleneck in expanding exports.

Box 3.2: Summary of Barriers to Growth, Cotton Ginning Value Chain

Issue Areas Barriers to Growth

Financial Smaller ginneries that cannot afford or have access to working capital to purchase spares must rely on fabricating their own parts to repair and maintain equipment; Some exporting companies are imposed VAT even though 100% of their

output is for export and hence exempted from the VAT; High un-documented costs paid to public officials through ‘sponsorship’

payments are draining working capital, especially from medium and large enterprises.

Market In addition to financing problems noted above, absence of local sources of

spare parts requires ginneries to rely on either high cost imports or fabricate own spares, which contributes to frequent need for repairs; Brain-drain of skilled engineers due to poor market opportunities and low

wages; Weak backward and forward linkage mechanisms to link large number of

small farmers and ginneries, with high brokerage fees and reliance on informal brokers to consolidate cotton harvest reducing capital retention for farmers; Inefficient distributional-operation of the rail wagon sector, limiting the

availability and increasing cost of wagon rentals.

Inputs High total cost of electricity due to the use of outdated equipment; High operations and maintenance costs due to high fuel costs—partly as a

result of reliance on outdated equipment and the use of off-grid power using diesel generators.

43

4. Yarn Production

139. Garment and textile manufacturers currently have three options to purchase yarn: imports from Russia, China and other regional markets; contraband yarn, principally from Uzbekistan; and domestic textile manufacturers.

140. Yarn production in the Kyrgyz Republic is relatively limited, and the principal source is a large former state-owned enterprise, which is an integrated facility, producing both yarn and fabric.54 In early 1990s, the enterprise was one of the largest and the highest quality producers of yarn and fabric in the CIS (processing 28,000 tons of cotton and producing as much as 120 million m² of fabric each year). At present, the plant’s operation is at a virtual standstill—at about 15-20 percent capacity utilization—heavily burdened with debt, and has a skeleton staff of 200 workers.55 With the exception of some recently purchased equipment using a Japanese Government credit-line, the equipment in the facility is outdated, and 70 percent of the equipment is already amortized. It appears that without technology transfer, including through change in management practices, what is left of the production structure is not likely to be put back into operation.

4.1. Yarn Value Chain

141. The yarn value chain is divided into five categories: raw material; spinning; administrative expenses; profit; and taxes. Interviews suggest that the cost of manufacturing yarn is approximately 86.059 som/kg (see Table 3.10).56

54 Owned by local investors, but the enterprise has too much debt to attract investors. 55 Even though virtually no production is taking place, the enterprise must pay over one million som/month to cover wages for its 200 staff. 56 It should be noted that breakdown of the ‘service’ fee, accounting for approximately 18.1% of the overall production cost was not possible; therefore this item was excluded from the end-process of the yarn value chain. Possible explanation for this undocumented cost may be related to ‘sponsorship’ payments and other unofficial

142. As shown in Diagram 3.4, raw material or lint cotton constitutes over one-half of the value chain, followed by taxes and spinning. Since the equipment is mostly old, maintenance costs and the cost of electricity and fuel accounts for bulk of the processing value added (approximately 80 percent). Similarly, much of the labor is acquired for maintenance and repair related activities.

143. As with all other segments in the cotton value chain, the lack of working capital and the limited supply of lint cotton, exacerbated by competition from contraband products and high tax burden, hinder growth prospects for yarn production.

costs. It was also unclear why these costs were not integrated into the overall production cost and passed on to the buyer. One possible explanation might be that their inclusion would have made the end-product more costly than the contraband yarn sold in the market.

Table 3.10: Yarn Production Value Chain for Kyrgyzstan

Yarn 86.059 som/kg

Raw Material Spinning Admin. Exp Profit Taxes TotalUnit value 47.187 11.567 4.932 8 14.373 86.059% of Total 54.8% 13.4% 5.7% 9.3% 16.7% 100%

Source:Staff estimates based on interviews.

144. Yarn/faadequate workcotton mostly only 50 percentbe paid once thsame time, howorking capitachain, most ginthe cost of capimanufacturers. between ginmanufacturers leading ginneri

VAT: 13.77som/kg (95.8%) Social Tax: 0.603 som/kg (4.2%)

Diagram 3.4: Yarn Production Value Chain for Kyrgyzstan

Lint cotton purchased at 47.187/kg

44

bric processors lack access to ing capital, purchasing lint based on upfront payment of upon delivery, with the rest to e yarn/fabric is sold. At the

wever, given the shortage of l and liquidity up the supply neries cannot afford to carry tal as requested by yarn/fabric

Consequently, linkage neries and yarn/fabric are continually strained,

es to export lint cotton rather

thva

5.

14enopthm10reendi

Raw Material 54.8%

Spinning

13.4%

Admin Expense 5.7%

Profit

9.3%

Taxes

16.7%

Fuel/ Electricity 34.1%

Labor

20.8%

Maintenance

45.1%

Outdated equipment requiring frequent repairs and inefficient fuel consumption

an to channel cotton towards greater local lue adding activities in the Kyrgyz market.

Textile Product: Terry Cloth Towel

5. It is estimated that approximately 70 terprises of varying size and capacity are erating in the Kyrgyz textile market. Of is total, 6 enterprises are involved in ready-ade garments. These 6 enterprises produce percent of total industry output, with the maining 90 percent produced by small-scale terprises. This picture suggests a highly saggregated textile industry.

45

Box 3.3: Summary of Barriers to Growth, Cotton Yarn Value Chain

Issue Areas Barriers to Growth Financial Lack of adequate access to working capital causes delays in input payments,

with the lag time varying between 2-6 months, which leads smaller farmers and ginneries, with little liquidity, to usually opt for selling seed or lint cotton to illegal brokers at a discount (simply to have some liquidity) and/or for exporting low-processed cotton, which channels cotton away from value adding activities.

Market Absence of support industries forces yarn producers to rely on imported spare parts.

Inputs High electricity and fuel costs due to reliance on outdated equipment, and the use of off-grid electricity using diesel generators;

High cost of imported spare parts to maintain spinning equipment.

146. The high-end value chain analysis in this section focuses on a textile product less prone to market cycles, which is more likely to be the case with traditional garment such as men’s dress shirts, T-shirts and the like. In this context, terry cloth towel was chosen, particularly as the product is currently exported to a number of countries both within the region and outside.

147. The analysis was carried out focusing on an enterprise, which has gone through extensive renovations and upgrading relatively recently (at around 1998). Principal products produced in the plant are furniture material (a wool-cotton blend), and towels (hand and bath towels, and kitchen towels). Most of the cotton yarn is sourced from Osh and Jalal Abad where the price of yarn ranges from 75-100 som/kg—in comparison, contraband yarn from Uzbekistan is available at a price of about 65 som/kg, albeit at poorer quality which is more likely to breaking during the production process.

148. In addition to cotton and wool, the factory also uses synthetic material (mainly polyester), which is either sourced through Russia or Turkey. In both cases, barter is used to trade-in finished towels for chemicals and synthetic material. However, since the barter price is too expensive, the company has focused principally on producing pure cotton or wool-cotton blending. This, in turn, also poses a problem with marketing, as some clients are seeking cotton-blend rather than 100 percent cotton products. Current capacity utilization for both furniture and towel material is estimated to be only 6 percent.

149. In the local market, competition for finished goods comes principally from Uzbekistan and China. Imports, usually contraband, are priced at least 10 percent less than local products, but they are also of a lower quality. Nevertheless, as mentioned earlier, local consumers are motivated by lower prices and less sensitive to differences in quality.

150. Therefore, both furniture and towel material have better potential for sales in foreign markets such as Kazakhstan and Russia where consumers are more quality conscious. In Russia, for instance, towels produced by this company can fetch as much as 2-3 time more in the retail market then sales in the local market. Nevertheless, the enterprise is not able to capitalize on potential demand from the regional markets due to its own-structural weaknesses. For instance, it is unable to respond to a large potential order from Kazakhstan (for 1 million m² of towel material, equivalent to US$2.5 million), due to lack of adequate working capital to purchase input material; and the potential client is unwilling to make advance payments for the order. But this, on the other hand, explained in part by its heavy debt burden, undercutting its ability to both access financing and attract potential investors.57

57 Managers of the company were unwilling to reveal the ownership structure of this enterprise.

46

5.1. Terry Cloth Towel Value Chain

151. Terry cloth material is one of the most popular items that the enterprise sells. The value adding activities consist of yarn, weaving, trimming/finishing, taxes, amortization and profit (see Diagram 3.5). Yarn constitutes the largest cost in the value chain. Interviews suggest that approximately 0.33 kg of yarn are required to produce one square meter of terry cloth material. Currently, the enterprise pays 37.33 som for yarn to produce one square meter of terry cloth material. The production cost for the same amount of yarn is estimated to be approximately 28.4 som. This suggests that the use of brokers and agents to transfer goods from a yarn producer to a finished good manufacturer imposes a 31 percent transfer cost.58

152. Next comes weaving, where the enterprise expends about 38 som/m² of finished towel. As is evident from the value chain analysis below, chemicals constitute the largest portion of the weaving cost. The entire Kyrgyz manufacturing industry is dependent on imported chemicals, usually from Russia. But the principal problem is that in most cases, companies are importing chemicals on an individual corporate basis rather than through larger wholesale agents. Most all such transactions are based on barter, and barter prices always favor the seller of chemicals by a substantial margin.

153. As noted earlier, market intermediaries tend to enjoy disproportionate financial gains compared to other players in the value chain that add real value in a transaction. In addition to a need for more market-based linkage between different segments of the value chain, it is critical to improve access to major inputs such as chemicals to help reduce overall input costs. Specifically, all of the companies interviewed for this exercise require chemicals of one form or another in their segment of the value chain. In most instances, the purchase of

58 No formal transport service to transfer goods to Bishkek.

required chemicals is done on an individual company basis in which bulk purchase discounts and economies of scale, particularly as it relates to transport costs, are not enjoyed by Kyrgyz enterprises. The reliance on intermediaries, particularly in the absence of market information, transparency, and commercially based linkage mechanisms, often has a negative impact on enterprises along the value chain.

154. Taxes constitute approximately 20 percent or 30.71 som/m² of finished terry cloth material. On the other hand, since the company had a substantial amount of barter transactions, both for the purchase of inputs from within and outside the country, it was difficult to determine whether and how tax payments were accounted for.

155. As in the analysis of yarn value-chain, the breakdown of ‘other expenses’ category was not possible. It is likely that these expenses are in part associated with ‘sponsorships’ and other undocumented fees incurred by the enterprise.

156. Interviews suggest that while the enterprise is capable of producing high quality products, it lacked marketing capability to identify buyers in foreign markets, particularly in markets where consumers are quality conscious. As noted earlier, its heavy debt burden on the other hand undercut is ability to capitalize on opportunities as they arise. Furthermore, the lack of market information and alternative sources of facilitation reduces key players along the value chain to price takers, particularly those who add the most value in the value chain. Open auctions or other more open facilities to intermediate transactions are necessary to help the value added manufacturing sector enjoy economies of scale and to leverage market opportunities in favor of further local value addition, as well as to improve wealth retention among local enterprises.59

59 There exists no wholesale agents that offer a wide variety of options for buyers. Producers of yarn do not have marketing agents and representatives, and no

47

formal delivery and transport service is available in the market.

48

Box 3.4: Summary of Barriers to Growth, Terry Cloth Towel Value Chain

Issue Areas Barriers to Growth Financial Small finished goods producers having difficulty in getting VAT rebates. Market Lack of market information and channels, leading finished goods producers to

be a mere price takers, e.g.: • Absence of commercial wholesalers/agents, which results in finished

goods producers to rely on informal brokers in purchasing their inputs, such as yarn, with a brokerage fee of as high as 31% of the purchase price;

• Limited number of wholesale agents that sell chemicals based on bulk purchase from abroad and at a more favorable prices.

Inputs Complete absence of local suppliers of chemicals, with producers relying on imported chemicals, which, as noted above, turn out to be expensive in the absence of efficient market mechanisms to procure.

6. Factors Inhibiting the Development of the Cotton and Textile Exports

157. The value chain analysis was useful in identifying several policy and market based barriers, inhibiting the development of the Kyrgyz cotton and textile exports. Box 3.5 integrates them and the Volume I of this Report discusses them in detail along and the ways of addressing them.

158. These barriers, in turn, explain, at least in part, the reliance of Kyrgyz Republic’s on production and export of low-value added activities, with 60 percent of its cotton exports composed of lint cotton. The way forward requires not only addressing these barriers but—given the competiteveness

of global cotton and textile industries—designing a niche strategy.60

159. Further, given the relatively low volume of cotton production within the Kyrgyz Republic, adequate access to raw materials cannot be realized without improving the efficiency of farm-to-finished good production process within the country. In addition, improved transparency and access 60 With assistance from Helvetas/Swiss Development Corporation, production of organic cotton is currently being piloted. Nevertheless, since existing farms must operate for over 5 years without the use of chemical fertilizers and sprays before gaining an organic status, extension of this line of production would require significant and sustained assistance.

Yarn

24.3%

Weaving

21.3%

Trimming/ Finishing

18.7%

Taxes

20%

Amortization

11.9%

Profit

4%

Chemical

37.9%

Labor

18.6%

Electricity

14.6%

Other Expenses

20.1%

Non-Op Costs

8.9%

Social Tax

16.5%

VAT

83.5%

Diagram 3.5: Terry Cloth Towel Value Chain for Kyrgyzstan

49

to medium and high grade cotton from Uzbekistan could also help in expanding Kyrgyz exports of value added cotton. Improving the farm-to-finished good production process would entail the following.

Step 1: Improve the cost structure at the farm level through:

Improving labor productivity (training, access to farming implements/tools, introduction of modern farming techniques, post-harvest handling); Decreasing the cost of importing fertilizer

(develop wholesale chains for secondary support industries to improve bulk purchase of inputs, negotiate the reduction of transfer tax, particularly through Kazakhstan, improve efficiency of VAT system); Improving fertilizer quality to help

increase per hectare yield rates (establish and enforce labeling standards, strengthen laboratory services to check quality of

inputs, improve monitoring of agricultural imports; Introduce new seed varieties with stronger

and longer strand characteristics (strengthen farm associations and cooperatives, research labs, form strategic relationships with foreign cotton research institutions).

Step 2: Improve ginning equipment and technology to increase the raw to lint cotton conversion ratio (current ration is 35 percent). In addition, help reduce overall electricity and fuel cost by improving access to equipment upgrading, improve consistency in electricity delivery, and improve access to spare parts.

Step 3: Improve quality and cost structure of finished products through:

Improving labor productivity through skills development and training; Improving access and cost structure of

imported chemicals.

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Box 3.5: Factors Inhibiting Growth and Competitiveness of Value-Added Cotton and Textile Industries

Policy-Based Barriers Market-Based Barriers Poor border control resulting in: Inflow of illegal, low quality fertilizers and

pesticides, which leads to low crop yield as well as foregone public sector revenues;

Cheap illegal labor from Uzbekistan that forces local wage rates down.

Poor access to working capital and trade finance which leads to: Barter trading for inputs like fertilizer that

have a mark up as high as 62 percent; Production and export of low values-added

goods, such as lint cotton, where competition from Uzbekistan is high, rather than capitalizing on it as an input for further value added activities;

Higher prices for raw material inputs during peak production season.

High undocumented costs, particularly for large firms, as a result of high ‘sponsorship’ payments to government officials including fire department, police, local, regional and national government officials and NGOs

Poor access to investment capital leading to continued use of outdated and inefficient equipment, which in turn limits local enterprises from meeting export quality requirements.

Absence of a systematic approach and limited support structures for: On-farm technical support Bulk input purchase agreements Contract negotiations Market information and access, and Variety selection

No supply chain structure between key sectors in the value chain (cotton farm–ginnery–yarn processors–textile–garments), increasing the marginal cost of each transaction, where independent brokers enjoy the highest economic return, and operate informally.

Weak agricultural farm policy and land distribution scheme promoting disaggregated farming community with an inability to respond efficiently to downstream market demand and market shifts.

Weak market support services and organized transport services to service farm-to-consumer movement of goods; High yielding cotton farm land is fully utilized calling for increased focus on higher value added production and production for niche markets.

Inconsistent power supply undercuts profitability of already liquidity-strapped ginneries, contributing to reliance on exports of low value added cotton. Under-regulated rail transport sector, resulting in monopolistic behavior among suppliers of railroad wagon, thus increasing transport costs and imposing time delays.

Increasing number of micro ginning facilities risking reduction in quality of lint cotton in the absence of quality control mechanisms

Lack of employment opportunities contributing to ‘brain-drain’ of skilled technical workers, such as engineers and mechanics, creating skill-gap and reducing efficiency of downstream value added industries

Absence of secondary support industries, such as spare parts manufacturers and importers, as well as wholesalers of inputs such as fertilizers and chemicals that can negotiate more favorable bulk purchase prices

Weaknesses in VAT administration, delaying VAT rebates and, at times, resulting in unwarranted collection of VAT, which discourage new investments and encourages informalisation of the sector

Limited yarn production facility, creating a bottleneck in the industry, and reliance on outside sources

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D. WOOL INDUSTRY IN THE KYRGYZ REPUBLIC

160. Since the collapse of the Soviet system, the wool market in the Kyrgyz Republic has evolved into a dual market structure, which revolves around brokers, both local and foreign, who buy and sell raw wool from farmers for resale into both formal and informal markets. The evolution of parallel markets can partly be blamed on the lack of financing available in the industry, particularly among wool processors, to offer cash to farmers for greasy wool (raw wool)—most wool processors are only able to offer a combination of cash and term financing to farmers. This is not the case for brokers—both foreign and local—who operates in cash, and who also engage in speculative buying in the market, thereby controlling the price/premiums, while reducing the transparency of market transactions between sheep farmers and wool processors.

1. Market Segmentation

161. In both the formal and informal sector, the wool market is generally segmented into four clusters of value adding activities (see Diagram 3.6): sheep farming; wool processing; woven/knit material producers (a subset of enterprises that are also involved in the production of yarn which is sold directly to finished good producers); and finished good producers. As noted above, transactions between sheep farmers and wool processors are largely dictated by brokers, which to a certain extent also applies for transactions that take place across the remainder of the value chain.

1.1 The Formal Market

162. Generally, there are at least three channels through which sheep farmers sell wool. In the formal market, farmers sell wool to processors either directly or through the use of brokers. A formal classification system for wool in the wool market is absent as does the norms/mechanisms for monitoring compliance with national and international quality standards for hides and wool. This

problem is further aggravated by the active informal sector, in which movement towards market formalization does not seem imminent.61

163. Given the wool processors limited access to financing, only a limited volume of wool is purchased directly by wool processors from sheep farmers and mostly in term financing, where farmers are paid only after wool processors have processed and sold the processed wool.

164. Once greasy wool is processed, it is sold through at least two channels: wool/knitted material producers; and yarn producers. There are a number of former state-owned integrated yarn-to-fabric producers still operating in the Kyrgyz Republic. Such enterprises tend to be large and generally in need of technology upgrading. They operate with excess capacity, particularly as the supply of high quality wool is limited, and as demand from both local and foreign enterprises for yarn and fabric is on the decline. Yarn producers generally tend to be somewhat smaller in size when compared to integrated yarn-to-fabric factories. They too face a similar problem of limited raw wool supply for processing.

165. Eventually, however, output from both types of processors ends up being sold to finished good producers, principally in the garment industry.

166. According to interviews, finished goods producers in the formal market have at least five different channels through which their products are sold. Those channels include: local wholesale markets; local retail markets; direct sales; government contracts; sales to foreign markets through export agents; and custom orders, particularly from foreign customers.

61 Similarly, brokers in the informal market also approach farmers directly, often times offering cash upfront for the available wool.

52

167. In many cases, medium and large companies tend to have contracts with the Government, particularly the military, to provide uniforms and coats. In some instances, finished goods producers might have over 40 percent of production ‘transferred’ to the Government. The term ‘transfer’ is used to reflect the fact that producers are paid ‘in-kind’ rather than in cash for the goods provided—usually against payments for electricity, taxes, and other public goods (including water and sewage).62

168. In the absence of formal marketing structure and support services to help SMEs identify market outlets, most SMEs involved in finished goods production have limited access to local and regional market networks, and rely on wholesale and retail agents to sell their products where profit margins are reduced to as low as 10–12 percent. SMEs with limited market access also seems to sell finished products directly to consumers and, at times, other retailers through a store- front mechanism.63

169. Sales to foreign markets are done principally through two channels: an export agent, and custom orders. According to interviews, while the use of export agents tends to yield market opportunities where producers would normally not have market access, they also entail high cost leaving very small profit margins. Nonetheless, most producers view the use of export agents as a marketing tool to establish market contacts and brand recognition outside of traditional markets. As such, successful sales through export agents often leads to direct custom order from foreign customers. Nevertheless, both systems of sales seems to continue to operate in an ad hoc fashion without translating one-off sales into medium and long-term volume sales contracts.

62 Interviews suggest that this form of barter between public and private institutions remains to be a common form of business in the country. 63 They usually operate out of a container, which costs approximately US$1,000 and which is also used to store finished products.

1.2. The Informal Market

170. A healthy informal market exists in the wool sector in the Kyrgyz Republic, which mirrors the formal market, displaying an entire production chain—up to 80 percent of the market maybe operating informally. Brokers who purchase wool from farmers tend to pay in cash in return for a slightly more favorable price when compared with brokers and wool processors who provide term payment to farmers. In addition, their net return is higher as they avoid taxes. Brokers in the informal sector are both local and foreign buyers.

171. Brokers in the informal sector have two channels through which they generate profits. First, they sell wool back into the formal market through wool processors, but often at discounted prices. Secondly, they sell wool to small local wool processors operating in the informal sector, with both parties avoiding taxes.

172. As the processing technology, equipment and available skills in the informal market are lower quality than those in the formal market, wool yarn and woven/knit fabrics produced in the informal sector tend to also be of lower quality. Similarly, finished goods producers that operate in the informal sector tend to use cheaper and poorer quality inputs, and thus produce goods of a lesser quality than those offered by companies in the formal sector.

173. According to one local producer, wool material purchased through the formal market is priced at about 260 som/m², while similar material of a lower quality sold through local Chinese traders in the informal sector cost approximately 150 som/m². Given the poor market conditions facing most companies in the Kyrgyz Republic, substantial differences in the price of inputs (73 percent) between the formal and informal sector represent a clear disincentive for companies currently operating in the formal sector to continue to operate in a transparent manner.

53

Sheep Farmer Broker Broker

Wool Processor

LeB

WB

Leather Processors

Export to Foreign Markets

Yarn Producers

Woven/ Knitted Material

Producers

Finished Goods Producers Local Wholesale

Local Retail

Direct Sales

Government Contracts

Export Agents

Diagram 3.6: Market Segmentation of the Wool Industry

ather roker

ool roker

in the K

Info

Export to Foreign Markets

Wool Processors

Woven/ Knitted Material Producers

Finished Goods Producers

Foreign Wholesale Market

Custom Order

yrgyz Republic

rmal Sector

54

174. From the perspective of enterprises operating in the formal sector, a clear market distortion is created by the existence of a parallel market, resulting in unfair competition from low quality products coming into the local market. As there is no fashion design industry in the Kyrgyz Republic, designs and patterns of finished goods tend to originate from similar sources. Consequently, as far as product appearances are concerned, finished goods from both the formal and informal markets do not exhibit a marked difference to the untrained eye. In addition, taking into account the relatively low disposable income of local consumers, customers generally tend to be price sensitive and less prone to pay a premium for higher quality. Consequently, it is not surprising to find companies in the formal sector having to compete with an exact copy of a product produced in the informal sector at 28-38 percent cheaper prices.64

1.3 Semi-Processed Hides: Secondary Product

175. What was once a thriving wool industry, is transformed into a disaggregated sheep farming structure today, where sheep farmers now raise breeds more suited for meat rather than wool production. As a result of this shift in herd selection, sheep farming has also resulted in the creation of a derivative market for semi-processed hides.

176. Centralized and organized slaughtering, which was once the norm during the former Soviet era, is no longer functional and has been replaced by small formal and informal slaughtering operations. The downside of this is that nearly 30 percent of the skins that come to market today are of marginal quality.

177. Somewhat similar to the wool and wool-processing sector, the hide processing industry is characterized by a parallel market 64 One producer manufacturing wool half coats indicated that his products sell for 900 som in the wholesale market, while a replica of this coat manufactured by producers in the informal sector sold through kiosks and other points of sale for a price between 650-700 som.

structure in which both formal and informal market channels, principally dominated by brokers, exist.

178. As with the demand for wool, competition to purchase skins is fierce. It is estimated that demand exceeds supply by 2-3 times. Consequently, brokers and hide-processors that are unable to offer cash for skins tend to have limited access to skins. Currently, it is estimated that 3-4 hide processors of significant scale operate in the Kyrgyz Republic. Generally, hide-processors rely on 6-7 brokers strategically located in a number of locations across the country to purchase hides from sheep farmers.

179. According to one hide-processor, 30 percent of all skins sold through export markets are untreated with an average price of approximately US$5/hide, and the remaining 70 percent are treated, which can attract a price of about US$5.60/hide. With this said, however, in the absence of national and international standards for hide and hide processing, quality and consistency of skins entering the market vary dramatically. Consequently, high quality hides can sell for as much as US$7-8/hide, while low quality hides fetch less than US$3.

180. Currently, there is no leather processing facility in the Kyrgyz Republic. Consequently, all hides are exported to a number of countries including China, S. Korea and other Asian countries. There also exists healthy informal sector engaged in trade, with much of the unprocessed and semi-processed hides exiting the country through informal market channels.

2. Sheep Farming: Background

181. The livestock sector is an important activity for the Kyrgyz economy, in which livestock production contributes over 40 percent of the gross value of agricultural output. The composition of the livestock market has, however, shifted from fleece wool producing sheep to cattle and fat tail sheep principally raised for meat. The fat tail sheep survive in poorer pastures and on low quality fodder, but produce coarse and colored wool.

55

182. Some estimate that during the 1990s the Kyrgyz Republic had a sheep population of about 12–14 million, though statistics provide a much grimmer picture. The decline in herd population combined with decline in market demand has had a suffocating effect on the value added wool industry and export of wool products in the country.

183. Notable causes of this include structural changes in the sheep industry resulting from pressure for subsistence level agriculture; land ownership (poor land titling) and leasing regulations (with unclear grazing rights); the collapse of farm-to-market support infrastructure, decline in wool quality, the declining ginning capability (resulting partly from lack of access to capital) and the absence of modern processing technology.

184. As wool related industries have played an important role in the Kyrgyz export trade, it is important to understand specific issues that inhibit the revitalization of the industry. The value chain analysis for export oriented wool industry is developed in three major areas of activity: sheep farming; wool processing; and finished goods based on wool.

2.1 Sheep Farming: Production System

185. Currently, sheep farming is divided into three farming categories: small-scale private farms, independent cooperative farms; and public sector farms. Small-scale private farms are made up of family farms, peasant livestock owners and production cooperative farms. Independent cooperative farms represent approximately 10 percent of the farms, and the remainder is divided evenly between public and small-scale private farms.

186. Three sheep breeds are dominate in Kyrgyz sheep farming: Kyrgyz Fine Wool breed; Tian Shan breed; and Alai semi-coarse wool breed. Kyrgyz Fine Wool is the most popular breed, constituting over 90 percent of all sheep in the country. Prior to the collapse of the Soviet system, breeding was conducted at the state level using artificial insemination to cross breed imported and local breeds. Currently, breeding decisions are made

principally by farmers on a relatively ad hoc basis.

187. It is estimated that 89,000 km² of pasture land is available to support the livestock industry.

Summer pasture: 39,000 km² Spring-autumn pasture: 27,000 km² Winter pasture: 23,000 km²

188. The carrying capacity of the grazing land is approximately 7,000,000 sheep equivalent, which is substantially less than the total number of livestock. Nonetheless, overgrazing has greatly reduced the productivity of pasture-land in the past 30 years—for instance, where summer pastures yield nearly 639 kg/ha of hay, overgrazing has reduced the per hectare yield rate by some 35 percent. More troubling is the decline in winter pasture yield when feed is especially in short supply. It is estimated that winter pasture yield has declined by a staggering 69 percent from 297 kg/ha to 93 kg/ha.

189. Combined, ad hoc breeding techniques, increasing cost of winter feed and fodder, and a rise in animal disease65 have led to decline in average productivity in sheep wool. The average body weight of sheep has dropped from 36 kg to well below 31 kg, and the average wool yield has declined from 3.2 to 2.9 kg per sheep.

2.2 Sheep Farming Value Chain

190. For the purpose of this exercise, costs associate with sheep farming were categorized into eight areas of value adding activities, namely feed; pasture lease; veterinary services; testing; marketing; transport and storage. An analysis of the cost distribution for sheep farming suggests that, on average, the cost per head of various breeds of sheep is

65 Incidents of brucellosis have been on the rise and entail increasing costs from veterinary services. This has been a particular problem among smaller farmers who are not compensated when animals must be slaughtered after testing positive for disease (governments usually compensate farmers when animals must be slaughtered as a result of an outbreak of diseases). Consequently, diseased and sick animals remain under reported.

56

approximately US$3.30 (135.19 som).66 Based on these figures, and an assumption of per sheep greasy wool yield rate of 3.7 kg/sheep, cost per kg of greasy wool is approximately US$0.89/kg (36.54 som).

191. The distribution of costs/kg is presented in Diagram 3.7 below, which suggests that the highest cost associated with sheep farming is feed, accounting for over 34 percent of the overall cost of sheep farming. This cost is followed by costs associated with pasture lease (32.1 percent), and veterinary services (21.7 percent), areas where farmers used to enjoy significant government support when sheep farming and wool production was under a centralized system.

2.1.1 Feed and Fodder

192. Total planting of fodder crops, namely lucerne and sainfoin, have declined by a dramatic 53 percent from 432,400 ha in 1990 to 231,500 ha in early 2000, and have been replaced with wheat production to help offset local demand for wheat and wheat flour. During the same period, the production area for barley, another feed grain used by sheep farmers, also declined from 266,399 ha to 101,961 ha, a 38 percent decline. The decline in local production of feed grains and fodder is also accompanied by the gradual degradation of lowland pastures, particularly as fuel shortages (to heat barns during winter months) have forced many mountain herders to graze animals at a lower elevation.

193. These factors have placed pressure on demand for imported feed grains at a time when farmers face problems with access to financing. Prevailing data suggests that proper feeding and maintenance of a flock would require approximate 1.5 kg of feed per day at a cost of about US$0.05/kg. While the winter feeding period can last from November to February, estimates used for this exercise approximated a need for this level of feeding for 40 days. This assumes farmers must have access to other feed such as straw and hay during the winter season. 66 This figure is based on an exchange rate of 41 som per dollar.

2.1.2 Pasture Lease

194. The Pasture Lease Law of 1991 outlines short-term (5 years) and long-term (maximum of 25 years) lease on grazing lands. The municipal council or local rayon governments are responsible for the management of pasture leases, as well as to oversee the use and maintenance of stock routes. But as noted above, unclear leasing regulations are creating difficulties for farmer access to pasture land, which has led to overgrazing and excess pasture load. These problems need to be addressed through rotational grazing and other rehabilitation policies.67

2.1.3 Veterinary Services

195. Infrastructure to deliver veterinary services has been deteriorated and state-owned veterinary offices and laboratories are under-funded, both limiting the adequacy of the services delivered.

67 The constitution recognizes land to be the principal holding of the State (Chapter VII, Article 21, Land of Agricultural Purpose as an Object of Sales/Purchase), but that the State has the authority to grant the right of possession to second parties on a 49 year lease. 50 percent of the land tax and fees collected are kept by the rayon government and the remainder is distributed to the oblast and central authorities.

57

Table 3.11: Value Chain Breakdown for Sheep Farming

Cost/kg of Wool $0.89 /kg

FeedPasture

lease Vet

service Shearing Testing Marketing Transport Storage TotalUS$ $0.30 $0.29 $0.19 $0.02 $0.01 $0.01 $0.05 $0.02 $0.89 Som 12.47 11.75 7.92 0.83 0.43 0.39 2.05 0.70 36.54 % of Total 34.1% 32.1% 21.7% 2.3% 1.2% 1.1% 5.6% 1.9% 100%Source: Staff estimates based on interviews.

Diagram 3.7: Sheep Farming Value Chain

(36.54 som/kg of greasy wool)

196. In general, costs associated with veterinary services are divided into three areas:

Vaccines, drenching and insecticides (70 percent); Advisory services (7 percent); and Fuel costs (23 percent).

197. The cost of vaccines, drenching and insecticides remain particularly high, as necessary inputs are all imported, principally from Russia. Combined, high veterinary costs, decline in proper husbandry practices, above noted disincentives for farmers to report incidents and weak capacity to conduct on-farm inspections, there are increasing incidents risks of disease.

2.1.4 Summary

198. The decline in the number of sheep raised in the Kyrgyz Republic, can be attributed to a number of factors, including:

decline in international wool prices; financial constraints of farmers for

purchase of feed and proper animal care; summer pastures far from settlements; shortage of good winter pasture; underdevelopment of community sheep

herding; increase in the number of breeding ewes

and young females slaughtered for meat, explained both by increasing dependency of cash-strapped farmers on selling livestock for meat and improvement in the market distribution for meat.

Moreover, absence of adequate regulations and classification system for handling, and storage of wool, poor wool testing facilities, along with deteriorated disease control services and lack of marketing support, further hinders the growth of the value-added wool and textile industry.

Feed

34.1%

Pasture Lease

32.1%

Vet Service 21.7%

Shearing

2.3%

Testing

1.2%

Marketing

1.1%

Transport

5.6%

Storage

1.9%

58

Box 3.6: Summary of Barriers to Growth, Sheep Farming Value Chain

Issue Areas Barriers to Growth Financial Lack of working capital to purchase imported feed to supplement locally

produced fodder and declining access to winter pasture. Market Subsistence pressure, shifting farming preference away from lucerne and

sainfoin (fodder crops) to wheat, thus increasing dependence on imported fodder; Unclear pasture lease and land title contributing to increasing difficulties with

access to winter pasture; Rapid decline in available veterinary support service

Inputs Increasing cost of sheep farming, resulting in reliance on expensive imported fodder; Lack of affordable veterinary services and veterinary medicine, contributing

to increasing incidents of animal disease.

3. Sheep Hide Value Chain

199. As the sheep market structure shifted away from wool to meat production, the market for sheep hides also picked up, particularly for exports of hides to China and other Asian markets. It is estimated that current demand for hides from external markets is considerably above the supply.

200. According to local hide processors, demand for meat exports, particularly from the Middle Eastern markets has been healthy, but the breed with less fat is much more desirable for exports. Consequently, the potential for expanding hide exports is partly a function of shifting the sheep breed to less fatty breeds.

201. Nevertheless, at present, much of the skinning is done manually by untrained farmers. It is estimated that, at least 30 percent of the skins that come to market are of marginal quality. Furthermore, although a sizable number of sheep are slaughtered annually, principally for use in festivities, skins usually do not make it to market since they are not handled properly, resulting in fairly significant foregone revenues from exports.

202. Currently there are 3-4 major export-oriented hide processing enterprises operating

in the Kyrgyz Republic. All hide processors rely on agents for skin-inputs, who collect them from farmers. On average, a company may have as many as 6-7 brokers. As shown in Diagram 3.8, the cost of skins constitutes 83 percent of the total cost of processing, followed by chemicals and taxes. Since the market is fairly dynamic, farmers are able to command a reasonable bargaining position. Nevertheless, price paid by the hide processors (on average about US$5 per skin), is estimated to reflect a substantial fee charged by brokers―a concrete figure could not be obtained but the mark-up is estimated to be as high as 100 percent.

203. As in the case of the wool market, the absence of a transparent and formal market structure, uniform grading system and the lack of access to price information that links farmers with processors, tends to increase non-value adding transaction costs across the value chain. These transaction costs can potentially be reduced if alternative market structures are introduced—such as an auction house—which would help improve the transparency of transactions between farmers and skin processors.

59

Diagram 3.8: Sheep Hide Value Chain

Source: Based on staff interviews.

204. The second highest cost in hide processing is the cost of chemicals. In the absence of domestic chemicals production capacity, the majority of chemicals used in primary hide processing such as sulfides, acids, alkalis, and chromium, are imported from Russia. According to one processor, the amount of chemicals required to process 30,000 hides requires US$14,806 worth of chemicals. However, the final cost incurred by a processor is nearly US$20,000 after paying administrative fees and transport/transit costs—both formal and informal. (see Table 3.12).

205. According a local hide processor, there are few in-factory inspections and

disruptions during the hide processing stage and charges are small compared to the overall cost of the value chain.

206. Once hides are processed, they are trucked to the Chinese border where another agent is waiting to take over the cargo. Along the way, freight forwarder would usually be stopped by the road police several times, where a payment of 100-200 som per stop would be made. While, given the strong demand for hide, these informal costs are considered small by processors on a per hide basis, market they require attention by the authorities in the context of overall governance reform agenda.

Table 3.12: Administrative Costs Associated with Importing Chemicals

Russia VAT $ 2,961.26 14.8%Kazakhstan $ 530.00 2.7% Security accompany tax $ 500.00 2.5% Transit license $ 30.00 0.2%Kyrgyzstan $ 1,702 8.5% Transport $ 1,500 7.5% Customs $ 200 1.0% Traffic police $ 2.44 <0.1%Total Admin Costs $ 5,193.70 26.0%Admin cost/hide $ 0.17 Notes: The ‘security accompany tax’ is a fee, which a freight forwarder must pay whenever a truck goes through a different oblast within Kazakhstan. On average, fees are approximately US$100 per oblast, which is paid to local police. Once the cargo enters the Kyrgyz Republic, custom clearance is required but with a payment of US$200, freight forwarders can avoid a delay of up to 2-3 days and a parking fee of US$20/day. Source: Staff estimates based on interviews.

Hide 83%

Water 0.4%

Chemical 11%

Labour 1%

Environ. Fees 0.2%

Power 1%

VAT 2%

Transport 0.2%

Road Tax 0.01%

Chemical 74%

Russia VAT 14.8%

Kazakh Admin 2.7%

Kyrgyz Admin 1%

Transport 7.5%

60

Box 3.7: Summary of Barriers to Growth, Sheep Hide Value Chain

Issue Areas Barriers to Growth Financial Limited access to working capital, increasing reliance on export of

unprocessed skins Market Absence of a wholesale market structure, leading to excessive reliance on

brokers with high fees in access to hides Absence of local supplier of chemicals

Inputs High administrative and transport/transit costs, raising the cost of imported inputs, particularly chemicals, and of overall hide processing

4. Worsted Yarn Value Chain

207. The volume of wool production declined with the decline in sheep population in the Kyrgyz Republic: in 1991, the Kyrgyz Republic produced nearly 32,000 tons of greasy wool, which is currently down to about half of this amount (at about 15,000 tons). It is the 5th largest producer among the CIS countries, accounting for about 7 percent of total production.

208. Three formerly state-owned wool processing facilities (predominately owned by local entrepreneurs) operate in Kyrgyz Republic, mostly under-utilized.68 They are large, substantially lag behind in technology innovation and struggle to retain their market position. For instance, one of the plants visited was established in 1963. It operated 1,500 pieces of equipment spread out over 9 hectares of land. During Soviet era, in addition to supplying to the domestic market, factory used to export about third of its production to Italy. Today, its market dwindled to small volume sales to 20–30 SMEs and sales to the U.S. military at Manas Airport. Its carries large inventory (worth 7–8 million som) and high debts.

209. Generally there are at least seven stages of processing involved in producing worsted yarn69 from raw wool, before it is

68 Average capacity utilization is under 25 percent. 69 The type of worsted yarn selected for this exercise was a dyed 40/2 yarn, where the greasy wool to worst yarn conversion rate is approximately 1.537 (i.e., 1.537 kg of greasy wool produces 1kg of worsted yarn).

ready for finished good production. These stages include the following:

Scouring Carding Gilling Combing Spinning Dyeing, and Weaving/knitting

210. According to the value chain analysis, the production of one kg of dyed worsted yarn is approximately 276.71 som or US$6.75, where the largest input cost is the raw material, namely greasy wool, which constitutes 38.7 percent of the overall cost, followed by dyeing (18.3 percent) and spinning costs (9.5 percent).

4.1.1 Raw Material

211. Cost of raw material is obviously a large share of the value chain. What is notable is that compared to delivery price of greasy wool of about US$0.89/kg—as revealed by value chain for sheep farming—its purchase price by wool processors is estimated to be about US$2.61/kg—nearly three times higher.70 As noted earlier, this is explained by a substantial brokerage fee that the wool processors pay—it is not clear, however, if the brokerage fee also covers other informal transaction costs.

212. In a hypothetical example, assuming that better market structure improve transparency and linkage between farmers and 70 According to interviews, it is estimated that brokerage fees can range from 1.8 to well over 3 times the price offered to sheep farmers.

61

wool processors, and reduce commissions to 50 percent, this could improve the cost competitiveness of Kyrgyz worsted yarn by 18.9 percent. With rationalized cost structure and present wool production volume per year, the wool processing industry could potentially generate an additional US$15.3 million in revenue. Therefore, it would be worthwhile to further analyze the economic role played by brokers and alternative more efficient market structures, issues beyond the subject matter of this study.

4.1.2 Dyeing

213. In the absence of a domestic chemical production capacity, dyes are mostly purchased from Russia, where old networks from Soviet era continue to be exploited, particularly because suppliers are willing to offer term payments for some products, for the mostly liquidity-constrained Kyrgyz processors.

214. As in the case of most importers transiting goods from Russia through Kazakhstan, wool processors complain about costs and delays associated with imports. In most instances, a truck traveling from Russia must transit through at least 5-6 oblasts within Kazakhstan, where the freight forwarder is required to pay US$100 per oblast to the local police. In addition, the Ministry of Transport in Kazakhstan requires a license costing US$30 valid for 30 days to truck cargo through Kazakhstan. These costs, altogether, constitute about 0.5-0.7 percent of the value of a truck-load of chemicals.

4.1.3 Spinning

215. After dyeing, the next highest cost factor in the value chain is spinning. Spinning costs are principally distributed between maintenance (34.7 percent), labor (26.1 percent), and administrative costs (14.5 percent). Since the spinning process is largely mechanical, over 34 percent of the 26.2 som consumed in the spinning process is accounted by maintenance costs. Most enterprises operate with outdated and high-maintenance equipment, which partly explains the high maintenance costs.

4.1.4 Opportunity Cost of Informal Sector

216. As noted above, transfer of greasy wool from farmer to processing facility, is intermediated by brokers, who also generate rents from speculative buying/selling. Processors, who mostly operate on a term payment basis, can not compete with brokers operating on a cash payment basis in the informal sector. The data from the value chains for sheep farming and wool processing indicate that brokers are, on average, charging 2.4 times the farming selling price for their services, which goes untaxed. Forgone revenues from VAT, based on the present levels of 15,000 tons of greasy wool available from farmers in the Kyrgyz market, could be as high as US$3.7 million per year (see Table 3.13).

62

Diagram 3.9: Worsted

Raw Material

38.7%

Scouring

6.7%

Carding

4.0%

Gilling

7.4%

Combing

1.6%

Spinnin

9.5%

Electricity

1.0%

Fuel

1.5%

Water

0.5%

Electricity

8.7%

Fuel

4.8%

W

2.

Worsted Yarn Value Chain (276.71 som/kg of finished yarn)

Dyeing Cost Breakdown (50.54 som/kg of finished

Yarn Value Chain

g Dyeing

18.3%

Weaving/ Knitting

4.1%

Storage

8.4%

Packaging

4.2%

Social Insurance

1.6%

Chemical/ Dyes

87.3%

Labour

0.7%

Maintenance

1.1%

Marketing

0.4%

Admin. Expense

7.5%

ater

3%

Chemical/ Dyes 8.1%

Labour

26.1%

Maintenance

34.7%

Marketing

0.9%

Admin. Expense 14.5%

Spinning Cost Breakdown (26.2 som/kg of finished yarn)

yarn)

63

Table 3.13: Opportunity Costs Associated with the Brokerage System

Total wool production 15,000 tons (15,000,000 kg) Average broker commission 2.4 times value of farmer’s selling price (1.8 + 3.0)/2 Farmer’s selling price $0.89/kg Broker selling price to wool processors $2.14/kg ($0.89 x 2.4) Broker commission $1.25/kg ($2.14 - $0.89) Estimated revenue of broker transactions/year $18.69 million ($1.25 x 15,000,000 kg) Forgone revenue from VAT $3.7 million ($18.69 x 20%) Source: Staff estimates based on interviews.

Opportunity Costs Associated with Sales of Worsted Yarn through the Informal Sector

217. Wool processed in the informal market is sold at a cheaper price in the formal market, undercutting competitiveness of the enterprises in the formal sector. Interviews suggest that over 40 percent of worsted yarn sold in the market today originates from the informal market. If this is roughly correct,

then based on the present levels of 15,000 tons of greasy wool available from farmers in the Kyrgyz market, and the wool-to-worsted yarn conversion ratio of 1.537:1, the potential foregone public sector revenue could be about US$5.2 million per year, and the unrecorded GDP contribution could be nearly US$26.4 million (see Table 3.14).

Table 3.14: Opportunity Cost of the Informal Market on Public Sector Revenue

Total wool production 15,000 ton Wool entering the informal market 6,000 ton (15,000 x 40%) Wool-to-worsted yarn conversion rate 1.537: 1 Worsted yarn produced in the informal sector 3,903.709 tons (6,000 x 1.537) Unrecorded GDP contribution: $26,350,032 (3,903,709 x $6.75) Foregone revenue from VAT $5,270,007 ($26,350,032 x 20%)


Box 3.8: Summary of Barriers to Growth, Worsted Yarn Value Chain

Issue Areas Barriers to Growth Financial Limited access to working capital by wool processors, constraining their

ability to directly buy from sheep farmers, which increase the overall cost of processed wool.

Market Absence of market linkage mechanisms between farmers and wool processor, leaving market transactions in the hands of informal brokers, who raise the cost of accessing raw wool and, through speculative buying, create temporary shortages in the market to influence market prices; Lack of market information, reducing sheep farmer’s negotiating leverage

with brokers. Inputs High costs associated with importing chemicals from Russia through

Kazakhstan; Absence of domestic chemical suppliers; High cost of imported spare parts for maintenance of spinning equipment.

64

5. Wool Coat Production

218. As is evident from the discussion so far, finished goods producers operating in the Kyrgyz Republic have a limited number of choices to purchase yarn and wool fabric.

219. In addition to few, large formerly state-owned garment companies, specializing in wool products—supplied (over 60 percent of production) largely to the government—there are growing number of small enterprises, which cater to both local and export markets. They are characterized by a small number of employees working out of makeshift assembly operations, usually located in residential areas and apartments; and managers, who are conscious of fashion trends and consumer sensitivity to quality. The value chain analysis focused on the second group.

5.1 Wool Coat Value Chain

220. The value chain analyses was undertaken for a lady’s woven wool half coat, the most popular design in both the local and export market. One of the enterprises interviewed, is producing over 37 different models on an average of 1,200 pieces per month. The ‘factory’ is a converted apartment, which houses all of the weaving, knitting and sewing equipment and the operation’s 20 employees. It generates 30 percent of its revenue from sales to the Russian market, where products can fetch an attractive profit, even after paying commission to export agents.

221. The value chain for a lady’s woven half coat can be categorized into three major areas: production; packaging; and administration. Each of these major categories can then be divided into a number of subcategories where value is added. According to the value chain analysis, cost of a lady’s woven half coat is approximately 669 som or US$16.32. Wool yarn input constitutes 47.7 percent of the total value added for the production. This is followed by taxes (20.8 percent) and weaving (4.8 percent). (see Diagram 3.10).

65

Diagram 3.10: Wool Coat Value Chai

Yarn

47.7%

Weaving

4.8%

Sizing

1.4%

Cutting

1.1%

Sewing

3.1%

Trimming

3.9%

Finishing

1.3%

Packaging

0.2%

Office Expense

4.4%

Wool Processing Cost: $6.75/kgGarment Manufacturer’s Purchasing Price: $7.78/kg

15% margin above the 3.48 overhead multiplier

Labour

93%

Electricity

7%

Labour productivitydown by 25%

Cost of leasing office and factory space is high even after receiving financial support from a donor

Woman’s Woven Half Coat (669 som/unit)

n

MarketingExpense

2.4%

Repair/ Main-

tenance 2.3%

Other

3.0%

Taxes

20.8%

Social Fund

3.5%

VAT

66%

CorporateIncome

Tax 34%

Office/ Factory Lease 38%

Car Main-

tance/fuel42%

Office Expense

13%

Telephone

7%

No wholesale and freight service available resulting in use of personal vehicle and other private resources to acquire needed inputs

66

5.1.1 Production and Packaging

222. The production and packaging value chain is divided into 7 stages of value added activities as follows:

Weaving; Sizing; Cutting; Sewing; Trimming; Finishing; and Packaging

223. As noted earlier, cost per kg of processed worsted yarn was estimated to be approximately 276.61 som (US$6.75) per kg. According to interviews, the price paid for dyed worsted yarn for the production of lady’s half coat is 319 som (US$7.78). In addition, wool processor applies 3.48 overhead multiplier to its production cost figure and an additional 15 percent profit margin before yarn is sold to a garment manufacturer. It should be noted that wool yarn processed in the informal sector enters the formal market at this stage of production, at a price, which is nearly 58 percent lower than similar but higher quality yarn in the formal market.

224. Companies producing garments, particularly for the export market, while sensitive to the cost of yarn, are even more sensitive to the quality of their product. They, therefore, tend to opt for yarn produced in the formal market, where yarn quality is substantially higher.

225. Garment manufacturers in the formal sector, supplying to the domestic market—where consumers are somewhat less quality but more price sensitive—however, must compete with garments produced in the informal sector, as well as with contraband imports from several origins.

226. Costs associated with weaving were estimated to be around 32 som per coat, where most of the value added comes from labour input (30 som) and the remainder from electricity.71 It should be noted that during

71 Electricity is purchased at a price of 1.2 som/kwh.

Soviet era, training was an integral part of the production processes. At present, however, technical training has been less and less accessible, with negative implications for the labor productivity. Interviews suggest that the shopfloor worker productivity in the garment industry is declined by at least 25 percent.72

5.1.2 Taxes

227. Taxes, which are the second highest cost item associated with the production of wool coats, account for an estimated 140 som (US$3.40) per coat—i.e., 20 percent of the production costs. Large portion of the total (66 percent) is associated with VAT payments and the remaining with corporate tax payments.

228. Unlike large, formerly state owned enterprises,73 where inspections and undocumented rent seeking activities are reportedly frequent, interviews with small enterprises suggest that administrative interventions imposed by government authorities are minimal, but tax burden is high, particularly because of the competition form local and foreign contraband products.74

5.1.3 Office Expenses

229. While office expenses are not one of the top three highest cost in the value chain, when costs associated with worsted yarn are excluded, office expenses factors in relatively high. A breakdown of office expenses reveals that much of the costs are incurred by car maintenance and gasoline (42 percent) and office lease (38 percent).

72 Use of out dated equipment and the absence of local support institutions have contributed to this decline. 73 Interviews with a large formerly state-owned enterprises suggest that ‘sponsorship’ payments (undocumented contributions to local organizations and authorities, including the local and regional police, local government authorities, etc.) amount to about 10 percent of profit. Similarly, inspections by fire department, environmental inspections, security commission, and other undocumented payments for taxes and fees account for an additional 5-7 percent of net profit. 74 For instance, a wool half coat manufactured through the informal sector could be about 40 percent cheaper than the ones manufactured in the formal sector with inputs from the formal sector.

67

230. Interviews suggest that there are few reliable and cost effective freight forwarders that can handle consolidated cargo, and that it is difficult for enterprises with small volume purchases to seek market solutions through local service providers. Consequently, whenever an input material needs to be purchased or finished goods delivered, small business owners rely on their own arrangements. This suggests that there may be a void in the market for commercially based support services infrastructure catering to the needs of small enterprises, particularly those oriented towards small to medium volume, high value added export trade.

231. As for office lease, taking into account that most entrepreneurs have very limited collateral to lease or buy office/factory space, some support, usually from donors, to access start-up capital, seems to be making a big difference in promoting new entry into the market.

5.2 Need for Market Support Infrastructure

232. Due in part to the absence of a market support infrastructure that responds effectively to the needs of small enterprises, there exist a heavy cost burden placed on those players in the market, which adds the most value in the production process. For instance, in the case of wool half coats, the final cost to the manufacturer is approximately 669 som, and the sale price in the wholesale market is about 850 som, inclusive of a wholesaler commission of 100 som. This suggests that the profit margin for the manufacturer is approximately 12 percent while the wholesaler enjoys a margin of about 15 percent (see Table 3.15).

233. These costs of poor market infrastructure, combined with other transfer costs discussed earlier—e.g., for transfer of goods from one stage of production to another, which is dominated by brokers; and for. getting goods to market—put significant burden on market players. To avoid some of these transfer costs, small enterprises are opting for selling directly to retail outlets and/or for having their own direct retail stalls

where profit margins can be increased substantially. While direct selling is a reasonable alternative for small volume transactions, it is not sustainable as companies grow. These weaknesses—if not addressed, through promotion of professional and commercially viable market structures catering to volume production—could ultimately repress future opportunities for growth, particularly in export-oriented industries.

6. Summary

234. A number of market and administrative barriers to competitiveness have been identified across the entire wool value chain—i.e., from the sheep farming through a finished wool half coat (see Table 3.15). While there are clear challenges faced by key players at each stage of value adding activities, the most difficult challenge is the absence of a structured, transparent, and commercially viable market support infrastructure and market linkage mechanism that could facilitate transfer of goods from one value adding activity to the next. As a result, the transfer of goods is principally dominated by brokers and agents who are generally unlicensed, operate informally and charge high fees. While they facilitate the transfer of goods from one stage of production to the next, the costs are high to both producers and buyers as well as to general government budget through the foregone public revenues.

235. A strong informal market creates pressures on enterprises operating in the formal sector which must compete both with contraband products and products of lesser quality.

236. It is also evident that products manufactured in the formal sector tend to respond effectively to the overall price and quality requirements of foreign markets in the region. But this is more the case for newly established small and medium enterprises rather than large, formerly state-owned enterprises. The latter largely supply to the government mostly under barter payment arrangements, while the former follows

68

market trends and opportunities for finding market niches for their products.

237. Prospects for growth and expansion into large-scale production, however, require, among other steps, identifying targeted

support activities that could improve market linkage mechanisms and market support services that could respond to the unique requirements of new generation of small and medium enterprises in the market.

Table 3.15: Transaction Margins for Wool Half Coats per unit Profit Profit MarginCost 669 Wholesale 850 81 12% Wholesaler commission 100 15%Retail (direct sales) Low 950 281 42% High 1000 331 49%


Box 3.9: Summary of Barriers to Growth, Wool Coat Value Chain

Issue Areas Barriers to Growth Financial Barter transaction with the Government, limiting finished goods producers

ability to pay their input suppliers at terms more compatible with the informal market traders.

Market Absence of competitive commercial distribution system, forcing wool processors to be self-reliant in acquiring their input materials; Strong informal market both for input material and finished goods, repressing

the development potential of high quality finished wool products sector; Absence of support industries, particularly for technical training, constraining

labor productivity; Limited availability of affordable office and factory space, creating a barrier

to entry, particularly for new start-ups and small enterprises; Lack of a cost effective wholesale/retail distribution system, causing finished

goods producers to rely on informal brokers with high charges to get goods to market.

Inputs Cost increasing and growth constraining implications of reliance on own-arrangements to acquire input materials

69

Box 3.10: Factors Inhibiting Growth and Competitiveness of Value Added Wool Industry

Policy-Based Barriers Market-Based Barriers Barter payments system in transactions with the government, undercutting competitiveness and further deteriorating financial viability of large, formerly state-owned enterprises

Lack of access to working capital resulting in: broker-based market transactions system

which promotes price fixing; limited value added activities in favor of low-

processed hide exports Lack of government policy to compensate farmers for slaughtered animals, resulting in under reporting of diseases and sick animals; Absence of government sponsored veterinary programs; High bureaucratic hurdle for veterinary practitioners--complex licensing procedures and high registration fees.

High cost and poor quality of veterinary services, increasing risk and incidence of disease and animal loss

Unclear land tenure laws undermine free movement of animals for grazing

Decline in productivity of pasture land resulting from over grazing

Lack of adequate regulations and classification scheme for handling/storage of wool and hide

Shift towards subsistence sheep farming,: diverting resources away from wool industry

Unaffordable and limited intermediation capacity of the financial sector, constraining the development of an integrated wool processing industry

Parallel informal markets undermining cost competitiveness of enterprises in the formal sector, and distorting market pricing mechanisms

High undocumented customs clearance charges in acquiring input material through Kazakhstan

High cost of exporting due to the absence of formal export market support infrastructure

High incidence of road checks by traffic police, imposing delivery delays

Absence of support industry and skill development, reducing the quality of hide and increasing waste in the sector

Lack of regulatory enforcement to streamline brokerage activities, which among others implications, result in foregone public sector revenue

Absence of market linkage mechanisms, facilitating high brokerage fees to transfer skin from farm to processor

Absence of local chemical industry, increasing cost and dependence on imported chemicals

Lack of reliable market information channels, constraining farmer’s ability to have negotiating power in setting prices

Outdated equipment, placing high cost burden on enterprises to maintain equipment

Limited number of sources for yarn and fabric, increasing vulnerability of finished wool products industry to market fluctuations

Declining labor productivity, reducing competitiveness and limiting prospects for increased access to external markets

Absence of reliable trucking and freight forwarding services, forcing enterprises to rely on own-arrangements in acquiring their inputs and for delivery of goods to customers

Sheep Farming Feed/fodder: decline inlocal production and increased reliance on imported feed Pasture lease: degradaof pasture land leading thigh leasing costs Veterinary service: higimport cost for vaccinesdrenching and insecticid

70

tiono

h , es

Wool Processing Greasy wool: high transfer cost from farm-to-processor using brokers Spinning: high maintenance costs associated with imported spare parts – no local spare parts producers Dyeing: high cost of imported chemicals – no local chemical industry

Wool Coat Production Yarn: high transfer cost from wool processor to production facility using brokers Taxes: high VAT, where laps time for re-imbursement is either long or non-existent Weaving: decline in labor productivity and skills Office expense: absence of formal market support infrastructure. Difficulties and cost of accessing office and factory space inhibit growth and expansion potential

Market Wholesaler/Export Agents: high commission charged against garment manufacturers and absence of a formal market support infrastructure

Hide Processing Hide: demand exceeds supply by 2 – 3 times Chemicals: reliance on imported chemicals, high Russian VAT (often difficult if not impossible to collect reimbursement), and high transport costs VAT: high Kyrgyz VAT

Diagram 3.11: Key Factors Inhibiting Competitiveness of the Wool Industry in Kyrgyzstan

Source: Global Development Solutions, LLCTM.

71

E. DAIRY INDUSTRY IN THE KYRGYZ REPUBLIC

238. The market size of the dairy sector in the Kyrgyz Republic is estimated to be between US$6.5-7.0 million. The sector employs some 1,400 workers, principally in a number of large dairy farms around Chui Oblast, which supply a majority of the milk processed in Bishkek. Interviews suggest that 30 percent of the farms in the Chui Oblast supply over 80 percent of all raw milk processed in the Kyrgyz Republic. Winter-feeding is a major challenge for dairy farmers, leading price and the availability of milk to fluctuate as much as 50 percent between summer and winter seasons.

239. Milk processing is dominated by several medium and large enterprises, principally, Wimm Bill Dan (formally Bishkek Sut), Ak Sut, Ak Bulak, Sut Bulak, El West and Eridan Sut. These companies process 85-88 percent of milk, which comes onto the market and the remaining share is processed through small local companies.

240. The dairy sector has experienced an overall decline in both domestic output and consumption in recent years. The absence of adequate support services, concerning particularly on-farm sanitary-epidemiological control and breed selection, has contributed to a decline in fat content and an increase in bacterial count of the milk. In addition, the complete absence of both a ‘chill chain’ and a formalized distribution infrastructure for milk, combined with administrative barriers such as road police checks, have contributed to increasing the delivery time of raw milk from farm-to-processing facility, which in turn has had a critical impact on milk quality.

241. Nevertheless, processed dairy products, such as butter, cheese, and ice cream, continue to be exported in regional markets. More recently, a new cheese called “Dutch Cheese” became a nationwide brand and has been exported to Kazakhstan, Pakistan, Afghanistan, and Russia.

242. For the purpose of this exercise, a medium size private dairy processing facility

with annual sales in 2002 of approximately 110 million som (US$2.75 million), producing butter, cheese, ice cream, powder milk and several other dairy based products is chosen. The installed capacity of the enterprise is approximately 270-300 tons of milk per day, but currently it is operating at a level of 100 tons per day during summer peak season. The annual processing volume is around 12,000 tons. Suppliers of raw milk are small dairy farmers, all located within a radius of 160 km.

243. The enterprise exports nearly 50 percent of its output to regional markets including Russia, Pakistan, Afghanistan, and Kazakhstan, and relies on over 100 wholesale distribution outlets. Geographic proximity makes Kazakhstan the most desirable export market for processed dairy products, but in recent years, a number of market barriers have repressed market opportunities.

1. Dairy Value Chain

244. The value chain analysis for butter, and ice cream production points to the cost of raw material, principally raw milk, as the highest component in the value chain. The value chain analysis revealed that for a small dairy farmer, the cost of producing a liter of milk is approximately 5.1-9.8 som (US$0.12-US$0.24).75 The principal costs associated with milk production are in animal husbandry, milking and collection/delivery.

245. Value chain analysis of small dairy farms suggests that well over half (59 percent) of the cost of producing a liter of milk is associated with collection and delivery of milk to a processor. A further breakdown of the value chain for collection and delivery indicates that fuel (52.1 percent) and administrative costs (41.1 percent) constitute a dominating factor in the value chain.

75 As a comparison, the cost of producing a liter of milk in Zambia is less than US$0.15, where the cost of animal feed constitutes over 83 percent of the cost.

1.1 Collection and Delivery Costs

246. While there are a number of large dairy farmers operating in the industry, small and medium sized dairy farmers play an important role in the development of the dairy

processing industry and in employment creation, particularly in rural areas. At the same time, however, small and medium dairy farming in rural areas continues to be disaggregated and remains partly in the informal sector.

Animal Husbandry 26.9%

Milking

14.15%

Collection/ Delivery

59%

Labour

6.8%

Fuel

52.1%

Admin Costs 41.1%

Labour

30%

Feed

67.8%

Veterinary Input 0.5%

Admin Costs 1.7%

f

Average wage rate:1,200 som/month Each cow requires attention from animal husbandry, milking, and collection/delivery staff costing approximately 6,686 som/year

Fuel price: 12.9 som/litreDistance traveled: 170 km/day Cost of fuel/day: 731 som

Diagram 3.12: Value Chain for a Small and Medium Dairy Farm in Kyrgyzstan

4,643 som of eed/animal/year

72

Payments to Traffic Police: 640 som/day

73

247. As noted above, the value chain suggests that over 93 percent of costs incurred in the collection and delivery phase of the value chain is made up of fuel (52.1 percent) and administrative cost (41.1 percent). Interviews with farmers indicate that these two costs are somewhat interlinked. First, the delivery of raw milk to processing facilities in Bishkek is done through an informal network for dairy farmers usually clustered in a village. In most of the cases, delivery trucks must travel around 160-170 km round trip to deliver milk to processing facilities in Bishkek. As a consequence, fuel costs can be as high as 731 som per day. An additional factor contributing to the high cost of fuel associated with the delivery of milk is that drivers often take side roads to avoid being stopped by the traffic police where informal ‘fees’ must be paid.

248. According to interviews, the norm is for delivery trucks to be stopped by the traffic police at about five different times between the farm and the processing facility in Bishkek with a cost as high as 640 som per delivery traveling a distance of approximately 85 km one-way. More specifically, a delivery truck would be stopped twice by a local rayon police, which collect up to 30 som per stop. From there the truck would be stopped an additional three times within 5 km of Bishkek—first as it approaches the Bishkek City limits (charges of 200 som), and then two more times as it approaches the city center (similar informal charges by the traffic police each time), and then again within 1 km of the processing facility.

249. It was found that the delivery truck would be charged more by the traffic police when the delivery is late or when the driver is under pressure to make the delivery before the milk spoils. This is especially the case during the summer season as milk is delivered using an open, rather than a refrigerated, truck.

250. On a number of occasions, when a farmer refused to pay, the traffic police took the driver’s license away. Only after two days

of chasing after the policeman was the driver able to regain possession of his driver’s license and resume work to deliver milk to the processor (see Diagram 3.13). To avoid paying the traffic police, drivers routinely change routes into the city using back roads, often traveling much greater distances than would otherwise travel. The value chain analysis revealed that this extra effort to avoid the traffic police increased gasoline consumption from 219,300 som to 387,000 som per year, a 76 percent increase in expenditure. When drivers use the most direct route into Bishkek, payments to traffic police account for over 35 percent of the total cost of production (inclusive of delivery costs).

2. Animal Husbandry

251. According to the value chain analysis, animal husbandry constitutes nearly 27 percent of the cost of producing milk. Of this amount, 67.8 percent of the value added is derived from animal feed—for a small farm producing 140,000 liters of milk per year, the cost of fodder can be as much as 130,000 som.

252. Generally, small and medium farmers tend to rely heavily on grazing as a principal source of nutrition for cows. However, winters in the Kyrgyz Republic can be harsh, constraining opportunities for grazing. Consequently, fodder must be purchased during the winter months to help ensure some level of production. According to interviews, due to increases in cost of fodder during the winter months, production cost per liter of milk rises 33 percent (from 3.25 som/liter to nearly 4.33 som/liter), while milk yield per cow declines nearly 25 percent (from 20 to 15 liters) per day.

253. As outlined in the sheep farming value chain, winter pasture yields in the country have declined dramatically from 297 kg/ha to 93 kg/ha. In addition, unclear land tenure laws and pasture lease regulations have contributed to limiting access to precious pasture land.

74

2 traffic police stops20 som per inspection

RURALFARM

75 km

Diagram 3.13: Random Traffic Police Inspections during Delivery of Milk from Rural Farm to Bishkek Processing Facility

Rural farmers are paying upto 640 som per delivery fortraffic inspections to delivermilk to processing facilities inBishkek

5 km

Processing Facility Bishkek

City Perimeter

City Center

Traffic Inspection200 som charge

3 km

1 km

1 km



Box 3.11: Summary of Barriers to Growth, Dairy Value Chain

Issue Areas Barriers to Growth Financial Working capital constraint in purchasing animal feed and the decline in

availability of winter pasture, contributing to the decline in milk yield, particularly during winter months

Market High frequency of road checks imposed by traffic police, leading delivery trucks to spend excessive amounts on fuel to by-pass check points; High and frequent informal fees paid to traffic police in delivery of milk to

processors; High and frequent cost of government inspections; Fragmented production making collection and delivery of milk expensive,

particularly because there are no commercially available transport services and a ‘chill-chain.’

Inputs High cost of diesel fuel and reliance on old trucks to collect and deliver milk from villages to processing facilities

3. Butter Value Chain

254. For a medium size dairy processor purchasing milk from small dairy farmers, the value chain analysis suggests that the approximate cost of producing 1 kg of butter, inclusive of VAT is approximately 115 som. As shown in Table 3.16, raw milk as an input is a dominant factor in the value chain,

followed by VAT and labor costs. The value chain analysis suggests that the competitiveness of butter is predominately dictated by the ability of the sector to contain the cost of milk production, including costs associated with administrative barriers (e.g., traffic police).

Table 3.16: Butter Production Value Chain

Butter Production Cost 115som/kg

Raw material Packaging Labour Electricity Transport/

DeliveryFixed assets/ amortization

Marketing costs VAT Total

cost

Unit cost 59.97 2.49 14.47 4.79 8.43 1.05 4.6 19.2 115% of Total 52.1% 2.2% 12.6% 4.2% 7.3% 0.9% 4.0% 16.7% 100%Source: Staff estimates based on interviews.

Raw Material

52.1%

Packaging

2.2%

Labor

12.6%

Electricity

4.2%

Transport/ Delivery

7.3 %

Fixed Assets

Amortiz. 0.9%

Marketing

4%

VAT

16.7%

Value Chain: Small Dairy Farm

Anim Husb

26.9%

Diagram 3.14: Butter Value Chain for Kyrgyzstan

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al andry

Milking

14.15%


59%

Box 3.12: Summary of Barriers to Growth, Butter Value Chain

Issue Areas Barriers to Growth Financial Lack of working capital for upgrading and improving processing equipment Market High and frequent cost of in-factory government inspections;

Absence of commercially available transport services and a ‘chill-chain,’ requiring producers to operate their own distribution system; Weak packaging and advertising industry, adding to low product image and

spoilage at the retail level; Weak wholesale/retail distribution system; Heavy reliance on small informal retail shops for sales of goods where

payment of VAT charges are difficult to collect or do not apply. Inputs Low labor productivity resulting from lack of training, market support

services, and the use of old equipment; High cost of accessing raw milk (see the milk value chain section).

4. Ice Cream Value Chain

255. Ice cream is another popular product both for the domestic and regional markets. The principal challenge facing the ice cream market—more so than butter, cheese and other dairy products—is the absence of a structured and efficient ‘chill chain’ for the distribution of ice cream, particularly in the regional market. Concerning the domestic market, distribution system exists within the wholesale sector, but it is limited.

256. The value chain analysis for ice cream suggests that producing one kg of ice cream costs approximately 34.7 som. As can be expected, milk is the most significant input (36.5 percent) in the ice cream value chain,

followed by administrative costs (26.7 percent) and electricity/heating (13.4 percent). As with the value chain analysis for butter, raw milk used for ice cream was sourced from small dairy farmers; consequently, the value chain structure for raw material input, i.e. milk, is exactly the same for both products (see Diagram 3.15).

257. The major difference between the butter and ice cream value chain is the relatively high administrative costs associated with ice cream production. Specifically, the value chain analysis suggests that 9.26 som per kg of ice cream is spent on administrative costs (see Table 3.17).

Raw Material 36.5%

Flavoring

2.9%

Electricity/ Heating

13.4%

Labor

10.5%

Social Tax

2.5%

Spare Parts

7.2%

Admin. Costs

26.7%

NON- Operational 10.8%

Other Expenses

56.7%

Admin Costs

21.5%

ContingencyTax

5.1%

Profits

5.7%

Diagram 3.15: Ice Cream Value Chain for Kyrgyzstan

Value Chain: Small Dairy Farm

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Animal Husbandry

26.9%

Milking

14.15%


59%

77

Table 3.17: Administrative Costs Associated with the Production of Ice Cream

Non-operational

Other expenses

Administrative costs

Contingency tax Profits Total

Unit value 1 5.25 2 0.48 0.53 9.26 % of Total 10.8% 56.7% 21.6% 5.2% 5.7% 100%


258. As shown in Table 3.17, ‘non-operational expenses’ constitute over 56.7 percent of the overall administrative costs. While it was not clear from interviews how this category of expenses was defined, it was suggested that much of these expenses were to cover undocumented administrative costs associated with inspections, particularly road inspections. As discussed above, products, which are time sensitive, tend to confront more road inspections. Given the absence of a comprehensive ‘chill chain’, the delivery of ice cream from the processing facility to the

point-of-sales must be kept to a minimum to avoid damage or even spoilage. Therefore, very few options exist for ice cream producers except to pay for undocumented inspections.

259. Nevertheless, while administrative intervention costs play an important role in the overall production cost of Kyrgyz ice cream, as with butter, containing the cost of milk as an input is a defining factor for the competitiveness of Kyrgyz ice cream.

Box 3.13: Summary of Barriers to Growth, Ice Cream Value Chain

Issue Areas Barriers to Growth Financial Lack of working capital for upgrading and improving processing equipment

Delays in VAT rebates, placing a heavy financial burden on distributors who deliver to export markets

Market Absence of a competitive wholesale/retail distribution system Absence of a ‘cold-chain High and frequent cost of in-factory government inspections High non-operational expenses due to high ‘sponsorship’ payments to

government officials and local organizations Current VAT adm. procedures creating a barrier to entry for new distribution

companies Inputs Low labor productivity resulting from lack of training, market support

services, and the use of old equipment High cost of accessing raw milk (see the milk value chain section)

5. Non-Tariff Barriers

260. Unlike other perishables like vegetables and fruit where the relationship between delivery time and sales price can be depicted by a smooth bell curve, the relationship between delivery time and sales price for dairy products such as butter and ice cream is much more strong. In the absence of a well organized logistics support structure and ‘chill chain’, once the delivery time of

butter and ice cream exceeds a critical point, products are permanently damaged and retain no value. These weaknesses, however, undermine the ability of producers to deliver products to the point-of-sales on time. As noted above, this is further complicated by excessive inspections by various sort.

261. For instance, prior to 1998, prevailing trade regulations allowed Kyrgyz enterprises to deliver products to markets in Southern

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Kazakhstan, namely Almaty, Taraz, Shymkent, and Kzyl-Orda, within three days. However, the trade regulations and customs procedures imposed later on by the Kazakh authorities have increased the delivery time to as much as 15 days.

262. With the new procedures, several days are required to process a passport for the delivery, an additional 3-4 days before funds arrive to the customs office for the 16 percent VAT payment (payment by Kazakh import agents), and as many as 7-8 days are required to clear export documentation. During this period, the dairy processor must pay for the hotel accommodation of its driver and security personnel, and more importantly, the cargo must be kept refrigerated, consequently, additional electricity costs are incurred. According to interviews, there is constant negotiation between the dairy processor and the importer regarding who is responsible for these payments, and in most instances as product delivery has not taken place, added costs must often be absorbed by the dairy processor.

263. These delays and additional costs, put significant pressure on dairy processors in the past four years, with some Kyrgyz suppliers losing markets in southern Kazakhstan as a result of these administrative barriers.

6. Distribution and Logistics Support

264. Against this background, there are a few transport and logistics companies, focusing on the distribution of short shelf-life commodities. Interviews with distributors suggest that their profit margins are relatively slim. Consequently, competitiveness is defined by the ability to run a large volume business. According to distributors, the retail- trading sector poses unusual challenges for both producers and distributors. Sales staff in over 80 percent of the retail outlets has relatively low fixed salaries; very little incentive is available to encourage retail shop workers to provide support for restocking shelves and for ensuring that products are not left outside of refrigerated areas.

265. Furthermore, VAT administration procedures do not distinguish whether products are sold directly or through an agent. Consequently, distributors are forced to pay VAT immediately for the delivered amount when an invoice is received. As there are substantial inefficiencies in the VAT repayment scheme, distributors are having to carry the opportunity cost of capital between producers and retail outlets, particularly as retailer are unwilling and reimburse distributors for the VAT payment already incurred when it receives goods from a producer. In addition, many small retail outlets avoid operating as a formal retail trader to avoid paying VAT or they might not be VAT payer. A clear guidelines for the application of VAT is required to smooth the transfer of goods from producers to the point-of-sales.

266. According to one distributor, all business of retail outlets, which it distributes to, is based on cash transactions. This combined with the lack of information available on current laws and regulations, opens up opportunity for the tax police to exploit and seek rent from unsuspecting retail shop owners.

267. In addition to the tax police, traffic police also pose a critical problem for the distribution business as noted above. One distributor, which distributes goods to supermarkets and retail outlets within Bishkek, conceded that they must pay about 50-100 som per truck each time it is stopped by a traffic police. And these stops occur regularly each day. While the overall cost associated with stops made by the traffic police is relatively small, the frequency of stops and time delays associated with these stops are more problematic for distributors that carry time sensitive products.

268. Finally, as with many medium and large enterprises operating in the Kyrgyz Republic, sponsorship payments to local, regional and national organizations and groups, including the fire department, and other governmental organizations, take a large toll on the revenue stream of local enterprises.

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One distributor interviewed for this exercise estimates that sponsorship payments amount to as much as 5-7 percent of net profit!

7. Administrative Barriers Faced by Dairy Processors

269. A review of administrative interventions faced by dairy processors suggests that the principal sources of intervention originate from four inspection agencies: the Agritech Research Institute, a private research organization; SES; Kyrgyz

Standard; and other government and non-governmental organizations. The frequency and cost of each intervention faced by dairy processors vary considerably from case-to-case. This inconsistency suggests that agencies responsible for enforcement of laws and regulations are taking a liberal interpretation and implementation of what should be a relatively routine set of inspections and certifications (see Table 3.18).

Table 3.18: Administrative Interventions Faced by Dairy Processors

Frequency Cost of Inspection Additional OH Costs SME Large SME Large SME Large Agritech Research Institute

For each new product

For each new product

Min. of Health: 432 som National Statistics: 192some Kyrgyz Standard: none ARI: 8,875 som

Min. of Health: 432 som National Statistics: 192some Kyrgyz Standard: none ARI: 8,875 + 15,000 som for other technical documents

1,080 som 1,752 som

Kyrgyz Standard

1/year 1/year 525,000 som 13,000 som 1,080 som 779 som

SES 1 1/year 1/year --- 3,000 som --- 195 som SES 2 2/year 1/year 22,500 som 7,000 som 1,080 som 779 som SES 3 Upon

delivery of product to merchant

Upon delivery of product to merchant

36,000 som 18,000 som --- ---

SES 4 --- 4/year --- 17,000 som --- 3,116 som Kyrgyz Standard 1

2/year 4/year --- --- 144 som 1,558 som

Kyrgyz Standard 2

4/year --- --- --- 288 som ---

Kyrgyz Standard 3

2/year 1/year 280 – 300 som 500 som 144 som 389 som

Representation Costs

--- Ad hoc --- --- --- 383,7000 som

Sponsorship --- Ad hoc --- --- --- 121,000 som Non-operational Costs

--- Ad hoc --- --- --- 4,824,900 som


80

270. The interview data suggests that medium size dairy processors tend to face more frequent and costlier administrative interventions from SES and Kyrgyz Standard, but it is the larger commercial dairy farms that must pay substantial amounts in representation costs, sponsorships and non-operational costs. For instance, the re-certification of quality and production standards issued by Kyrgyz Standard is applied differently between a medium and large dairy processor. Specifically, the medium dairy processor pays nearly 525,000 som, while a large commercial dairy only pays 13,000 som. Similarly, the re-certification of production facilities costs a medium dairy processor 22,500 som between two visits, while a large dairy processor receives only one visit at a cost of 7,000 som. (see Table 3.19).

271. What is also evident from Table 3.18 is the number of different times that both SES and Kyrgyz Standard intervene with dairy processors. For instance, both medium and large dairy processors point to the problem that inspectors from different departments within Kyrgyz Standard conduct inspections at the dairy processing facility, but that they do not seem to coordinate internally within Kyrgyz Standard. While one department is responsible for the annual re-certification of quality and production facility, another department higher-up within Kyrgyz Standard returns to the dairy processing facility between two and four times a year to check up on the previously conducted re-certification work.

272. Reportedly, absence of information sharing, trust, and clear definition of roles between departments within Kyrgyz Standard, and resulting constant duplication of effort is common. Dairy processors pay the cost these inefficiencies in responding to an excessive inquiries/inspections.

273. Interviews also revealed that, in addition to these government agencies, Agritech Research Institute (ARI), a private sector enterprise providing support services to both food processors and the government, is also creating challenges for the food processing industry, not so much financially (in the context of the overall cost of production) but time-wise.

7.1 Medium Size Dairy Processor

274. Despite the entry of Winn Bill Dann, a major international dairy processor, medium size dairy processors continue to flourish in a number of milk and processed dairy sectors. In addition to stiff competition, medium size dairy processors face high costs associated with administrative interventions, particularly those imposed by Kyrgyz Standard (see Table 3.27 below).

275. While quality and production re-certification is necessary to help ensure that processors maintain expected health and product standards, 3,500 som per product per year totaling 525,000 som for medium size enterprises, was considered high particularly considering that a large commercial farmer is paying a fraction of the cost (13,000 som) for a similar inspection and certification.

Table 3.19: Administrative Interventions Faced by Medium Size Dairy Processor

Government Agency/ Department

Frequency Time required for inspection/ approval

Cost of inspection/ certification

Internal resources (time and money)

Types of Intervention

Research Agritech Institute – private

Once for registration of new product

Min. of Health: 10 days Nat. Statistics: 2 days

*Min. of Health: 432 som *Nat. Statistics: 192

3 hours/product 15 products 24 som/hr 1,080 som

*Preparation of official recipe *Preparation of technical production document

76 Up to 20 days for the preliminary response and an additional 10 days if clarifications are required. 77 In 2003, Kyrgyz Standard dropped its entire registration fee to zero for new product certification.

81






*Ministry of Health *National Statistics *Kyrgyz Standard

2 days Kyrgyz Standard: 20 days +10 days76 TOTAL: 1-3 mths

Statistics: 192 som *Kyrgyz Standard: no fee77 *RAI: 8,876 som 9,500 som

*Negotiate with Min. of Health, Nat. Statistics, and Kyrgyz Standard for certification stamp

Kyrgyz Standard

1 time/year 2-3 weeks 3,500 som per product 15 products 525,000 som

45 hours/year 24 som/hr 1,080 som

Re-certification of quality and production standards

SES 1 time/year 3-4 hours None None Re-certification of product quality (microbiological/sanitary)

SES 2 times/year NA 1,500 som per product 15 products 22,500 som

45 hours/year 24 som/hr 1,080 som

Re-certification of production facility (microbiological/sanitary)

SES Upon delivery of product to merchant

None 15 products 80 stores 30 som/seal 36,000 som 78

None Mandatory sales certificate required by processor to sell products through a store

Kyrgyz Standard

2 times/year 3 hours None, but faults are often found by inspectors to seek rent79

6 hours/year 24 som/hr 144 som

Supervisory visits to check the certification compliance on quality and production standard80

Kyrgyz Standard

4 times/year 3 hours None, but faults are often found by inspectors to seek rent81

Present certifications from *Veterinary *Product analysis *Metrology 12 hours 24 som/hr 288 som

Product and technology standard re-certification

Kyrgyz 2 times/year 3 hours 280 – 300 som 6 hours Equipment and instrument

78 An SES certificate must be accompanied by the delivery of products in order for stores to sell their products. 79 An example was given of a time when the processor was threatened with a fine of 30,000 som for not having a production date printed on the plastic yogurt container. Although Kyrgyz Standard did not have a standard for such a labeling requirement, the processor was required to comply with a randomly chosen policy. 80 The department responsible for conducting this supervisory visit is a high-level department within Kyrgyz Standard, and his/her main task is to review whether proper certification was conducted by properly by its own staff during the annual quality and production certification inspection. 81 An example was given of a time when an inspector took a random sample of a bacterial count off a worker’s hand where it was found that the bacterial count was above the prescribed level. As a result, the worker was assessed a fine of one-month salary.

82






Standard, Metrology Department

24 som/hr 144 som

re-certification

Electricity Authority

1 time/year 2 hours None 1 hour 24 som/hr 24 som

Regular inspection

Tax Inspectorate

2-3 times/week

NA 240 hours/year 24 som/hr 5,760 som

To argue corrections and defend accusations

Water Authority

1 time/year 1 hour None 1 hour/year 24 som/hr 24 som

Regular inspection

Ministry of Labour

1 time/year 3 hours None 3 hours 24 som/hr 72 som

Regular inspection


276. As shown in Table 3.20, a medium size dairy processor faces a number of administrative interventions, but the overall impact on the cost of production is relatively small, and in fact a large portion of the cost associated with administrative interventions occur during the quality testing stage of production. Policy reforms addressing the later would, therefore, have the largest impact on reducing the cost structure and competitiveness of medium size enterprises.

7.2 Sources of Administrative Barriers

277. Preliminary research suggests that several decrees, and laws and regulations, form the principal source of administrative barriers. In most instances, laws and regulations are broadly written or allow for liberal interpretation by the implementing agency. For instance, in the case of SES inspections, the frequency and the timing of inspections to be conducted are reflected in the inspection plan. The inspection plans are submitted by the inspecting bodies to the State Commission. However, the number of inspections actually conducted do not readily correspond with the plan. Table 3.20 below provides a summary of the laws and regulations, terms of inspection, and the

government entities responsible for inspecting and oversight.

278. Another uncertainty is the cost of each inspection and certification. While costs associated with inspections and certifications are generally defined by the State Commission on Antimonopoly, it is not evident that such guidelines are clearly followed by inspection agencies.

279. Interviews with enterprises also suggest that very little up-to-date information is readily available to the private sector, if any, on laws and regulations related to state inspections and certifications. Some enterprises keep a log-book, for inspectors to sign-in each time an inspection or a certification request is made.82 This could be an important step in streamlining the number of unauthorized inspections and certification, if enterprises access reliable source of information to clearly understand their obligation.

82 A log book would be used by enterprise managers to require inspectors to sign in each time a site visit is performed so that excessive inspections can be reported or so that the log book be used to discourage multiple inspections.

83

Table 3.20: Legal Matrix Summary Sheet, Dairy Industry

Inspecting Body

Law/Regulation Responsible Government Body

Terms of Inspection

SES Decree #778 (12/19/01) Law on sanitary-epidemiological welfare of the population Regulations on state sanitary-epidemiological service

Ministry of Healthcare Chief Sanitary Doctor

Frequency: determined by SES in the inspection plan Cost: unclear

Veterinary Inspectorate

Decree #377 (8/10/92) Regulation on state veterinary inspectorate Law on veterinary sector (3/6/92), edition #73 (6/2/98), #56 (6/17/99)

Ministry of Agriculture and Water Resources

Frequency: undefined Cost: undefined

Tax Inspectorate

Tax Code (Articles 19, 20, and 37)

Ministry of Finance Frequency: once/year (not more than 30 days in duration for inspection) Cost: none

Kyrgyz Standard

Decree #238 (5/21/01) Law on Standardization #8 (4/2/96) Law on Certification of Products and Service #6 (4/2/96) Regulation on State Inspectorate on Standardization and Metrology

State Inspectorate on Standardization and Metrology

Frequency: once/year (inspections of scales of measuring equipment used in markets: 2 times/year) More frequent inspections when complaints are filed Duration of inspections: Production of products: up to 8 days Repeat inspections: up to 2 days Other inspections: up to 5 days Cost: defined under the antimonopoly policy #21 (1/30/02)

Traffic Police Decree #517 (11/28/95) Regulation on State Automobile Inspectorate

Ministry of Internal Affairs

Frequency: ad hoc Cost: undefined

Source: Official data. 280. Another uncertainty is the cost of each inspection and certification. While costs associated with inspections and certifications are generally defined by the State Commission on Antimonopoly, it is not evident that such guidelines are clearly followed by inspection agencies.

281. Interviews with enterprises also suggest that very little up-to-date information is readily available to the private sector, if any, on laws and regulations related to state inspections and certifications. Some

enterprises keep a log-book, for inspectors to sign-in each time an inspection or a certification request is made.83 This could be an important step in streamlining the number of unauthorized inspections and certification, if enterprises access reliable source of

83 A log book would be used by enterprise managers to require inspectors to sign in each time a site visit is performed so that excessive inspections can be reported or so that the log book be used to discourage multiple inspections.

84

information to clearly understand their obligation.

7.3 Cost of Administrative Barriers on the Competitiveness of the Dairy Industry

282. Table 3.21 provides insights into administrative distortions taking place at various stages of production. Translating these distortions into the cost of production yields information about the impact of administrative barriers on the competitiveness of the dairy industry. To better understand the impact of administrative barriers on the cost of production, an analysis was conducted to estimate the cost of production per liter of milk at the two stages of production: at farm level, and at the processing facility.

283. Breaking down the rate of distortion of administrative barriers on production cost per liter of milk indicates that administrative interventions imposed by government and non-governmental organizations have the greatest impact on dairy farms, including small, medium and commercial dairy farmers. An analysis of the impact of administrative barriers on the cost of production on finished dairy products suggest that small and medium dairy farms and processors would benefit substantially more from elimination of administrative barriers, compared to their counterparts in the large commercial dairy farm and processing operations. It is estimated that the former this the potential of improving cost of production of the former group by over 33 percent.

284. Furthermore, since purchasing decisions of an average Kyrgyz consumer is driven more by price, elimination of administrative barriers has the potential for improving the competitiveness of dairy products against Russian and Kazakh products in the domestic market.

285. The discussion so far indicates that shallow management skills; fragmented production; weak or often non-existent enterprise support infrastructure such as distribution, freight transport, and warehousing; an underdeveloped packaging industry; and lack of access to market

information and marketing services have repressed market potential and growth opportunities for local enterprises. Some of these shortcomings could be addressed by:

Refocusing the use of existing distribution networks to fill the void in areas related to market support services; Strengthening new entrants in enterprise

support industries, particularly those related to packaging and labels, marketing and market information services; Introducing market mechanisms to

consolidate fragmented production into quality and quantity viable for meeting demands for both local and export markets; Cooperating closely with foreign and

export oriented enterprises currently operating in the Kyrgyz market to introduce benchmarking initiatives to comply with regional and international quality standards; Developing delivery mechanisms to

improve access to technical information and production technologies84 to redirect production towards high value added activities; Introducing mechanisms such as out-

grower programs and supplier development programs to help link large, medium and small enterprises into a coherent and structured outsourcing and subcontracting relationships; and Working closely with a number of leading

local and foreign enterprises in the Kyrgyz market to link their demand for goods and services with local suppliers.

84 Rely on existing regional networks established by associations, and NGOs as information ‘node’ to introduce MIS and real time market and technical information to farming communities.

85

Table 3.21: Impact of Administrative Barriers on Production Cost/Litre of Milk

Production Cost/Liter of Milk (som)

With Administrative

Barriers Without Administrative

Barriers Dairy Farm Small Dairy Farm 5.13 3.79 35.2% Commercial Dairy Farm 3.22 2.74 17.5% Dairy Processor Medium Size Processing Facility 9.82 9.73 0.9% Large Processing Facility 5.87 5.48 7.1% Source: Staff estimates based on interviews. 8. Summary

286. The value chain analysis suggests that the competitiveness of dairy based products such as butter and ice cream can be improved through various measures to be taken both at policy level and firm level. First step is to focus on streamlining supply and cost of raw milk. Clearly, improvements in production would contribute to reducing the overall cost to the industry, but containing the cost of raw milk, whether through the reduction of administrative barriers imposed by the road police on small dairy farmers, or improving the cost and availability of animal feed for

dairy farms, is important to the overall competitiveness of dairy based products.

287. Another critical area is improving conditions of export trade for dairy based products, particularly with neighboring Kazakhstan. This requires continued strong emphasis on improving trade relations between the two countries to encourage freer flow of goods, which has recently brought additional benefits. Clearly, the strength of the long-term growth prospects of the industry will eventually be determined by market access, given the limited demand generated through the small Kyrgyz local market.

Table 3.22: Factors Inhibiting the Growth and Competitiveness of Value Added Dairy Products

Policy-Based Barriers Market-Based Barriers Lack of on-farm sanitary-epidemiological control, contributing to decline in fat content and increase in bacterial count of milk.

Absence of a ‘chill-chain,’ deteriorating quality and quantity of milk available to the dairy processing industry.

Uncertain land tenure laws, constraining free movement of animals from grazing.

Lack of adequate formal market distribution channels, contributing to a range of market inefficiencies.

High administrative costs associated with police and government inspections.

Disaggregated small dairy farms, contributing to high cost and slow delivery of milk.

Trade relations with Kazakhstan, resulting in high transit taxes for goods moving in and out of the Kyrgyz Republic.

Limited access to working capital, contributing to difficulties in accessing animal feed during winter months.

Tax administration mechanism, creating disincentives for growth of transport and wholesale distributors.

Absence of support industries in infrastructure, transport and wholesale industry, increasing operating cost of dairy processing industry.

High rent seeking behavior among public sector officials, increasing delivery price of milk, posing delays and creating waste/loss for dairy farmers. Duplication of inspection by Kyrgyz Standard, increasing costs and reducing efficiency of dairy processors; Delays and increased costs posed by registration requirements under Agritech Research Institute.

Shallow management skills, particularly in the dairy processing industry.

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