By Myles G. Smith (04/18/2012 issue of the CACI Analyst)

A sharp cut in the production forecast of Kyrgyzstan’s lone large industrial enterprise could spell disaster for the country’s finances. A labor strike by workers at the mine in February led to an immediate freeze on production, which led to the company revising its 2012 production forecast from around 600,000 to around 400,000 ounces. The announcement led to an immediate downward revision of Kyrgyzstan’s industrial output and GDP for the first quarter of 2011 by 2 percent. But the government’s growing reliance on indirect taxation for revenues means Bishkek can expect ever greater fallout when the operations of Kumtor are disrupted.

BACKGROUND: The Kumtor Gold Mine is majority-owned and operated by the Canadian firm Centerra, with a 33 percent minority stake held by the Kyrgyz government. It is located high in a remote mountain plateau in the east of the country, 220 miles east of Bishkek. Kumtor’s output comprised almost 12 percent of Kyrgyzstan’s GDP in 2011.

Kumtor cites the 10-day February strike by mine employees for the downward revision. Local staff demanded that the company pay the staff’s portion of their social fund contributions, comprising about 5 percent of their pay. Its statement maintains that the work stoppage, combined with unusually heavy ice flows, led to waste buildup in a section of the pit that was due to be exploited in late 2012. At over 4,000 meters (13,000 feet) of altitude, Kumtor is located in the midst of several flowing glaciers.

Kumtor eventually agreed to the strikers’ demands, while grumbling that the strike violated the collective bargaining agreement it maintains through 2012. Kumtor maintains that employee incomes are already much higher than the national average.

Strikes, protests, and parliamentary inquiries have been a regular feature of Kumtor’s operations throughout its contentious history, which dates back almost to the country’s founding. Protesters complained about uncompensated exploitation of the region and environmental damage, blocking supplies bound for the facility in late 2011. Workers went on strike in October 2010, during Kyrgyzstan’s precarious post-Bakiev phase, to demand a 100 percent pay increase.

Despite the company’s own shortcomings on transparency and environmental stewardship, many such incidents are seen as ‘astroturf’ – instigated by criminal and/or political figures seeking a share of the country’s most reliable revenue stream. Often, they dovetail directly into concessions to the government itself.

In 2004, the government sold off US$ 80 million worth of its shares in the company following its Canadian IPO, and its ownership stake dwindled to 16 percent. Bakiev’s government moved to improve its position by demanding, and receiving, the present 33 percent stake in the company in 2009. It also won additional concessions on back taxes, rent, environmental fees, and other special taxes reserved exclusively for Kumtor. At the time, its US$ 30 million regular annual tax payment made up 10 percent of the government’s revenues.

Since Bakiev’s ouster in 2010, the pressure has ratcheted up again, with the current government investigating the terms of Kumtor’s 2009 deal with Bakiev, despite Kumtor’s legal protests. Bakiev’s every move has been delegitimized as traitorous by the government’s incumbents, which provides a convenient excuse for renegotiation.

The only other concentrated stream of foreign income, the U.S.’s Manas Air Base, received this treatment by the post-Bakiev authorities in 2011, with its fuel supplies and rental agreements revised in Bishkek’s favor. Now, it appears that Kumtor’s turn has come.

IMPLICATIONS: This round of offensives against Kumtor must lead to results, or the country may end up disemboweling the indirect taxation regime it has worked so hard to build across successive administrations.

Evasion of direct taxes is rampant in Kyrgyzstan. The citizenry, not without reason, is wary of government misappropriation and avoids taxes whenever possible. Tax collectors offer reduced payments in exchange for cash bribes. Large businesses conceal income to reduce tax liabilities. Small businesses stay small – forgoing viable growth opportunities in order to avoid the attention of the rapacious officials. As successive governments have been increasingly discredited in the eyes of the public, and attempts to raise revenues through utility fees and stricter tax enforcement have been met with public outcries and populist political rancor, the state budget has increasingly relied on indirect taxation and foreign concessions.

As such, Manas and Kumtor are the country’s most convenient targets, and are complemented by an ongoing effort to win grants and loans from foreign governments and development banks.

Additional efforts to appease a restive public have resulted in large salary increases promised to state employees during the 2010-11 elections. Long planned increases in utility fees were revised downward as well. The 2012 national budget comprises 30 percent of the economy, 6 percent larger than the record 2011 level. The deficit is projected at US$ 355 million, just over 5 percent of GDP.

While the budget looks bad on paper, its underlying assumptions appear even worse. GDP growth is projected at around 7.5 percent for the next three years. Kumtor’s troubles alone could shave 1-2 percent off growth in 2012. While Kumtor is projecting sharply reduced revenues, Bishkek is projecting sharply increased tax receipts. The Bishkek-based Central Asian Free Market Institute estimates that the government is projecting an 80 percent increase in revenues from Kumtor in 2012. Last year, Kumtor reported payments of about US$ 200 million in taxes, dividends, mandatory contributions, customs duties, and social insurance taxes – several times its 2009 level.

The budget also projects a 32 percent increase in tax payments, a 79 percent increase in fines and confiscations, and a 37 percent increase in customs duties. Kumtor’s output cut, the long refusal of the state to confront the shadow economy, and the likelihood that the Customs Union will further depress foreign trade, cast doubt on all of these assumptions.

Finance Minister Japarov promised that the 2012 budget would be without deficit or corruption, but confusingly also promised to close the projected deficit with US$ 30 million from the EU, a further sale of state assets, and another US$ 8 million from Kumtor. Perhaps Japarov was referring to the government’s new term for deficit: “negative fiscal balance.” Opposition leader Kamchybek Tashiev went further, demanding a parliamentary committee to “resolve the issue of Kumtor” in a set of accusations about its tax payment history. Minister of Economy Temir Sariev made the first official move on March 28, declaring the company pays too little in taxes, despite the fact that it appears to pay much more than the flat national corporate tax of 10 percent. Sariev proposed regulation on the mining industry to “standardize” tax rates across the sector, base Kumtor’s payments on revenues, not profits, and insulate them from the price of gold.

Gold prices have fallen recently from their 2011 high of US$1900/oz, to near US$1670/oz. While Kumtor has consistently conceded in previous negotiations, it may be reluctant to repeat this cycle as its bottom line erodes. In its current 2012 production estimate for shareholders, the company hedges heavily on the risk of future strikes, license renewals, and political unrest.

CONCLUSIONS: Sariev’s statement seems to be the beginning of a more aggressive move against Kyrgyzstan’s lone noteworthy foreign investment. With Centerra’s shares hit hard as a result of the February strikes, and the price of gold slowly receding, Bishkek may be headed for a calamitous budget deficit without dipping into the Kumtor well again. Russia demonstrated Kyrgyzstan’s vulnerability to fuel prices with its 2010 export duties. Kyrgyzstan has suffered the effects of the Customs Union, and the terms of its accession to that block may further erode duty revenues in 2013. On top of that, its lucrative base agreement with the U.S. ends in 2014. All of these threats to tax revenues come in a context of a growing state sector, promises to raise wages, and to forgo utility rate hikes.

Multilateral banks may not finance permanent budget deficits, and sovereign lenders may extract greater prices for their willingness to do so. Russia is demanding an increasing stake in Kyrgyzstan’s Dastan torpedo factory for loan forgiveness, the country’s only notable military-industrial enterprise.

Together, the forward risks to Kyrgyzstan’s budget beg for monumental government will to wind down the state sector of the economy, through transparent privatization, cuts in bureaucracy, modest utility rises, strict but fair enforcement of the tax code, and even revisiting unnecessary hospitals and universities. Such action would also require a patience and trust from the public at large. The last decade has shown little reason to expect either.

AUTHOR’S BIO: Myles G. Smith is an analyst and consultant based in Central Asia.