S&P Affirmed Ratings of Republic of Kazakhstan; Outlook Negative

December 5. KASE

S&P Affirmed Ratings of Republic of Kazakhstan; Outlook NegativeOn Dec. 5, 2014, Standard & Poor’s Ratings Services affirmed its ‘BBB+’ long-term and ‘A-2’ short-term foreign and local currency sovereign credit ratings on the Republic of Kazakhstan. The outlook remains negative.

At the same time, we affirmed our long-term national scale rating on Kazakhstan at ‘kzAAA’.

RATIONALE

We continue to view Kazakhstan’s resource endowment, which has driven fiscal and external surpluses and led to a build-up in fiscal and external assets in recent years, as a ratings strength. However, the resource endowment means that the economy is dependent on the oil sector, which directly accounts for more  than 13% of GDP, over 50% of fiscal revenue, and 60% of exports. We do not expect that Kazakhstan’s per capita GDP growth will regain its previous pace over our forecast horizon. We believe that lower growth, falling oil prices, lower-than-expected oil production, and a more challenging external environment will lead to a deterioration in Kazakhstan’s external and fiscal positions in the next three years.

Oil production is expected to remain relatively flat in the next few years, increasing slightly to 83 million tons in 2016 from 81.8 million tons in 2014, with a further modest boost in 2017 from the expansion of existing fields. We do not take into account any significant production gain from the offshore Kashagan oil field, which is not expected to resume output until 2017 at the earliest. Once it comes on line, the capacity of the first phase of production should eventually increase oil production by about 20%. However, there remains a great deal of  uncertainty about the field’s output resumption since production was suspended  in late 2013 due to a gas leak and the field’s network of pipelines needing replacement. Our latest oil price assumptions are for Brent crude oil to be $80/barrel in 2015 and $85/barrel in 2016-2017 (see “Standard & Poor’s Revises  Its Crude Oil Assumptions; Natural Gas Assumptions Are Unchanged,” Dec. 3,  2014).

After increasing by 6% in 2013, Kazakhstan’s real GDP growth slowed to an estimated 4% in 2014 due to lower oil and mining sector production, less-favorable terms of trade, and depressed consumer demand following the 19% devaluation of the tenge (KZT) in February. Consumption had been the key driver of GDP growth over 2012-2013, but we expect net exports will contribute more materially following the devaluation. In addition, we expect growth over the  next two to three years to stem primarily from investment, supported by a countercyclical fiscal policy in the form of a government stimulus plan totalling  6.5% of GDP, which will tap into the country’s oil savings. We also expect foreign direct investment inflows related to long-term contracted oil and gas projects to remain stable. However, growth could come under further pressure if the government’s stimulus plan is not fully implemented or is not as effective as expected.

We expect that the government will continue to report fiscal surpluses on a consolidated basis, though at an average of only 2% of GDP (compared with a 5% average over 2011-2013) given lower expected oil revenue. The government’s planned countercyclical fiscal policy and usage of oil fund savings come from a strong financial position. Since the financial crisis, which was the last time the government spent significant oil fund assets to support the economy, the government has saved on average half of its net annual oil proceeds in the National Fund for the Republic of Kazakhstan (NFRK), which totaled $76.8 billion (35% of GDP) as of the end of October. In 2014, the president announced two stimulus programs:

– $5.5 billion to be spent over 2014-2015 supporting the banking system, midmarket businesses, and infrastructure investment and

– $9 billion for infrastructure development, spread evenly over 2015-2017.

The stimulus spending comes on top of the $9.2 billion guaranteed transfer from the NFRK to the budget each year (the maximum budget transfer is set by law at $8 billion, plus or minus 15%). We expect the government to remain in a net asset position in the next few years, with general government assets decreasing to 35% of GDP in 2017 from an estimated 40% of GDP in 2014 under its current spending plans.

Kazakhstan’s external position was supported in 2014 by the currency devaluation and a better trade balance, but we forecast it to weaken in 2015. Due to the improved trade balance, combined with sovereign and quasi-sovereign debt issuance this year, reserves reached $27.4 billion (13% of GDP). Kazakhstan’s liquid external assets will continue to exceed external debt, but we expect gross external financing needs to remain above current account receipts  plus usable reserves through 2017. Our projections for a broader measure of Kazakhstan’s position vis-a-vis the rest of the world show net external liabilities  rising to 59% of current account receipts in 2017 from 24% in 2013. Lower exports due to lower oil prices will hurt the trade balance in the near term, while  we expect investment-related imports (70% of imports) to remain stable under  public and private investment plans. The deterioration in the trade balance will be offset somewhat by lower income account deficits; we expect that lower oil prices will mean lower profitability of inward foreign direct investment (FDI). The modest  current account surpluses will be partly financed by a stronger financial account, supported by stable FDI averaging 4% of GDP (the delays at Kashagan are  supporting new investments) and the sale of oil fund external assets to support  the government stimulus program.

We expect policymaking in Kazakhstan to remain highly centralized, which we believe will continue to limit institutional effectiveness and governance. Institutional risks remain high given the lack of transparency and clarity concerning the eventual presidential succession process and the corresponding policy implications, which in our view indicates that future policy choices may be  difficult to predict. To offset external shocks and a difficult regional environment, the government this year is aiming to speed up the reform process to boost foreign and private investment. There have been several new legislative actions  in recent months aimed at improving the business environment. However, we expect limited progress in diversifying the economy, especially as the non-oil economy will be under pressure due to lower domestic demand and given  expectations of medium-term oil sector expansion. Achieving sustainable and  inclusive non-oil growth in the near term will be challenging.

The currency devaluation earlier this year, followed by rising dollarization and a temporary deposit run on three banks, influenced our view of the credibility of Kazkahstan’s monetary policy. We anticipate that management of the exchange rate (despite the recent widening of the KZT-to-USD band to 170-188), the temporary withdrawal of pension funds from the money market, and limited central bank instruments to manage liquidity will lead to tight liquidity conditions this year. The government has developed an investment strategy for the unified pension fund, and the central bank has introduced foreign-exchange swap operations and plans to adopt inflation targeting in the medium term. That said, the effect of a unified pension fund on the domestic bond market and the central bank’s ability to support the economy, given its commitment to the exchange rate band, remain uncertain. The banking system remains burdened by high nonperforming loans, but we believe that authorities will deal more aggressively with these legacy bad loans through a distressed asset fund and tax breaks for loan write-offs.

OUTLOOK

The negative outlook reflects our view that lower-than-expected growth or weaker-than-expected terms of trade could lead to a sustained deterioration in the external or fiscal positions of the country beyond our current projections. The  ratings could come under pressure if expectations of medium-term oil sector development are further delayed. We could also lower the ratings if the limitations on monetary policy effectiveness–as well as the tight exchange rate management–were to result in the central bank being required to intervene heavily in the foreign exchange market as confidence in the financial system wanes.

We could consider revising the outlook to stable if Kazkahstan’s policymaking became more transparent and predictable and if its political institutional framework strengthened. We would also view an enhanced structural reform and diversification agenda, as well as efforts to increase monetary policy flexibility, as  positive for the ratings.

Other depository corporations (dc) are financial corporations (other than the central bank) whose liabilities are included in the national definition of broad money. Gross external financing needs are defined as current account payments plus short-term external debt at the end of the prior year plus nonresident deposits at the end of the prior year plus long-term external debt maturing within  the year. Narrow net external debt is defined as the stock of foreign-and local- currency public- and private-sector borrowings from nonresidents minus official reserves minus public-sector liquid assets held by nonresidents minus financial- sector loans to, deposits with, or investments in nonresident entities. A negative number indicates net external lending. CARs–Current account receipts. The data  and ratios above result from Standard & Poor’s own calculations, drawing on national as well as international sources, reflecting Standard & Poor’s independent view on the timeliness, coverage, accuracy, credibility, and usability  of available information.

Standard & Poor’s analysis of sovereign creditworthiness rests on its assessment and scoring of five key rating factors: (i) institutional and governance effectiveness; (ii) economic structure and growth prospects; (iii) external liquidity  and international investment position; (iv) the average of government debt  burden and fiscal flexibility and fiscal performance; and (v) monetary flexibility. Each of the factors is assessed on a continuum spanning from 1 (strongest) to 6 (weakest). Section V.B of Standard & Poor’s “Sovereign Government Rating Methodology And Assumptions,” published on June 24, 2013, summarizes how the various factors are combined to derive the sovereign foreign currency rating, while section V.C details how the scores are derived. The ratings score snapshot  summarizes whether we consider that the individual rating factors listed in our methodology constitute a strength or a weakness to the sovereign credit profile, or whether we consider them to be neutral. The concepts of “strength”, “neutral”, or “weakness” are absolute, rather than in relation to sovereigns in a given rating category. Therefore, highly rated sovereigns will typically display more strengths, and lower rated sovereigns more weaknesses. In accordance with Standard &  Poor’s sovereign ratings methodology, a change in assessment of the  aforementioned factors does not in all cases lead to a change in the rating, nor is  a change in the rating necessarily predicated on changes in one or more of the  assessments.

RATINGS LIST

Ratings Affirmed                                               Kazakhstan (Republic of)

Sovereign Credit Rating                                    BBB+/Negative/A-2

Kazakhstan National Scale                                kzAAA/–/–

Transfer & Convertibility Assessment              BBB+

Senior Unsecured                                               BBB+

Short-Term Debt                                                A-2

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