Information about Middle East Oriente Medio

VII Capital Flows and External Debt

International Monetary Fund
Published Date:
August 1999
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Jimmy McHugh

Total external debt of the Central Asian states grew almost sevenfold during 1992–98, reaching $10.5 billion by end-1998 (Table 7.1 and Figure 7.1). The growth in debt started from a nonexistent base; all of the Central Asian states had effectively accepted the “zero option” following independence, under which Russia took over both the foreign assets and liabilities of the countries of the former Soviet Union (Box 7.1). The subsequent accumulation of external debt in the region occurred in two distinct phases. During 1992–94, the breakdown of the traditional trade and payments systems within the BRO countries, the collapse of the ruble zone, and large current account deficits financed by credits from Russia all led to the rapid accumulation of intra-BRO countries claims. From 1994 onward, the Central Asian states increasingly experienced more conventional forms of capital inflows. In order to promote economic growth—especially in export-oriented industries such as oil, natural gas, agriculture, and metal extraction—all five states resorted to foreign borrowing. Initially, most of the loans received were from official bilateral and multilateral sources. More recently, private sector flows—primarily in the form of FDI and commercial bank loans—have gained importance in a number of the Central Asian states (notably in Kazakhstan).

Table 7.1.Public External Debt
1992199319941995199619971998 Prov.
(In millions of U.S. dollars)
Kyrgyz Republic52924145857339571,123
(In percent of GDP)
Kyrgyz Republic0.623.837.436.441.554.165.8
Weighted average16.322.526.322.921.425.725.4
Source: International Monetary Fund.

Figure 7.1.Public External Debt1

Sources: IMF Staff Country Reports.

1 Data for 1998 are provisional.

During 1992–97, the external indebtedness of the region rose but, as a whole, remained moderate by international standards, both in terms of the size of the debt stock and the ability to service the debt. In 1997, the debt to GDP ratio and the debt service ratio in the region were, on average, 26 percent and 9 percent, respectively. The average debt service ratio in these countries is estimated to have risen sharply to 29 percent in 1998 (Table 7.2), reflecting a bunching of repayments, as well as a weakening in exports following the Russian crisis. As in the rest of the BRO countries, much of the borrowing that took place in the early years of independence financed current expenditure, including the settlement of arrears on wages and pensions, so that the returns that were needed to service the debt could not always be generated. If the recent rapid growth in external debt is sustained and the funds are channeled toward unproductive uses, the region could develop a serious debt sustainability problem. In recognition of this, under successive reform programs, most of these countries have developed a keener awareness of the need to strengthen external debt management and to better prioritize the use of foreign resources. Also, the Central Asian states have made some progress in setting up debt management structures and restricting government guarantees, although more work remains, particularly in the areas of data collection and assignment of overall institutional responsibility for debt management.

Table 7.2.Public External Debt Service
199319941995199619971998 Prov.
(In millions of U.S. dollars)
Kyrgyz Republic5773483843
(In percent of exports)
Kyrgyz Republic1.51.917.
Weighted average2.
Source: International Monetary Fund.

Breakdown of the Trade and Payments System

The Central Asian states faced balance of payments difficulties following the move by Russia (their key source of imports) to using world prices in trade with the countries of the former Soviet Union. Initially, significant adjustment was delayed because the deficits were financed by Russia through so-called technical credits issued by the Central Bank of Russia in the form of correspondent accounts.1 Based on changes in correspondent account balances during 1992, such transfers, received by the Central Asian states as a proportion of GDP, were estimated at about 42 percent for Tajikistan, 34 percent for Turkmenistan, 28 percent for Uzbekistan, 15 percent for Kazakhstan, and 11 percent for the Kyrgyz Republic.2

The Russian Federation became increasingly reluctant to continue financing the trade deficits of other countries of the former Soviet Union. In April 1993, it announced that the previous arrangements would be terminated, and that all future credits would be issued on the condition that all outstanding balances on existing correspondent accounts be transformed into interest-bearing government debt. The Central Asian states (except Turkmenistan) agreed to this arrangement, thereby acquiring significant government debts owed to Russia.

In May 1993, the Central Bank of Russia stopped processing payments through the correspondent accounts, signaling an end to the ruble zone. The collapse of the ruble zone left the member states with a series of bilateral correspondent accounts, whose balances were subsequently frozen. Disputes arose regarding the valuation of these accounts, as the new domestic currencies fluctuated widely. Therefore, the exchange rates to be used in converting the outstanding balances became the subject of protracted negotiations among the parties concerned. Nonetheless, some progress was made in resolving these bilateral disputes. In March 1997, Uzbekistan reached an agreement with Russia over disputed correspondent account balances, with the final agreed amount exceeding $500 million. In October 1998, Kazakhstan concluded an agreement with Russia canceling all mutual claims up to 1998, including all state debts due to Russia arising from outstanding correspondent account balances pertaining to transactions during 1991–94, outstanding rent due to Kazakhstan for the use of the Baikonur space complex, and related ecological damages. Kazakhstan has also resolved its dispute on correspondent account balances with Georgia. The Kyrgyz Republic reached agreements with two of its main creditors, Kazakhstan and Uzbekistan, Turkmenistan recently resolved a dispute with Russia involving correspondent account balances valued at over $100 million, but contested balances remain with some of the other countries in the region.

The accumulation of interenterprise arrears among the Central Asian states added to the external debt of these countries. While accurate data on arrears are unavailable, anecdotal evidence suggests that they were widespread. Many state enterprises, which could not sell their products and faced growing liquidity problems, continued production and accumulated payments arrears with other BRO countries enterprises. In some cases, importers obtained government guarantees on commercial credit agreements, as a precondition for supplying further inputs. In other cases, external trade-related debts were restructured into government-guaranteed debt.

Among the Central Asian states, Tajikistan suffered most from trade-related debt problems. Unlike the other countries in the group, Tajikistan chose to remain in the ruble zone after 1993 and continued to receive transfers from Russia. In order to avoid disruption to the delivery of industrial inputs, the government issued guarantees on commercial credits, which were often contracted with very short maturities and on unfavorable terms. In October 1995, the government announced that it would no longer guarantee debt arising from interenterprise arrears and would regard all such debt as private commercial debt. By 1996, Tajikistan’s outstanding debt stock exceeded $860 million (84 percent of GDP) and its debt service obligations reached 24 percent of GDP. Consequently, Tajikistan was unable to service most of its debts, and short-term financing to the country dried up. The National Bank of Tajikistan created a special debt service account for the government to meet current debt commitments and to service debt to those creditors who agreed to reschedule arrears. During 1996–97, Tajikistan reached agreements with Russia and Uzbekistan to reschedule their outstanding claims at concessional interest rates.3 In a 1995 agreement, Kazakhstan rescheduled outstanding claims on Tajikistan.

Box 7.1.External Debt of the Soviet Union

After the dissolution of the Soviet Union, it was unclear which countries would assume responsibility for the U.S.S.R.’s external debt commitments and claims. On October 28, 1991, Russia and the newly independent states signed a Memorandum of Understanding, under which signatories agreed to be jointly responsible for the debt, and to designate the Russian Bank for Foreign Economic Relations as the sole institution responsible for managing the outstanding obligations of the U.S.S.R.

On December 4, 1991, nine countries signed the Interstate Treaty, which indicated each country’s responsibility for servicing U.S.S.R. debt on the basis of a number of key macroeconomic indicators. The signatories were also required to deposit foreign exchange reserves in the Russian Bank but the treaty was broken when only Russia met this requirement.

In April 1993, Russia proposed the Zero Option Agreement under which signatories would give up their claims on former Soviet assets in return for Russia taking responsibility for all outstanding debt of the U.S.S.R. All states except the Baltics accepted these terms, although some countries (Ukraine) have still not obtained parliamentary approval. The Baltic countries argued that they were legally never part of the U.S.S.R. and, therefore, the question of ownership of the former assets and liabilities of the Soviet Union did not arise.

By contrast, Turkmenistan accumulated large trade-related claims against Ukraine, Georgia, Azerbaijain, and Armenia, arising from the nonpayment by these countries for gas imports during 1992–95. Prior to 1996, the trade credits issued by Turkmenistan for its gas exports received government guarantees from the importing countries. Although such guarantees were not sufficient to prevent the accumulation of arrears, the latter were subsequently rescheduled into government debt, with maturities of three to five years. As of end-1997, Turkmenistan held a stock of outstanding government-guaranteed claims totaling over $1 billion against these countries. Currently, Turkmenistan is receiving timely payments of interest and principal on this debt, with the exception of principal payments by Georgia, which is seeking a further rescheduling. As of January 1, 1996, Turkmenistan’s gas exports are conducted on the basis of commercial transactions for which government guarantees are no longer granted. During 1996–97, private gas supply companies operating in the BRO countries (notably in Ukraine) accumulated a further $500 million in payments arrears to Turkmenistan, which have since been more than halved through repayments (although often in goods of questionable quality and price), as well as rescheduling.

Capital Inflows

During the widespread economic disruption caused by a breakdown of the trade and payments system after independence, the Central Asian states were considered to be highly risky by foreign private investors. With very low domestic savings, the region had to depend heavily on official bilateral and multilateral sources for financing new investment projects (Box 7.2). As the Central Asian states made significant progress toward macroeconomic stabilization, there was a marked increase in private capital flows in the form of commercial bank lending and foreign direct investment, notably into the traditional export-oriented, resource-based industries.

Under the system of government guarantees, often obtained from line ministries without central government clearance, state enterprises borrowed abroad heavily. Given their limited capability of generating foreign exchange revenue immediately, such loans became difficult to service and guarantees were often called in. For example, in 1994, the government of Kazakhstan was forced to assume external debt service equivalent to 0.6 percent of GDP on nonperforming government-guaranteed loans contracted by state enterprises, and subsequently canceled guarantees on $2.8 billion of undisbursed credits.4

Growth in capital flows was promoted by the easing of capital controls and reform of foreign investment laws (Table 7.3 and Box 7.3). The Kyrgyz Republic maintains the most liberal capital account regime (with full capital account convertibility) within the group. All of the other countries have maintained restrictions on capital account flows, primarily on the acquisition and sale of capital, money market instruments, and real estate, and on the purchase of foreign exchange by residents. In Kazakhstan, foreign investments have to be registered with the central bank. These restrictions have not unduly affected FDI flows.

Table 7.3.Capital Account Balances
1992199319941995199619971998 Prov.
(In millions of U.S. dollars)
Kyrgyz Republic−373158249347259212
(In percent of GDP)
Kyrgyz Republic−0.45.914.316.619.014.712.4
Source: International Monetary Fund.

Nonpayments for gas exports are recorded as arrears in the capital account, since gas exports are recorded on an accrual basis in the trade account.

Source: International Monetary Fund.

Nonpayments for gas exports are recorded as arrears in the capital account, since gas exports are recorded on an accrual basis in the trade account.

Uzbekistan and Turkmenistan have the most restrictive capital account regimes. In Turkmenistan both inward and outward capital transfers are subject to central bank approval. FDI requires approval by the ministry of economy and finance and, for amounts above a specified limit, by the cabinet of ministers. Regarding outward transfers, usually only commercial banks are allowed to hold foreign deposits, financial instruments, and equity. In Uzbekistan, overseas portfolio investments in domestic assets are restricted.

Box 7.2.Investment and Savings in the Central Asian States

Under centralized planning, investment was undertaken within the context of an overall national plan directed from Moscow, with little regard to the efficient use of capital. Central planners focused on the accumulation rather than the quality of capital. Thus, there was a tendency to “overinvest” in projects with questionable economic value. Technical innovation was limited and the quality of new investment goods was low. The breakup of the Soviet Union accelerated the process of capital obsolescence. As trade barriers were lifted, state enterprises faced greater foreign competition, which exposed their technological weaknesses. Many of the traditional ex port-oriented industries such as oil, natural gas, and metals desperately needed to be re-equipped in order to compete effectively in world markets. However, the region faced two major difficulties in raising funds from domestic sources to finance such investments.

First, financial markets within the region were underdeveloped, and their ability to attract domestic savings was limited. Financial services within the Soviet system were centralized, leaving a minimal financial infrastructure in the rest of the Union. Following independence, the financial sector in each state was subjected to excessive slate intervention. Governments made extensive use of commercial banks to channel directed credits to ailing industries, which weakened bank balance sheets and eroded public confidence in the financial system. A second factor constraining domestic savings was the surge in consumer spending. Prior lo the breakup of the Soviet Union, consumption was severely suppressed through rationing and shortages. After independence, there was a “catch-up” effect, as households and economic agents substituted consumption for savings. The changing pattern of consumer spending resulted in a significant increase in the marginal propensity to import from nontraditional markets.

Official Financing

Low-interest trade credits have constituted a significant proportion of bilateral capital flows, notably in Kazakhstan, By 1996, Kazakhstan had accumulated more than $850 million in such liabilities, owed mainly to Japan, Germany, Turkey, and other Organization of Economic Cooperation and Development countries. Turkmenistan also received large bilateral trade credits, primarily for imports of food and construction materials. A large proportion of total debt contracted was with Germany and the United States. As of mid-1998, about 67 percent of the Kyrgyz Republic’s external debt was owed to multilateral creditors and 33 percent to bilateral creditors. Approximately two-thirds of debt was contracted on concessional terms (mostly World Bank loans). About 90 percent of Tajikistan’s external debt is owed to official creditors—primarily Russia, Uzbekistan, and the European Union—but this mostly represents nonpayment of commercial credits on which government guarantees were called. In Uzbekistan, while debt to bilateral official creditors still represents almost one-half of the country’s total debt stock, commercial bank lending has grown substantially since 1993.

Private Market Financing

Since 1995, there has been a marked increase in private sector flows into the region, with Kazakhstan being the most significant major recipient of such flows and the first country in the region to receive a sovereign credit rating. Subsequently, it has issued two sovereign Eurobonds, although one-third was postponed following the financial turmoil in Russia in 1998. The bond issues were considered by the Kazakh authorities to serve as a sovereign benchmark against which Kazakh corporations could borrow abroad.5 Turkmenistan contracted a number of syndicated loans to finance infrastructure projects, the largest of which involved the rehabilitation of a major oil refinery in Turkmenbashi, coupled with the development of a number of satellite projects for the production of oil derivatives. It also borrowed heavily to finance aircraft purchases and to develop its airport. During 1996–97. Turkmenistan contracted short-term private loans to finance cotton production (partially collateralized by future cotton deliveries), which it rolled over in 1998. The Kyrgyz Republic is an example of a country in the region where private market financing was used in conjunction with multilateral financing and FDI; the $452 million Kumtor gold mine project was financed with a mix of private-sector loans and FDI supplied by the Canadian Cameco mining corporation.6 During 1997–98. private financing was used to support the cotton harvest in Tajikistan. Despite these developments, private capital flows into the region have generally been constrained in the absence of domestic financial markets.

Box 7.3.Foreign Investment Laws in the Central Asian States


Reforms to encourage foreign investment have included the lifting of profitability controls, the establishment of a securities and exchange commission, and the adoption of a de-monopolization and privatization program. The 1997 Foreign Investment Law provides for tax holidays and customs exemptions for investments in priority sectors. Bilateral trade, investment, and avoidance of double taxation treaties signed with the U.S. guarantee nondiscriminatory treatment, hard currency repatriation rights, expropriation compensation, and the right to third-party international arbitration in the event of disputes. Foreign investors are permitted to engage in privatization initiatives. A number of special economic-zones have been established, providing lax incentives to foreign investors.

Kyrgyz Republic

The Foreign Investment Law stipulates that the legal status and conditions recognized for foreign investors shall never be less favorable than those for domestic investors. The law provides for tax-exempt status for foreign investors for two to five years, depending on the sector of the economy. Full repatriation of profits is guaranteed. Six free economic zones were created in 1996. These zones permit virtually tax-free imports as businesses are partially or fully exempt from custom duties, excises, VAT. and income taxes. These zones have attracted very limited production, however, and were increasingly abused for the purpose of channeling imports through to avoid taxation. In late 1998, three zones were closed and regulations tightened. The government has created the Agency for Direct Foreign Investment, which registers and assists foreign investors.


Tajikistan also offers significant tax incentives to foreign investors. Enterprises bringing in foreign capital of at least 30 percent are granted tax holidays on a sliding scale of between two and five years, depending on the amount of foreign capital. Foreign investors enjoy the same land lease and purchase rights as ordinary Tajik citizens, and may purchase natural resources. Mineral extraction requires a government license. There are no restrictions on the percentage of foreign ownership in a joint venture, and wholly owned foreign subsidiaries can be established. Foreign investors have equal access to government contracts.


A number of steps have been taken to encourage foreign investment. A series of laws were passed in 1993, which provided the legal framework for foreign investments, banking, taxation, and property rights. The government is working on the creation of a comprehensive commercial code. In 1993, seven free economic zones were created, which provide tax and production incentives to foreign investors. In early 1997, the Petroleum Law was passed, which allows production-sharing agreements in the oil and gas industries. Foreign investors are exempt from export surrender requirements.


The 1994 Law on Foreign Investment guarantees full repatriation of profits from foreign investment and access to foreign arbitration in the event of disputes. In 1994, joint ventures with more than SO percent foreign participation were granted a five-year exemption from mandatory hard currency conversion requirements. In late 1996, a presidential decree granted tax breaks to foreign companies, subsidiaries, and joint ventures, which derive more than 60 percent of their total income from manufacturing and in which the foreign investment share of capital is not less than 30 percent.

Foreign Direct Investment

The Central Asian states encouraged foreign direct investment inflows, primarily by conducting far-reaching reforms of their foreign investment laws (see Box 7.3 and Table 7.4), which entailed, among other things, the issuance of guarantees on the unrestricted repatriation of investment and profits. They also reformed their domestic company laws to facilitate the formation of joint ventures with foreign investors, and Kazakhstan developed the institutional framework for its domestic equity market (Box 7.4). Available data on FDI flows for the region suggest that, until the recent crisis in Russia, such flows were growing, particularly into Kazakhstan. Since 1992, Kazakhstan has received more than $5.7 billion in FDI, which accounted for about 76 percent of total direct investment flows to the region. A main advantage of FDI has been its close association with much-needed transfers of technology and managerial skills. The Kyrgyz Republic has received modest FDI flows, connected largely to the Kumtor gold mine project. Since independence, Turkmenistan has received more than $700 million in FDI, primarily in the oil sector. Cumulative foreign direct investment flows into Uzbekistan were of a similar magnitude during 1992–98. By contrast, Tajikistan has received very little FDI. despite its liberal foreign investment laws, with most investments concentrated in mining operations and textiles. Political turmoil and an unstable economic environment have reduced the attractiveness of the country for foreign investors.

Table 7.4Foreign Direct Investment
1992199319941995199619971998 Prov.
(In millions of U.S. dollars)
Kyrgyz Republic0104596468352
(In percent of GDP)
Kyrgyz Republic0.
Sources: IMF Staff Country Reports.

External Debt Management

The Central Asian states had little prior experience in effectively managing and monitoring external debt because such activities were conducted centrally in the Soviet Union by the state bank for foreign economic relations (Vneshekonombank). A frequent consequence of this initial lack of debt-monitoring infrastructure in the newly independent states was the indiscriminate granting of government guarantees by line ministries, often without the knowledge of the government and an adequate assessment of the projects being financed. Also, countries tended to borrow under terms with short maturities, which often resulted in payments difficulties and the accumulation of arrears on debt service obligations.

To address these early problems, the Central Asian states increasingly focused on strengthening external debt management. In Kazakhstan, the finance ministry is responsible for external debt monitoring and repayments on ail government-guaranteed loans. During 1995-96, a number of measures were taken to strengthen debt monitoring, including the introduction of the United Nations Conference on Trade and Development system for external debt management and creation of the Committee for the Utilization of Foreign Capital, which was given explicit responsibility for coordinating and managing government debt. Data deficiencies—particularly for loans contracted prior to 1994–have hampered efficient debt monitoring. In 1998, a decree was issued in Uzbekistan restricting the authority to grant government guarantees to the ministry of finance and the central hank, while in the Kyrgyz Republic debt management was strengthened by centralizing the authority to contract or guarantee external debt at the ministry of finance.

In Tajikistan and Turkmenistan, institutional responsibilities for external debt management remain less clearly delineated. Tajikistan has suffered from particularly weak debt management structures, which has contributed to an explosion of external indebtedness. More recently, the government has created, with technical assistance from the World Bank, a special debt management unit within the ministry of finance and has stipulated that all future government guarantees require the authorization of the minister of finance, Turkmenistan has complicated debt management arrangements. It is in the unique position, within the region, of being both a large external debtor and creditor, raising two very distinct debt management problems. The primary responsibility for managing government-guaranteed public debt rests with the state bank for foreign economic relations. The central bank manages its own portfolio of guaranteed loans. The situation is further complicated by the existence of a third source—the foreign exchange reserve fund, under the direct control of the President of Turkmenistan—which grants government guarantees. Debt owed to Turkmenistan is primarily tracked by the ministry of oil and gas, although some debt monitoring is also undertaken by the central bank, and repayments are directed to both the foreign exchange reserve fund and the budget.

Box 7.4.Equity Markets in Kazakhstan

Kazakhstan has undertaken a number of important institutional reforms designed to strengthen and encourage the development of its domestic equity market. In 1996, the Kazakh National Securities Commission was created to oversee the development of securities markets. New requirements for the registration of brokers were introduced, minimum capital requirements for market participants were raised significantly, and the creation of a national association of broker dealers was encouraged. The securities commission drafted legislation providing a legal framework for issuing convertible bonds. In September 1997, a new stock market was established, replacing the three smaller markets for equities established after independence. Preliminary estimates suggest that the new stock market may have market capitalization as high as $8 billion (EBRD, 1997).

The Kazakh National Securities Commission envisages the development of a three-tiered domestic equity market. The first tier would consist of “blue chip” companies which would fulfill stringent listing requirements. The second tier would include companies on a pre-relisting board which would meet less stringent listing requirements. Finally, the equity market would provide over-the-counter trading facilities for unlisted companies. The development of the domestic equity market has been strengthened by the commitment of the Kazakh government to undertake a rapid and far-reaching program of privatization.

Kazakhstan has tried to link the development of securities markets to pension reforms, by establishing a number of private pension funds which are expected to provide the domestic market with liquidity. Available data suggest that the use of equity sources for private sector financing for investment projects has been limited, and largely restricted to Kazakhstan. There are early indications that foreign investors are showing interest in Kazakh equity. In 1997, a number of investment funds were created with the objective of investing in both listed and unlisted equities, and in convertible securities.

Improvements in debt management techniques in the Central Asian states have thus been limited essentially to developing the recording of debt flows and limiting the extent to which government guarantees are granted. Little progress has been made in developing risk management techniques. While data on currency composition of external debt are not readily available, the Central Asian states have borrowed heavily in two or three foreign currencies. They have large open positions, which exposes them to foreign currency risk. Sharp adverse swings in exchange rates could potentially create debt-servicing problems. Another important weakness of current debt management practices is the lack of a thorough evaluation of debt sustainability based on medium-term projections of the balance of payments, debt-servicing requirements, and future debt disbursements.


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The newly independent states of the BRO countries abolished the old centralized interbranch payments system based on the State Bank of the U.S.S.R. (Gosbank), and introduced a new payments system based on a series of bilateral correspondent accounts held in each newly created central bank.

The debt agreement with the Russian Federation was signed on October 16. 1999. The amount rescheduled was $288 million, with a three-year grace period, and amortization during 1998–2008. The agreement with Uzbekistan was signed on January 10. 1997 and provided for the rescheduling of debt in the amount of $200 million, with no grace period, and amortization during 1997–2003.

The first issue (1996) was for $20U million, with a three-year maturity and a spread of 350 basis points over the comparable U.S. Treasury bond. The second issue (1997) was for $350 million, with a five-year maturity and a spread of 245 basis points.

The Kyrgyz government provided a one-third equity share to this company, as well as guarantees for the project and a 10-year tax holiday. During the initial years of the project (which started production in 1997) the bulk of the profits are to be used to repay foreign debt.

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