S&P Global Ratings downgrades Foreign Currency LT credit rating of Development Bank of Kazakhstan to “BB+”; outlook negative

KazMunayGas Rating Lowered To 'BB-' On Weakening State Support

On June 30, 2017, S&P Global Ratings lowered its long- and short-term foreign
and local currency issuer credit ratings on Development Bank of Kazakhstan
(DBK) to ‘BB+/B’ from ‘BBB-/A-3’. At the same time, we lowered the Kazakhstan
national scale rating to ‘kzAA-‘ from ‘kzAA’. The outlook is negative.

The downgrade primarily reflects our view of the gradual decline in the
Kazakhstani government’s willingness to provide resources for timely debt
service to the government-related entity (GRE) sector in case of need. This is
evidenced by the authorities’ comparatively limited involvement in ensuring a
timely payment on the obligations of several GREs in Kazakhstan over the past
18 months.

Nevertheless, we still believe that the Baiterek group remains an essential
government tool, and the likelihood of the group receiving extraordinary
support from the government remains almost certain. DBK remains a core
institution within the Baiterek group. Correspondingly, the ratings on DBK
incorporate several notches of support, being higher than what its intrinsic,
stand-alone creditworthiness would warrant. We assess at ‘b’ DBK’s
creditworthiness on an autonomous basis, that is, without factoring in the
potential for extraordinary government support.

Under our approach, by extraordinary support we typically mean support to
ensure the full and timely servicing of an organization’s debt in a stress
scenario. Government transfers that sustain or expand the activities of an
institution, such as government programs aimed at development of specific
projects or supporting certain economic sectors, form part of our assessment
of ongoing support. The latter is incorporated into our analysis of
stand-alone creditworthiness.

Over the past 18 months, there have been several instances whereby timely
extraordinary government support was weaker than we would have expected. The
cases involved two 100% government-owned GREs: the railway company Kazakhstan
Temir Zholy (KTZ) and the energy company Samruk-Energy, both of which are key
subsidiaries of the Samruk-Kazyna holding company.

We have observed that in the case of KTZ, the administrative procedures for
receiving extraordinary support were complex and time consuming. Last year KTZ
still did not have financing secured for its $350 million notes three weeks
before the maturity on May 11, 2016 (see “Research Update: Railway Operator
Kazakhstan Temir Zholy And Subsidiary Kaztemirtrans ‘BB’ Ratings On
CreditWatch Negative,” published April 20, 2016). Later, the government did
not intervene in a timely manner to prevent late payment of more than five
business days by Vostokmashzavod, a relatively small subsidiary of KTZ, on its
payments to Halyk Bank on its loan of $31.9 million, which is partially
guaranteed by KTZ. The event came close to triggering the cross-default
clauses on KTZ’s bonds. We subsequently lowered our ratings on KTZ in October
2016 (“Research Update: Railway Operator Kazakhstan Temir Zholy Downgraded To
‘BB-‘ On Weaker Assessment Of Government Support; Outlook Negative,” Oct. 19,

Currently, Samruk-Energy, another portfolio company of Samruk-Kazyna, is
facing the upcoming maturity of $500 million in Eurobonds in December 2017. We
understand that within about half a year before the repayment, the available
cash and equivalents and committed lines covered only about one-half of the
annual liquidity needed for 2017. We have therefore lowered our ratings on
Samruk-Energy by a cumulative two notches over the last six months and they
currently remain on CreditWatch negative (“Research Update: Kazakh Electricity
Group Samruk-Energy Cut To ‘B+’ And ‘kzBBB-‘ On Increasing Refinancing Risk;
Still On CreditWatch Neg,” April 12, 2017).

In our opinion, these precedents indicate declining willingness of the
government to provide extraordinary support to the GRE sector. Against this
background, we also note that, in general, the government provides no explicit
guarantees on the liabilities of the GRE sector.

Although we continue to assess the likelihood of extraordinary government
support to the consolidated Baiterek group as almost certain, we no longer
equalize the group credit profile (GCP)–which reflects the creditworthiness
of the consolidated operations group, taking into account extraordinary
government support–with the ‘BBB-‘ sovereign credit ratings on Kazakhstan.
Our assessment of the GCP is now one notch lower, at ‘bb+’, which balances the
aforementioned negative trends against the still sizable risks for the
government emanating from not bailing out the entities within Baiterek Group
if they were under stress.

We view DBK as playing a core role within the Baiterek group. It accounted for
close to 60% of the group’s consolidated assets as of end-2016. DBK’s general
mandate to contribute to the development of Kazakhstan’s economy through
investments in priority sectors closely aligns with the overall Baiterek group
strategy. We also consider it highly unlikely that DBK would be sold. As we
now assess the Baiterek group’s credit profile at ‘bb+’ and, owing to DBK’s
core status within the Baiterek group, our ratings on DBK are four notches
higher than its ‘b’ stand-alone credit profile (SACP).

Our ‘BB+’ long-term ratings on DBK factor in the negative trends in government
support in Kazakhstan, but we still expect the institution to benefit from a
considerable degree of government backing. Specifically, we assess the
likelihood of extraordinary government support as almost certain based on:

DBK’s integral link with the government of Kazakhstan, which fully owns
and monitors DBK through National Management Holding Baiterek. DBK was
established in 2001 by a Presidential Decree, and it has special public
status as a national development institution under the Law On Development
Bank of Kazakhstan. For instance, DBK is not required to have a banking
license or to comply with prudential regulations applicable to commercial
banks. The government has injected additional capital into DBK in the past
via Baiterek Holding. For instance, the share capital was increased by
Kazakhstani tenge (KZT) 40 billion in 2015 and by a further KZT20 billion
in 2016.

DBK’s critical role as the primary institution mandated to develop
Kazakhstan’s production infrastructure and the processing industry. It
generally provides long-term funding to large and capital-intensive
investment projects that have strategic significance for the government of
Kazakhstan for economic or social reasons. DBK plays a key role in
implementing several government programs including the five-year State
Program of Industrial and Innovative Development (SPIID) 2015-2019 and the
Nurly-Zhol State Program for Infrastructure Development.

In March 2017, Baiterek Holding amended its development strategy through 2023.
We understand that DBK aims to follow in the third quarter of 2017. According
to management, the amended strategy will include an increasing focus on
attracting nongovernment funds, as well as a closer focus on financing the
non-commodity-related sectors of Kazakhstan’s economy. We also understand that
the rules governing DBK’s financials have been amended, with the bank now
allowed to achieve a higher maximum leverage of 7 to 1 instead of 6 to 1

DBK’s stand-alone credit profile (SACP) remains ‘b’, reflecting the anchor of
‘bb-‘ for a financial institution operating in Kazakhstan, as well as its
adequate business position, adequate capital and earnings, moderate risk
position, below average funding, and adequate liquidity.

Our assessment of DBK’s business position balances its public-policy role as a
specialized development institution financing infrastructure and industrial
projects in the private and public sectors, against the government-directed
nature of its lending, which impedes its business stability. DBK is Baiterek’s
largest subsidiary and accounted for 60% of Baiterek’s consolidated assets at
year-end 2016. That said, DBK had assets of KZT2.3 trillion ($7 billion) as of
March 31, 2017, making it somewhat smaller than the largest two commercial
banks–Kazkommertsbank JSC (KKB) and Halyk Savings Bank of Kazakhstan (Halyk),
both of which have assets of about KZT4.7 trillion, but comparable in size to
the third largest bank, Tsesnabank.

Our assessment of DBK’s capital and earnings reflects our view of the bank’s
adequate capitalization and moderate loan growth plans. We forecast that our
risk-adjusted capital (RAC) ratio will reduce to about 9.5%-10.0% by year-end
2018 from 10.3% as of year-end 2016. During 2016, the bank received an
unexpected KZT20 billion capital increase from the government, which was not
included in our original forecast. DBK does not have to comply with minimum
regulatory capital requirements; however, its regulatory Tier 1 and total
capital adequacy ratios were 16.3% and 19.7% as of March 31, 2017 with a
leverage ratio of 5.2x.

As a state development bank, DBK’s business strategy is not primarily
profit-driven but is, rather, policy-role focused. Nevertheless, the bank
seeks to ensure that earnings are sufficient to cover its operating and
borrowing costs. DBK’s income has been volatile and core profitability low
over the past six years. Its ROA was 0.27% in 2016 and 2015.

Our assessment of DBK’s risk position mainly reflects weaker loss experience
than Kazakh commercial banks that have not been restructured during the past
financial crisis; a high share of loans in foreign currencies; and high
industry concentrations. The loan portfolio is concentrated in the
manufacturing and carbon & petrochemicals sectors. The share of top-20 loans
reduced to about 2.6x of total adjusted capital (TAC) as of March 31, 2017
from 3.4x a year earlier, which compares well with large Kazakh banks but is
high when compared globally.

DBK’s loss track record compares poorly with the nonrestructured commercial
Kazakh banks due to its mandate of government-directed lending, which has
invariably been advanced to weaker quality borrowers. Nonperforming loans
(NPLs), as a percentage of total loans, peaked at 41% at year-end 2012. In
2013-2015, however, DBK transferred all its NPLs to Investment Fund of
Kazakhstan, which is a sister company within the Baiterek group. New NPLs have
been significantly lower in 2016, at about 1% of loans and mainly relate to a
few small leasing projects and loans to Kazinvestbank, which is a small Kazakh
bank that defaulted in late December 2016. On the other hand, restructured
loans are fairly high, accounting for about 19.5% of total loans as of March
31, 2017, and reflect mainly loans in foreign currency that were converted
into tenge. We expect NPLs to increase over the next two years when DBK’s
loans season and the grace period on some loans ends. The maturity profile of
the loan portfolio is fairly long term with 76% of total loans having a
remaining maturity of more than five years.

In our opinion, DBK’s funding is below average reflecting a high refinancing
risk due to its concentrated wholesale funding profile. This is despite our
stable funding ratio being consistently above 100% over the past five years,
albeit on a clear declining trend. Since 2017, DBK’s aim is to increase the
share of nongovernment funding by replacing maturing government funding with
market sources.

Of loans from financial institutions, about 90% was accounted for by
Export-Import Bank of China and China Development Bank, to which DBK repaid
ahead of term $200 million in January 2017. Debt securities are comprised of
Eurobonds (67% of total as year-end 2016), tenge bonds (31%), and Islamic
bonds (2%). In 2016 DBK issued KZT212.5 billion of local bonds.

We assess liquidity as adequate, reflecting adequate holdings of liquid assets
and moderate wholesale debt repayments. Cash, cash equivalents, and placements
with banks accounted for 12% of total assets as of March 31, 2017. Investments
in available-for-sale securities accounted for an additional 12%.

The negative outlook on DBK mirrors our outlook on the sovereign ratings on
Kazakhstan. We would likely revise the outlook or change the ratings on DBK if
we took similar rating actions on Kazakhstan.

We could lower the ratings on DBK if we saw signs of waning government support
to the group or, more broadly, to other government-related entities over the
next 12 months. We could also lower the ratings if we perceived the role of
DBK for the government as reducing in contrast to the role of the overall