S&P: Kazakhstan Ratings Affirmed At ‘BBB-/A-3’; Outlook Remains Negative

Kazakhstan – Big Potential And NPLs

Standard & Poor’s Global Ratings affirmed its ‘BBB-/A-3’ long- and short-term foreign and local currency sovereign credit ratings of Kazakhstan, reports KazWorld.info with reference to the official website of ratings agency.

  • The weak asset quality of Kazakhstan’s banking system remains a drag on economic and fiscal performance. Nevertheless, the government’s fiscal position remains supported by its strong balance sheet, underpinned by sizable government liquid assets of about 30% of GDP.
  • We are therefore affirming our long- and short-term ratings on Kazakhstan at ‘BBB-/A-3’.
  • The negative outlook primarily reflects the risk that Kazakhstan’s fiscal and external profiles may weaken from their still relatively strong levels and that growth may fall short of expectations.

RATING ACTION

On March 10, 2017, S&P Global Ratings affirmed its ‘BBB-/A-3’ long- and
short-term foreign and local currency sovereign credit ratings on the Republic
of Kazakhstan. We also affirmed the Kazakhstan national scale ratings at
‘kzAA’. The outlook on the long-term ratings is negative.

RATIONALE

Our ratings on Kazakhstan remain primarily supported by the government’s
strong balance sheet, built on past budgetary surpluses accumulated during the
era of high commodity prices. The ratings remain constrained by our view that
future policy responses may be difficult to predict due to the highly
centralized political environment; the country’s moderate level of economic
wealth; and limited monetary policy flexibility.

The government revised its 2017 budget in February, largely in order to
accommodate a sharp increase in spending in relation to a recapitalization of
the distressed asset fund (amounting to 4% of GDP) to allow the fund to
purchase nonperforming loans (NPLs) from the domestic banking system. We
understand that, in practical terms, there has been limited improvement in the
level of NPLs in the banking system. The central bank (the National Bank of
Kazakhstan; NBK) reported a fall in NPLs (by its definition of loans overdue
by principal for more than 90 days) to 6.7% of the loan portfolio as of Jan.
1, 2017, from 8% at the same time in 2016, but we understand that the
improvement is largely due to write-offs or the sale of NPLs to
special-purpose vehicles (SPVs) that are not consolidated under local
standards. This is partly in response to a regulatory requirement to decrease
NPL levels below 10% by end-2017. We currently classify Kazakhstan in group
‘8’ under our Banking Industry Country Risk Assessment, on a 1-10 scale with
’10’ being the weakest score (see “Banking Industry Country Risk Assessment:
Kazakhstan,” published Sept. 26, 2016, on RatingsDirect).

Adjusting for the off-balance-sheet loans, restructured loans, and the 2015
loan from Kazkommertsbank to JSC BTA Bank, we believe NPLs could be more than
4x higher than officially reported. The NBK will conduct a stress test and
asset quality review of the banks in 2017. In our view, weak banking system
asset quality could remain a drag on Kazakhstan’s economic performance over
the medium term. A transparent assessment of banking system weaknesses and a
comprehensive program to mitigate them would provide a baseline to transform
the banks into a true engine of growth in Kazakhstan, in our view. The process
of strengthening the banks and stabilizing the system could cause additional
costs for government, and could weaken the country’s fiscal position,
depending on the size of government support required.

Government debt service increased to 6% of general government revenues in
2016, from 5% a year before. This was partly due to the depreciation of the
Kazakhstani tenge, as 52% of government debt stock is in foreign currency. The
uptick in the debt service ratio was exacerbated by the depreciation-induced
rise in annual inflation to 14.6% as the government’s stock of
inflation-indexed debt is around 16% of the total (see table 4 in “Sovereign
Debt 2017: Global Borrowing To Drop By 4% To US$6.8 Trillion,” published on
Feb. 23, 2017, on RatingsDirect). With some of those one-off effects fading,
we expect government interest costs to moderate to 4.8% of revenues on average
over 2017-2020, alongside average inflation of 6% over the period. However,
should the debt service ratio not decline, we could review downward our strong
assessment of the structure of the government’s debt.

Oil is the key sector in Kazakhstan. It directly accounts for about 15% of
GDP, over half of exports, and 35% of general government revenues. However,
although supportive of the economy when prices are high, we view these oil
revenues as exposing Kazakhstan to significant volatility in terms of trade
and the government to a volatile revenue base.

We project that the economy will return to moderate growth rates from 2017,
with output expansion averaging 2.5% over 2017-2020. This will be supported by
stronger investments, recovering private consumption, and stronger export
performance as the oil price outlook marginally improves (see “S&P Global
Ratings Raises Its Oil And Natural Gas Prices Assumptions For 2017,” published
Dec. 16, 2016 on RatingsDirect) alongside our expectation of accelerated
production at the large Kashagan oil field. We estimate that trend growth in
real per capita GDP (which we proxy by using 10-year weighted-average growth)
will amount to about 1% during 2011-2020, at the lower end of the range for
peers that display similar levels of development.

At present, we continue to view the government’s strong balance sheet as a key
factor supporting our ratings. We forecast that general government liquid
assets will amount to a sizable 42% of GDP at the end of 2017. Government
assets consist mostly of the National Oil Fund of the Republic of Kazakhstan
(NFRK), which predominantly invests abroad, and deposits at the central bank.
We have excluded NFRK’s tenge financing of Kazakh state-owned enterprises
(SOEs) from our calculation of liquid assets because these loans and bond
purchases are generally characterized by concessional rates, very long
maturities, and uncertain repayment prospects. As such, we consider those
assets illiquid and probably unavailable to mitigate potential financial
stress. Given relatively low debt of about 20% of GDP, the government
therefore remains in a net creditor position, also of about 20% of GDP in
2017.

Our calculation of the general government balance covers the central
government, local governments, and NFRK. We explicitly include the government
off-budget economic support programs, channeled through SOEs and financed by
the NFRK, in our calculation of general government expenditures. In contrast
to the authorities, we exclude the revaluation effect of NFRK’s foreign
currency assets expressed in tenge in our general government revenue
calculations. Revaluation effects had a large positive impact on official
budgetary statistics following the deep depreciation of the tenge in 2015. We
estimate that, under our approach, the general government deficit improved to
4% of GDP in 2016 from closer to 9% in 2015. We expect the deficit to remain
close to 4% in 2017, which takes into account the 4% of GDP the government
intends to spend to recapitalize the distressed assets fund.

We estimate government budget capital expenditures (capex) at about 15% of
total expenditures. Adding the expenditures of the oil fund, we estimate that
capex-like expenditures amount to about 25% of general government
expenditures. We believe that such a high share of capex affords Kazakhstan
fiscal flexibility should a steep fiscal tightening become necessary.

In our view, Kazakhstan’s strong narrow net external debt position and modest
gross external financing needs support the ratings. However, we continue to
see balance of payments risks from Kazakhstan’s sizable stock of inward
foreign direct investment (FDI) of a debt-like nature. The amount outstanding
was about $83 billion in 2016 (58% of the total stock of inbound FDI), which
is close to 60% of GDP or 174% of current account receipts. We understand that
debt-type FDI is principally concentrated in the oil and mining sectors. While
FDI tends to be much stickier than portfolio flows, they still constitute a
foreign liability of the economy and could exert balance of payments pressures
in case of accelerated repatriation of profits and equity.

The quality of the NBK’s international reserves are diminished, in our view,
as about 20% are constituted by an offsetting liability in the form of foreign
currency bank deposits (correspondent accounts) at NBK, albeit down from
closer to 30% in 2015. In addition, international reserves are further
encumbered as NBK is engaged in currency swaps with domestic banks of about $3
billion (10% of usable reserves) to support the banks’ local currency
liquidity, effectively shifting these external assets from the banks to NBK.
However, we expect most of these swaps to mature in 2017.

Our ratings on Kazakhstan are constrained by the limited flexibility of its
monetary policy. In August 2015, the central bank announced a switch to a
floating exchange rate and inflation targeting. The subsequent exchange rate
adjustment has eased the accumulated external pressure. That said, we believe
that the implementation of effective inflation targeting will take time and
challenges to monetary policy credibility remain, including excess tenge
liquidity in the context of muted bank lending growth and the short tenor of
the tenge yield curve. However, we note that inflation has fallen from double
digit rates in 2016 to the upper end of the NBK’s 6%-8% target band in 2017
(annual inflation was 7.9% in January and 7.8% in February 2017). We believe
NBK could also be subject to political influence, as exemplified by some
activities in which it has participated in recent years that in our view fall
outside the remit of a central bank. These have included becoming a
shareholder of the National Company KazMunayGas and compensating
tenge-denominated deposits after last year’s currency depreciation.

We also view the high level of resident deposit dollarization in the economy
as limiting Kazakhstan’s monetary flexibility by weakening the transmission
mechanism of monetary policy. The share of foreign currency deposits to total
deposits remains high despite a recent fall to 55% from a peak of about 70% at
the end of 2015. This level of dollarization is one of the highest among the
130 sovereigns currently rated by S&P Global Ratings (see our quarterly
“Sovereign Risk Indicators,” last published on Dec. 14, 2016. A free
interactive version is available at spratings.com/sri).

Our ratings on Kazakhstan also remain constrained as, in our view, decision
making remains highly centralized, which can reduce policymaking
predictability. There have been no transfers of power since Nursultan
Nazarbayev became president following Kazakhstan’s independence in 1991.

The president has stated that he expects to serve his full term to 2020.
Considerable uncertainties surround the eventual presidential succession. The
flipside of the concentration of power is that Kazakhstan has benefited from
one of the most stable political environments in the region since the break-up
of the Soviet Union.

In early March 2017, Kazakhstan’s parliament passed constitutional changes,
announced by President Nazarbayev, to increase the role of the cabinet and
parliament at the expense of the president. We view these as an effort to
prepare institutions for the eventual transition from President Nazarbayev,
but we do not expect the constitutional changes to have any practical impact
until that time.

OUTLOOK

The negative outlook reflects our view of risks to Kazakhstan’s fiscal profile
over the next 12 months. We could lower our long-term ratings if Kazakhstan’s
fiscal, external, or economic performances do not improve in line with our
baseline expectations. For example, the sovereign rating would come under
pressure if the government’s net asset position were to deteriorate beyond our
current expectations and government debt service costs were to surpass 5% of
government revenues for a sustained period.

We could also lower the ratings if Kazakhstan’s trend growth rate per capita
were to fall below 1%, a floor level we consider common for economies at
similar levels of development.

We could revise the outlook to stable if balance of payments pressures remain
contained and monetary policy flexibility improved. The latter could occur if
resident deposit dollarization reduced substantially, improving the ability of
the central bank to influence domestic economic conditions.

Additional information is available on www.standardandpoors.com

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