Pre-Feasibility Study on Housing Finance in the Kyrgyz Republic

Transcription

1 Pre-Feasibility Study on Housing Finance in the Kyrgyz Republic Prepared for Prepared by Raymond Struyk The Urban Institute KfW Kreditanstalt fuer Wiederaufbau Frankfurt, Germany Assignment No Friedemann Roy Bankakademie International THE URBAN INSTITUTE 2100 M Street, NW Washington, DC May 2006 (202) Version 2 UI Project 07941

2 Kyrgyz Republic 2 Executive Summary This project s objective is to define alternatives for a KfW investment program in housing finance in the Kyrgyz Republic. The TOR directed the team to begin by defining the Republic s substantial housing problems and then designing a project to address some of them using housing finance as a tool. Further development of market-rate lending for housing is another key project goal. Present Situation Banking sector. Nineteen commercial banks operate in the country. Fifteen are owned by foreign investors, including 4 with 100 percent foreign capital. Owners are mainly Kazakh and Russian banks. Some of the banks have received ratings from Moody s and Fitch. In the past two years banks have grown rapidly in terms of assets and have succeeded in expanding deposits significantly. As per January 2006, 317 credit unions operate throughout the country. Most of their lending activities concern agricultural finance. Lending activities are financed by shareholders equity and a refinancing facility of the Financial Company for Support and Development of Credit Unions in the Kyrgyz Republic (FC). In addition, there are 103 micro credit institutions, with the biggest being Finca and Bai Tushum. They offer a mixture of crop, livestock, agro-processing, trade and mortgage loan products. Combined lending amounted to KGS 783 m (as per 12/2005). The Kyrgyz Agricultural Finance Corporation (KAFC) also belongs to this group, which has been extending micro loans to farmers with World Bank financing. For the past several years the banking sector has continued on a path to stability. The IMF informed the team that all banks met the prudential requirements and that stress scenarios did not reveal any irregularities. Overall, bank profitability and the quality of the loan portfolios have improved, and banking competition has intensified following the strong expansion of foreign (mainly Kazakh) ownership of banks in recent years. Mortgage lending. Mortgage lending has increased sharply since At the end of 2005, these loans accounted for 2.4 percent of bank assets and 7.0 percent of outstanding loans. These figures give the upper limit to the development of mortgage lending for home purchase and improvements because the National Bank does not collect separate information on residential loans. But even if one includes loans for other purposes secured by property, compared even to the countries of Eastern Europe, mortgage volume is very small--0.4 percent of GDP. Sixteen of 19 commercial banks with full banking licenses are originating mortgages as are some micro finance companies. Mortgage loans are characterized by high interest rates (20-24 percent annual) and short loan terms (3 to 7 years). Average loan amounts are about $15,000 according to the IFC, although there appears to be considerable variation among banks. Most lenders impose prepayment penalties. Loans are fixed rate, selfamortizing. Most banks require property insurance but life insurance is viewed as excessively expensive. It is common practice to charge a 1 percent origination fee.

3 Kyrgyz Republic 3 Under these conditions, a small share of Kyrgyz households is able to take a mortgage loan for home purchase. All banks and NBFI interviewed stated that they made home improvements loans as well and in all cases these are also secured by a mortgage on the property. Lending terms vary. At some banks the loan term (up to 5 years) and interest rates are the same as for home purchase loans. But at others the loan term is as short as one year, and both interest rates and loan origination fees are higher. Mortgage lending in Kyrgyzstan entails significant credit and interest rate risk. Banks are much more aware of the interest rate risk. They have found ways in the short run to address most sources of credit risk and are pressing the Government and parliament to strengthen provisions in the Law on Mortgage. National housing problems. Based on statements of officials and experts interviewed and a review of relevant consultant reports, the following problems were identified: Deterioration of the multi-family housing stock. With the former State housing stock almost completely privatized by 1995, the State withdrew support for housing maintenance and rehabilitation. Private action has done little to organize owners in multifamily buildings to address these needs, despite homeowner associations being formed in about 25 percent of the buildings. Marginal housing rings or novostroika. The shuttering of plants and the disappearance of other work opportunities during the transition in smaller cities and in the countryside produced a major wave of migration to Bishkek and Osh. These migrants created new marginal rings, i.e., unserviced sub-divisions, around the destination cities. Around Bishkek, some 42 communities have been established, with a total population of about 250,000. The marginal rings are expected to continue to grow. Municipalities are charged with eventually providing infrastructure services to these areas but progress is painfully slow. Housing upgrading does occur, however, slowly and unevenly over time. Insufficient affordable newly constructed dwellings. Government officials see the lack of deeply subsidized new construction as related to the marginal rings phenomenon. No one speaks of a general housing shortage. Rather it is of the shortage of affordable housing for households in the lower middle income class and below. Affordability of basic housing services. The combination of Kyrgyzstan s temperate climate, the high incidence of poverty, the severe energy inefficiency of the housing stock, and the necessity that the country must import to meet its energy needs means that a large share of the population has problems paying for the running costs of their dwellings. Compared with other housing problems, this one has been relatively thoroughly addressed through government programs. Shortage of mortgage finance. Several officials spoke of the need to develop mortgage finance as a problem that required active government intervention. As reported below, mortgage lending has been established and is developing at a brisk pace without government assistance. A better statement of the problem is the perceived lack of access by lower income families to mortgage finance.

4 Kyrgyz Republic 4 Government Housing Sector Initiatives The government s program for is focused on expanding homeownership opportunities for households in the lower half of the income distribution. The government has developed three new programs that tackle the related areas of housing construction and mortgage finance, the initial funding for which is included in the 2006 budget. The following provides an overview of the three programs as defined in late February. Housing for young teachers and doctors in rural areas. The program is aimed at retaining these skilled professionals in rural areas for longer periods through a 3-year accumulation scheme that leads to dwelling purchase. There is no income testing, but the salaries paid are very low the expected monthly salary in 2009 is Som 1, One thousand persons are to be assisted annually. Under the program, a savings account is opened in a commercial bank in the participant s name and the State contributes the equivalent of $100 per month for 36 months, i.e., $3,600 total. A 10 percent annual interest rate on deposits is assumed. At the end of the accumulation period, the funds are used as a downpayment for a dwelling. The participant receives a mortgage loan for the balance of the purchase price as needed; an 18 percent interest rate is assumed. Creation of a contract savings scheme for housing. This features the implementation of a contract savings scheme of the closed type, i.e., following the Bausparkasse model, by a publicly owned bank. The plan calls for an interest rate on savings of 4 percent, with a 30 percent bonus (subsidy) paid with state funds. The accumulation period is 2-5 years, with shorter periods for relatively higher income households, i.e., those who can save at a higher rate. It is expected that the accumulated funds will equal 40 percent of the purchase price. The interest rate on the mortgage loan is set at 6 percent. A number of technical questions about the scheme exists. Over the period, a total of 3,625 families are to receive flats. Social housing construction program. This program supports the construction of modest flats (40 sq.m.) for moderate-income households. Although this is called a social housing program, the units are provided to beneficiaries on an owner-occupancy basis. Participant households are expected to make a downpayment of 6.5 percent of the purchase price. Ten percent of unit costs will be covered by a government grant. The balance of 83.5 percent of the purchase price will be financed by a zero interest rate, 15-year mortgage. Total housing production of 2,000 units by 2010 is planned. Possible Objectives of a KfW Investment Program The objectives listed below are based on an overall program goal of maximizing the developmental impact of KfW s involvement. In selecting objectives, the team considered Kyrgyzstan s housing problems and the current and planned activities of other donors. 1. Help control the deterioration of the multifamily housing stock. There is no question that this is a major problem. KfW could provide finance to lenders who make loans to comparatively strong homeowners associations (HAOs) for rehabilitation projects. 1 The exchange in early March 2006 was about Som 49 = 1 EUR.

5 Kyrgyz Republic 5 2. Accelerate the rate of improvement in housing and infrastructure in marginal housing rings. KfW could provide finance to micro finance companies or commercial banks who would make loans for home improvements and upgrading in these areas. 3. Accelerate the development of mortgage lending. Three nonexclusive options are present. (a) KfW could provide finance to partner banks to fund mortgage loans that meet standards agreed with KfW. Similar to what KfW is doing in Armenia, a maximum loan amount could be set to channel KfW s funds to moderate and lower income borrowers. As part of this package, it could work with the same banks to improve risk management systems and with the industry overall to improve professionalism in loan underwriting and servicing, including the introduction of Minimum Quality Standards; a variable interest rate mortgage product might also be introduced to manage interest rate risk. (b) KfW could provide support for the establishment of the contract savings scheme being launched by the Government. (c) KfW could supplement the funds available for the Government s social housing construction program by providing funds to finance mortgage loans to dwelling purchasers. Programs to implement both initiatives 1 and 2 would use a contract savings period to establish the creditworthiness of potential borrowers. But this would not be a full contract savings scheme for housing (CSSH). In the report, the three program elements listed under the third goal, accelerating development of mortgage lending, are developed and evaluated as separate options. The mechanics of the programs to reach these objectives are spelled out in report section II.B. Each program is then assessed against eight criteria including the development impact on the financial system, the absorptive capacity of partner financial institutions and of the market (demand for the product), sustainability, and the complexity for and risk to KfW. Recommendations For two reasons the team believes that highest priority should go to funding the program of home upgrading loans focused on novostroika areas. First, the market is underserved. Targeted loans funded by KfW could dramatically expand lending from current low levels. Second, the impacts on the welfare of borrower households would be significant, both in the health effects of upgrading dwellings from non durable mud-brick to durable construction materials and in the savings in energy expenditures resulting from the improvements.

6 Kyrgyz Republic 6 The second priority program is loans from KfW to lenders for financing mortgages for home purchase and home improvement organized so as to strengthen the lending at the partner lenders and to improve mortgage lending overall in the country. One reason that this is given the second priority is that the IFC technical assistance project, should it be funded, could be adjusted so as to promote the general adoption of the MQS by all banks through a process of consultation and mediation with all mortgage lenders and to institutionalize training at the new Banking Training Center, rather than focus on development of model standards and documentation working with specific banks. In assessing the options, it is important to note the size of the envisioned KfW program in relation to the present volume of mortgage lending for home purchase and home improvement. Roughly, the volume of residential mortgage lending in 2005 was from EUR 2.6 and 3.9 mln. This illustrates that the KfW resources will be large compared to likely lending even two years in the future. Under this circumstance, KfW may well be able to fund multiple initiatives.

7 Kyrgyz Republic 7 Table of Contents Executive Summary 2 Contents 7 Acknowledgements 8 I. SETTING THE STAGE 9 A. Overview of the Current Situation 9 B. Government Policies and Programs Current and Planned 19 C. Current and Planned Donor Activities 22 D. Balance of the Report 24 II. IINVESTMENT PROJECT ALTERNATIVES 26 A. Possible Program Objectives 26 B. Programs to Achieve the Objectives 26 C. Assessing the Objectives 38 III. RECOMMENDATIONS 43 A. Program Components 43 B. Criteria for Partner Lenders 44 Annexes 1. Persons with Whom the Team Met One-Page Program Summary Persons Attending the Seminar on Contract Savings Schemes for Housing 49

8 Kyrgyz Republic 8 Acknowledgements The project team received support from many quarters in preparing the study. We wish first to recognize the consistent help offered by Felix Hartmann at KfW. He and his colleagues provided extremely useful comments on the draft report. Our principal counterpart in the Kyrgyz Republic, Sultanbek Usenov, at the Ministry of Economics and Finance, was forthcoming and helpful throughout. The team met with over forty individuals during the field work to obtain information and insights about the workings of Kyrgyzstan s housing, housing finance, and financial markets. These individuals were without exception cooperative, open, and informative. They are listed in Annex 1. We owe a special vote of thanks to the IFC for giving the team advance access to material on the Kyrgyz Republic developed under its Central Asia Primary Mortgage Market Development Project. Additionally, we were fortunate in having excellent support for the field work. The Urban Institute s office in Bishkek, led by Charlie Undeland, helped organize our visit to be maximally efficient. Consultant Beknazar Musaliev did a fine job of scheduling meetings, adjusting to changing requirements. While these individuals provided invaluable assistance to the team, the authors are solely responsible for the report. The statements herein are the authors alone and not necessarily the views of KfW, the Urban Institute, or Bankakademie International.

9 Kyrgyz Republic 9 I. SETTING THE STAGE One result of the negotiations between the German and Kyrgyz Republic governments in 2005 was an agreement that KfW would explore options for future involvement in the Kyrgyz financial sector. The Kyrgyz Government gives high priority to the further development of housing finance and mortgage lending. This report defines options for a KfW investment program in this sphere. A. Overview of the Current Situation This part outlines the current situation in several areas: the broad macroeconomic and political environment, national housing problems, conditions in the banking sector, and the development of mortgage lending. Some sections rely heavily on a recent report prepared by the IFC on mortgage lending in the country. 2 Statements here that are based on this report are marked with an asterisk ( * ) after the statement. A.1 Macro-economic and political conditions These two topics are best considered together, particularly in light of developments since winter As shown by the data in Table 1, by 2000 the Kyrgyz economy had emerged from the deep recession linked to the 1998 Russian financial crisis and, with the exception of 2002, enjoyed solid economic growth, low inflation and rising foreign investment. This happy pattern was reported to have been brought to a halt as a result of the turmoil associated with the tulip revolution of February-March, 2005 (official figures for the year are not yet released). GDP growth is said to have declined sharply in 2005 along with foreign investment and inflation to have increased. Recovery in the GDP growth rate to 5 percent is anticipated in Table 1. Macro-economic Indicators, Indicator GDP growth rate (%) Inflation rate (%) Unemployment rate (%) Foreign investment ($ millions) Exchange rate (Som/$) Source: IFC report. During the winter of , after the election of a new president in July 2005, political tensions again rose. At the time of this writing in early March, the situation remains unsettled. Despite the growth during , the country remains poor, with a per capita GDP of only $400 in 2004; in 2000, 52 percent of the population lived 2 IFC, Kyrgyzstan Housing Finance Gap Analysis, draft February 27, 2006.

10 Kyrgyz Republic 10 below the poverty line. 3 The Kyrgyz Republic remains substantially rural in character with 65 percent of its 5.1 million population still living in the countryside. In 2003, agriculture and forestry accounted for 52 percent of employment. 4 A.2 National housing problems This section first provides an overview of the sector and then outlines several major housing problems identified by government officials and external experts. A.2.1 Tenure, housing conditions, housing construction The Kyrgyz Republic, like Bulgaria and Hungary, is a so-called super homeownership state, with 95 percent of the former state and municipal housing stock having been privatized. State-owned units in 2002 accounted for only 3.8 percent of the stock and cooperatives and other tenures for the balance of the stock. 5 About 500 homeowner associations accounting for about 1,300 buildings and 25 percent of all units have been formed throughout the country. 6 After privatization, the State ceased all assistance for dwelling maintenance and rehabilitation. The result has been widespread deterioration in the multifamily housing stock. While some condominium associations have done well at maintaining their properties, not all have; 7 and the other three-fourths of the stock has been grossly neglected. Table 2 gives basic statistics on the provision of dwelling units with basic services. The information reflects the country s poverty. Only 70 percent of urban families have access to running water or are connected to a public sewage system. Under half have piped hot water in their units. The population growth rate is low at about 1 percent per year, partially as a result of significant out migration by those in search of work. This would suggest that the volume of required newly constructed housing should be modest. However, during the transition there has been a substantial movement of households from rural areas and smaller towns to major cities (see below) and this has increased the need for new housing. Residential construction rose significantly in 2004 (the latest year for which data are available). Measured as a share of GDP, after resting at percent of GDP from 2000 through 2003, residential construction rose to 2.0 percent in Building permits were issued for 5,300 units and 5,000 were certified for 3 World Bank web site, Kyrgyz Republic Data Profile, as of January Economic Intelligence Unit, Country Profile 2005: Kyrgyz Republic, p Information from, Institute for Urban Economics, Report for the Kyrgyz Republic: The Environment Millenium Development Goal (MDG) in Europe and Asia, Degraded Housing Target. (Moscow: IUE, 2004). The great majority of privatized units are owner-occupied but some are rentals. 6 Unlike in Kazakhstan, for example, formation of these associations was on a voluntary basis. 7 Reports of The Urban Institute on HOAs in Kyrgyzstan are available at: ;

11 Kyrgyz Republic 11 occupancy. Most years over 90 percent of the units built are single family dwellings. 8 Table 2. Total dwelling square and percent of households with access to services, 2001 Housing Percent of households with amenity Indicator stock Total Urban Rural (m 2 ) (%) (%) (%) Kyrgyz Republic total equipped with Running water Public Sewage Flushing toilet N/A Bathroom (shower) Hot water District heating N/a Central gas supply Telephone Electricity interruptions less frequently than once per week (%) N/A a. Source: Institute for Urban Economics, op. cit., Table 2. A.2.2 Major housing problems A Deterioration of the multi-family housing stock. The origins of this widespread problem were noted above. There are no reliable estimates of the extent of the problem. 9 A Marginal housing rings or novostroika areas. The shuttering of plants and the disappearance of other work opportunities during the transition in smaller cities and in the countryside produced a major wave of migration to Bishkek and, to a less extent, Osh. These migrants created new marginal rings, i.e., unserviced sub-divisions, around the destination cities. Around Bishkek, some 42 communities have been established, with a total population of about 250,000. The marginal rings are expected to continue to grow. Municipalities are charged with eventually providing infrastructure services to these areas but progress is painfully slow. Housing upgrading does occur, however, slowly and unevenly over time. These settlements were created by occupancy of completely unserviced land. The development of novostroika areas is often referred to locally as invasions. As discussed further below, invasions is a misnomer. After a short initial experience, the sub-division process has been organized by Bishkek s four municipal raions (districts) that prepare sub-division plans and allocate plots to qualifying households. Site plans developed prior to the invasion demark streets and sites for schools and other public purposes. These plans have generally been 8 9 Source: background tables prepared for the IFC report cited earlier. Institute for Urban Economics, op. cit.

12 Kyrgyz Republic 12 enforced. Road rights-of-way are generous and residential lot sizes large 500 to 600 sq.m. is typical (5-6 sotka). Hence, these are low-density areas in contrast to the invaded areas of Asia and Latin America. The settlements locations differ sharply in their quality, with some being in areas subject to frequent flooding or other hazards. Some families brought doors, windows, and other elements from their former units to use in constructing new units that begin really as shacks. Generally, the development of dwelling units has followed the classic model of incremental construction. Initially, a small unit is often constructed of mud bricks. It is then improved and expanded over time. In the oldest novostroika areas, most dwellings are now constructed of durable materials, although a large share is not fully completed. A Insufficient affordable newly constructed dwellings. Government officials see the lack of deeply subsidized new construction as related to the marginal rings phenomenon. No one speaks of a general housing shortage. Rather, they speak of the shortage of affordable housing for households in the lower middle income class and below. A Affordability of basic housing services. The combination of Kyrgyzstan s temperate climate, the high incidence of poverty, the severe energy inefficiency of the housing stock, and the necessity that the country must import to meet its energy needs means that a large share of the population has problems paying for the running costs of their dwellings. Compared with other housing problems, this one has been relatively thoroughly addressed through government programs (see section A.5). A Shortage of mortgage finance. Several officials spoke of the need to develop mortgage finance as a problem that required active government intervention. As seen below, mortgage lending has been established and is developing at a brisk pace without government assistance. A better statement of the problem is the perceived lack of access by lower income families to mortgage finance. A.3 The banking system After independence in 1991, a two-tier banking system was implemented in Kyrgyzstan. Chart 1 shows the structure of the banking system (as per 2005) which consists of four different groups. Supervision is executed by the National Bank of Kyrgyzstan (NBKR): The 19 commercial banks operating in the country report assets of Som billion and equity worth Som 3.5 billon (as 12/2005). 10 Fifteen banks are owned by foreign investors, including 4 with 100 percent foreign capital. Owners are mainly Kazakh and Russian banks. Some of the banks have received ratings from Moody s and Fitch. As per January 2006, 317 credit unions operate throughout the country. Lending amounted to KGS mln to 21,215 customers. Their combined equity is 10 The current USD/KGS exchange rate is about 41.

13 Kyrgyz Republic 13 Som mln. Most of their lending activities concern agricultural finance. Lending activities are financed by shareholders equity and a refinancing facility of the Financial Company for Support and Development of Credit Unions in the Kyrgyz Republic (FC). 11 This institution was established in order to support the development of the credit unions, which received a loan from the Asian Development Bank (ADB) and technical assistance from GTZ. It may be privatized or liquidated this year. 12 Chart 1: structure of Kyrgyz banking system National Bank of Kyrgyzstan Commercial banks Credit unions Micro finance institutions Currency exchange and Pawn shops In addition, there are 103 micro credit institutions, with the biggest being Finca and Bai Tushum. 13 They offer a mixture of crop, livestock, agro-processing, trade and mortgage loan products. Combined lending amounted to KGS 783 mln (as of 12/2005). 14 The Kyrgyz Agricultural Finance Corporation (KAFC) also belongs to this group, which has been extending micro loans to farmers with World Bank financing. 15 For the past several years the banking sector has continued on a path to stability. The IMF informed the team that all banks met the prudential requirements and stress scenarios did not reveal any irregularities. Overall, bank profitability and the quality of the loan portfolios have improved, and banking competition has intensified following the strong expansion of foreign (mainly Kazakh) ownership of banks in recent years. 11 Credit Unions were not allowed to collect deposits. For a pilot project, however, NBKR granted 10 credit unions a temporary license for deposit collection last year. 12 For a final decision on the future of FC, an assessment is currently done. ADB informed the team that the future existence of FC would depend on a further inflow of funds. 13 See International Business Council, Priority Recommendations to improve the Kyrgyz Business Environment, summer See Demir Kyrgyz International Bank, Annual Report 2004, page It will remain a non-bank institution until its privatization which is expected to be completed by end See IMF, Kyrgyz Republic: First Review under the three year Arrangement under the Poverty Reduction and Growth Facility Staff Report, November 2004, page 15.

14 Kyrgyz Republic 14 Table 3 shows some key data of the Kyrgyz banking system, excluding credit unions and micro finance institutions. Table 3: Key indicators of Kyrgyz banking system (figures in millions of Som) 31 Dec Dec Dec Credits and financial 2, , ,963 lease to clients Total Assets 11, ,020.4 Demand deposits of 2, , ,888.4 legal entities deposits of individuals 1, , ,663.7 Time deposits of legal , ,536.1 entities Total capital 2, , ,513 Total provisions for credits to clients Current liquidity 93.2 % 90.8 % 86.9 % ratio16 Source: NBKR From 2003 to 2005, lending to the private sector grew by 277 percent. In 2004, credit to the private sector in relation to GDP amounted to 7 percent. For 2006 and 2007, these figures are estimated to increase to 8.7 and 9.7 percent, respectively. 17 Credit growth was also accompanied by a rising inflow of deposits from private individuals. From 2003 to 2005, deposits went up by 86 percent, reflecting rising, though slowly, confidence in the banks. However, terms with a maximum of 1 year remain short. Moreover, about 72 percent of deposits are in USD. Net profit for the first half of 2005 reached KGS 0.2 billion. Annualized ROA and ROE of all commercial banks as of 1st of July 2005 made up 2.3 and 17.3 percent, respectively. 18 The current liquidity ratios show that banks are highly liquid. The IMF informed the team that they have pushed NBKR to absorb the excess liquidity. However, The IMF considers NBKR to still lack the adequate instruments for this task. Chart 2 illustrates the development of interest rates for loans and deposits. Since 2001, spreads have fallen; but at 12 to 14 percentage points, they still remain considerably high. These spreads are the result of perceived credit risk, interest rate risk and liquidity risk. First, many banks are considered to pursue very conservative lending policies. 19 Second, with their short-term liabilities, banks have to bear the interest rate risk, since customers do not accept variable interest rates. Third, most of long-term loans are financed by short-term funds with 16 This ratio is calculated over assets up to 30 days. NBKR requires a ratio at least 30 percent. 17 See IMF, Kyrgyz Republic: First Review under the three year Arrangement under the Poverty Reduction and Growth Facility Staff Report, November 2004, page Source: NBKR. 19 For example, Demir Kyrgyz International Bank does not grant loans for terms longer than 3 years.

15 Kyrgyz Republic 15 varying interest rates. Average costs of funds vary around 8 to 9 percent. 20 As a result, lending is rationed and the costs of lending are spread over a small number of loans. Current market development is mainly driven by Kazakh and Turkish banks since they have access to long-term funds. The IFC believes that Kazakh banks seek to invest their excess liquidity in Kyrgyzstan since the rates of return are higher than in Kazakhstan. These banks typically report higher returns on equity than their Kyrgyz competitors. In terms of net profit, Ineximbank, Demir Kyrgyz International Bank and Asia Universal Bank are reported as the most profitable banks. 21 These banks are also better capitalized than Kyrgyz banks. A further consolidation is currently not expected. 22 Further stabilization and growth of the banking sector depends on the political development in the country and the government s determination to undertake reforms. Both the Banker s Alliance (which represents the banks interests) and International Business Council are pressing for further reforms. 23 Chart 2: development of interest rates in the Kyrgyz banking sector Interest rate on loans Interest rate on deposits Source: IMF; NBKR Interest rates on deposits fluctuate between 3 and 4 %. Banks also lend at other banks in order to manage liquidity risk. In these cases cost of funds can soar up to 10 %. See for example, Ineximbank, Annual Report 2004, page Data were delivered by Demir Kyrgyz International Bank which informed the team that banks inform themselves about key figures. These figures correspond to the figures collected by NBKR. 22 Rumors of a merger between Ineximbank and Energobank have been only reported once to the team, but were not echoed by other banks or international donors active in banking sector development. 23 The International Business Council (IBC) has among its members EBRD, Kyrgyz Investment Credit Bank and Demir Kyrgyz International Bank. In summer 2005, IBC mentioned in a paper several areas of necessary reforms in the banking sector such as establishment of deposit insurance scheme, improvement of the legislative framework etc. 24 Lending interest rates are weighted average interest rates on KGS denominated loans. Deposit rates reflect rates in KGS for about 6 months.

16 Kyrgyz Republic 16 Interest rates are likely to further decrease, albeit only slightly. The IMF noted that reductions depend on the government s intention to develop the securities market. In 2004, about USD 28 mln in government bonds and less than USD 600,000 in corporate bonds were issued. All of these bonds are short-term in nature with government bonds having the longest term of eighteen months.* The local World Bank representatives informed the team that banks consider KAFC s interest rates as a kind of benchmark due to their considerable farm lending activities. Thus, KAFC s interest rate could be viewed as a replacement for a lacking benchmark typically provided by government bonds. A.4 Mortgage lending Mortgage lending has increased sharply since 2002, reaching Som 540 million in outstanding loans at the end of Year-on-year growth in outstanding loan balances was: , 372 percent; , 230 percent; and, , 90 percent. At the end of 2005, mortgage loans accounted for 2.4 percent of bank assets and 7.0 percent of outstanding loans. 25 These figures give the upper limit to the development of mortgage lending for home purchase and improvements because the National Bank does not collect separate information on residential loans. But if one includes loans for other purposes secured by property, compared even to the countries of Eastern Europe, mortgage volume is very small. For example, the stock of mortgage loans is the equivalent of 0.4 percent of GDP in Kyrgyzstan, compared with 5 percent for the Czech Republic and Poland.* Two banks, Energobank and Halyk Bank, accounted for 43 percent of the market at the end of 2005, with the next two largest lenders, Kazkommerzbank and Kyrgyz Kredit Bank, accounting for another 27 percent. Sixteen of 19 commercial banks with full banking licenses are originating mortgages, and at least one of the remaining three is initiating mortgage lending. Generally, banks with some Kazakh ownership have been aggressive in the market, and they have built their lending programs on the experience acquired in their home market. Some non bank financial institutions are also originating mortgages for amounts significantly lower than those of commercial banks. One example is the Bai Tushum micro finance company, where home purchase mortgages in Bishkek average about $10,000 and home improvement loans about $5,000. A few of the country s 300+ credit unions have recently begun making mortgage loans. A.4.1 Mortgage products As shown in Table 4, interest rates are high and lending terms short. Average loan amounts are about $15,000 according to the IFC, although there appears to be considerable variation among banks. 26 Many lenders impose prepayment penalties, but these seem mostly to apply only to the first year or two of the loan term. Maximum payment-to-income ratios are hard to define because the presence of substantial income that goes underreported or unreported to avoid taxes. Trying to determine true borrower income is a major challenge to loan 25 Data provided by the National Bank of the Kyrgyz Republic. 26 One bank with whom the team met stated an average mortgage loan amount of $30,000 to $35,000.

17 Kyrgyz Republic 17 underwriting. Banks interviewed report using very high standards for the maximum share of monthly income for the mortgage payment as a percentage of net income (PTI), i.e., 50 percent and even higher. Loans are fixed rate, self-amortizing. Most banks require property insurance but life insurance is viewed as excessively expensive. It is common practice to charge a 1 percent origination fee. Under these conditions, a small share of Kyrgyz households is able to take a mortgage loan for home purchase. The affordability problem associated with the short loan term and high interest rates is worsened by the extremely high tax on property sales (5 percent).* 27 Table 4. Home Purchase Mortgage Product Examples at the End of 2005 Minimum Annual Annual Term Prepayment down interest rate interest rate (years) penalties? payment (%) ($) (Som) Energobank Yes Kyrgyz Credit No Halyk Bank KYG Yes Demir Kyrgyz Int l Bank N/A 3 Yes IneximBank No Bai Tushum a 40 N/A 24 5 Yes a. Micro finance company Source: IFC report with authors additions. All banks and the NBFI interviewed stated that they made home improvement loans as well and in all cases these are also secured by a mortgage on the property. Lending terms vary. At some banks the loan term (up to 5 years) and interest rates are the same as for home purchase loans. But at others the loan term is a short as one year, and both interest rates and loan origination fees are higher. 28 Several banks stated that they were making loans for the construction of multifamily housing projects. 29 Later stages are secured by the building itself. Lenders interviewed had experienced few problems with such loans, but the experience is over a very limited time period. Moreover, the responses to the few questions the team was able to ask did not suggest a high degree of professionalism in underwriting these loans. A.4.2 Risks in mortgage lending The two larger risks associated with mortgage lending are credit and interest rate risk. Liquidity risk is also a problem with long-term loans reducing the ability of 27 The high charges create strong incentives for collusion between the buyer and seller to understate the sales price. 28 For example, at one lender the terms for a home purchase mortgage are a 5 year loan term, with a 20 percent interest rate and a 1 percent origination fee; for a home improvement loan the term is 1 year, the interest rate 27 percent and there is a 3 percent origination fee. 29 Until an amendment in 2006 to the Law on Registration the law did not permit pledge of a construction project until it had reached a certain stage of completion. So loans for early stages of construction were secured by the building site and other collateral.

18 Kyrgyz Republic 18 banks to generate cash quickly should it be needed. On the other hand, exchange rate risk associated with dollar denominated loans is manageable as 73 percent of deposits in commercial banks were in foreign currency at the end of A Credit risk. There are four significant sources of credit risk. At least at some lenders, underwriting practices and elements of loan servicing are not well-developed, with an absence of clearly defined procedures and staff training.* There are presently no publicly offered training courses for mortgage loan officers or on housing finance topics in general. 31 The process for registering the mortgage is not only cumbersome but also entails risk because there is a several day period between the recordation of the sale, and probably the payment of the seller by the bank, and the recordation of the mortgage lien.* Worth noting is that amendments to the Law on Registration were passed in January 2006 that permit private persons to access full records on individual properties, something that was not previously possible. Actual registration fees are low. The foreclosure process contains a good deal of uncertainty in principle. This arises from the ability of the borrower-in-default to exercise the option of having the bank s claim adjudicated in court at any time, even when an out-of-court settlement is near completion. It is also possible for the borrower-in-default to drag out the court process for as long as two years. Finally, proceeds obtained by the bank from in-court settlements are subject to taxation which can be as high as 16 percent.* Clear eviction regulations and procedures are absent.* Property appraisals are done by bank staff who do not have specialized training in appraisal, putting lenders at risk of inflated value estimates. 32 Most banks interviewed cited few problems in practice with registration and foreclosure. They are, however, pressing for amendments to the Law on Mortgage that would make the process more certain and efficient. 33 Moreover, the EBRD representative and some bankers indicated that they saw the foreclosure process as quite uncertain with respect to timeliness. 30 Data from the NBKR web site. 97 percent of new deposits were in foreign currency, reflecting the political uncertainty in the country. 31 A Bank Training Center has recently been founded that is associated with the National Bank. The team was unable to meet with the director. 32 This is according to the Association of Kyrgyz Appraisers. It is worth noting that thanks to a donor-financed technical assistance program, the Association offers a range of course on appraising various types of property using international standard methods. The Association certifies qualified members; certificates are signed as well by four government agencies. There are no licenses. The Association reported that generally bank staff are not interested in this type of training. It appears that prior donor SME finance programs, for example, have not required banks to use certified appraisers. 33 In late February when the team was in Bishkek amendments to the Law on Mortgage were being considered by the parliament that would strengthen banks position in the process.

19 Kyrgyz Republic 19 Other tools absent for managing credit risk include title insurance and affordable life insurance. In contrast, a credit bureau (Credit Information Bureau Trust) was established two years ago as a for-profit entity. It provides reports on juridical and physical persons. Presently about seven banks contribute data and get credit reports. Others complain of the high fees associated with membership and individual credit reports. A Interest rate risk. Banks are often making 5-7 year loans funded by shortterm deposits. As long as mortgages and other long-term loans accounted for only a few percentage points of a bank s assets, the risk is clearly manageable. But if mortgages begin to account for a greater share of assets, they will represent a significant risk in the event that the cost of liabilities rises significantly. Banks have no way to hedge this risk. A.4.3 Summary Mortgage lending is currently subject to significant risks and inefficiencies. Importantly, major inefficiencies and certain sources of credit risk are caused by government policies and therefore could be eliminated with legislation changes. Banks have found ways of operating that work around these problems but do not really manage them. It is unclear whether loan pricing realistically accounts for the various risks. The IFC report cites major deficiencies in risk management generally. The risks stemming from poor underwriting and loan servicing practices can be addressed by a good training program for loan officers that is available to all banks combined with development of good procedures manuals at the bank level. The training course could be sponsored by the Association of Banks and offered by a local training institute. B. Government Policies and Programs Current and Planned B.1 Deterioration of the multi-family housing stock The national government has no programs to address this problem operating at this time and, as described below, its thrust in the near term is on the development of new housing that will be affordable to lower income households. B.2 Marginal housing rings Experience in developing countries has fully demonstrated the complexity of defining and implementing a successful approach to upgrading squatter areas or marginal housing rings. A few countries have succeeded in organizing initial land occupancy by the invaders so that it is orderly, thereby greatly facilitating the eventual provision of basic infrastructure. 34 The orderly process in Kyrgzstan is notable in this regard. 34 For a good discussion of the components of a comprehensive upgrading program, see L. Antolihao and B. van Horen, Building Institutional Capacity for the Upgrading of

20 Kyrgyz Republic 20 As noted, in Bishkek the term invasion is something of a misnomer. The current reality is that households wanting a land plot in a new area apply to government of the municipal raion where the land sought is located. This procedure was created in 1989 to accommodate those wanting to move to Bishkek. Qualifying for a plot is demanding. Among the requirements in principle is that the household resident in Bishkek demonstrate that it has had at least one employed member for three years, someone is currently employed, and the household does not own a dwelling in the city. The raions have prepared the layouts of the novostroika areas and allocated the plots to those on the approved waiting list. Land rights come with the allocation, which the household can then register quite inexpensively. The land allocated by the raions has all been publicly owned. Land, mostly from collective farms, has been transferred to the municipality by a series of Government Resolutions. No private land has been taken. When households have claimed private plots, municipal officials have required them to give up the land. In 2006 the Government decided that it would not allocate additional land to the municipality and that further novostroika around Bishkek would be in the Chui Oblast. The municipality has the responsibility for providing infrastructure services, including roads, water, electricity, schools, and poly-clinics. Since 1996 funds for this purpose have been transferred from the Republic budget. In 2005, the agency responsible (OGUKS) had a budget of Som 162 million of which Som 104 million came from the Republican budget. 35 In oldest novostroika areas roads have been paved, electricity provided, schools built, and water pipes laid, although water-borne sanitation is not present. But the municipality is constrained by low budget resources and areas already 5-6 years old have only electricity installed. Transportation everywhere is provided by private vans that operate on municipally approved routes. In short, the municipality has the responsibility for providing these services but is able to finance a small part of the needed investment. The national government does not acknowledge any responsibility for improving the housing in the novostroika. An official at the Ministry of Economics and Finance stated simply that upgrading the housing in these areas was not a task of government. Barangay Commonwealth in Metro Manila, Housing Studies, vol. 20, no.6, 2005, pp Indonesia is an example of a country where informal land development has been regularized. See Chapter 4 in R. Struyk, M. Hoffman, and H. Katsura, The Market for Shelter in Indonesia Cities (Washington, DC: Urban Institute Press, 1990). 35 OKUGS has a program to service all areas by 2010 but the director says that funding is totally inadequate for this schedule.

21 Kyrgyz Republic 21 B.3 Insufficient affordable newly constructed dwellings Shortage of mortgage finance At present there is one operating government program addressing these issues. 36 This program is targeted at persons whose housing has been destroyed or severely damaged by natural disasters. In 2005, the State budget contained Som 127 million for this purpose. The program provides interest free, 15-year loans, with a three year grace period, of up to Som 200,000 to these families for dwelling construction, purchase, or rehabilitation. The program is administered directly by a government agency, the Fund for Housing Loan Development. Going forward this is the area where the Government s program is focused. The MOEF has developed three new programs that tackle the related areas of housing construction and mortgage finance, the funding for which Som 200 million, as reported by the ministry--was included in the 2006 budget. The following provides an overview of the three programs. 37 Note that at the time of the team s visit the specific definitions of the programs were evolving rapidly so that the description below may be quickly out of date. All programs are directed at households in the lower half of the income distribution. B.3.1 Housing for young teachers and doctors in rural areas The program is aimed at retaining these skilled professionals in rural areas for longer periods through a 3-year accumulation scheme that leads to dwelling purchase. There is no income testing, but the salaries paid are very low the expected monthly salary in 2009 is Som 1,733. One thousand persons are to be assisted annually. Under the program, a savings account is opened in a commercial bank in the participant s name and the State contributes the equivalent of $100 per month for 36 months, i.e., $3,600 total. A 10 percent annual interest rate on deposits is assumed. At the end of the accumulation period, the funds are used as a downpayment for a dwelling. The participant receives a mortgage loan for the balance of the purchase price as needed; an 18 percent interest rate is assumed. A bank will be selected on a competitive basis to administer the program. B.3.2 Creation of a contract savings scheme for housing Under this program a government-owned organization will be created to operate a contract savings scheme of the closed type, i.e., following the Bausparkasse model. This agency, the State Housing and Savings Company (SHSC), may eventually be privatized. 36 Existing legislation calls for the construction of over 4 million sq. m. of housing at government expense by But the Ministry of Economy and Finance reports that there are no funds for it and that the whole program is unrealistic. There have been special cases where government-sponsored construction has been executed or at least initiated. One example is three buildings started in Bishkek initially with municipal financing and later national government financing that remain uncompleted. 37 The description is based on the information contained in the memorandum from the Acting State Secretary of the Ministry of Economy and Finance, A. Dikambaev, to the World Bank, IMF, ADB, and EBRD representatives of February 13, 2006, no /1168.