S&P downgrades KazAgro to ‘BB-‘ On Negative Trend In Government Support; Outlook Negative

S&P downgrades KazAgro to 'BB-' On Negative Trend In Government Support; Outlook Negative

On June 30, 2017, S&P Global Ratings lowered its long-term foreign and local
currency issuer credit ratings on Kazakhstan’s KazAgro National Management
Holding (KazAgro) to ‘BB-‘ from ‘BB+’. The outlook is negative. We affirmed
the short-term foreign and local currency issuer credit ratings at ‘B’.

At the same time, we lowered the Kazakhstan national scale rating to ‘kzBBB+’
from ‘kzAA-‘.

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 KazAgro group remains an essential
government tool, and the likelihood of the group receiving extraordinary
support from the government remains almost certain. The ratings on KazAgro
Holding incorporate several notches of support, being higher than what its
intrinsic, stand-alone creditworthiness would warrant. We now assess at ‘b-‘
the consolidated group’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,
2016).

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 cover 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 KazAgro group as almost certain, we no longer
equalize the group credit profile (GCP), which reflects the creditworthiness
of the consolidated 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 if it does not bail out the entities within the KazAgro group if
they are under stress.

The group and its parent company KazAgro Holding were established in 2007 by
presidential decree. The shares of seven 100% government-owned development
institutions operating in the agricultural sector were transferred to the
holding company shortly after its creation. The subsidiaries broadly focus on
implementing several government programs by providing lending and financial
support to the socially important agricultural sector (which employs close to
half of the population of Kazakhstan).

Our ‘bb+’ assessment of the consolidated group’s creditworthiness is based on
our view of the group’s:

Integral link with the government. The state owns 100% of the holding
company, which in turn fully owns its subsidiaries. The government has
injected capital to the group on several occasions in the past. For
instance, the government made a Kazakhstani tenge (KZT) 20 billion
(approximately US$60 million) equity injection into the holding company
following the tenge devaluation in February 2014. In 2015, the government
also decided to prolong the maturity of the loan granted to the holding
company from the National Oil Fund to 2041 from 2023. The latter allowed
the holding company to recognize approximately KZT60 billion as additional
equity. More recently, at the end of 2016, the holding company’s capital
was increased by about KZT77 billion, which will be primarily deployed to
support the agricultural sector via the subsidiary Kazakh Agrarian Credit
Corporation. We believe the government closely monitors the activities of
the holding company, given that the deputy prime minister heads the
holding company’s board of directors. We also note that the board of
directors has recently been strengthened with several government ministers
now represented on it.

Critical public policy role as the government’s primary vehicle for
providing financial support to, and developing, the agricultural sector
and rural areas. KazAgro’s subsidiaries support the agricultural sector
through a number of instruments including leasing, providing short- and
long-term lending, extending micro-financing, and others. The group
participates in implementing several government strategies, including the
new program for the development of the agricultural sector in 2017-2021,
adopted in February 2017. According to management estimates, the group’s
current share in total lending to the agricultural sector is about 45%.

Our ratings on KazAgro Holding are two notches lower than the GCP, reflecting
the higher credit risks characteristic of a nonoperating holding company
compared with its operating subsidiaries. These include the holding’s reliance
on distributions from operating companies to meet its obligations, as well as
structural subordination of some holding company obligations to those at the
operating company level.

The holding company’s role involves overseeing the implementation of
government programs, managing the subsidiaries, in particular improving their
financial performance, and removing any duplication of functions. However,
while we view this function as important for the government–as it improves
the operational efficiency of dealing with several development
institutions–we do not view it as critical from a credit standing point of
view.

We have revised our assessment of KazAgro group’s risk position to moderate
from adequate, and thereby have revised down its unsupported GCP to ‘b-‘ from
‘b’. The unsupported GCP reflects the creditworthiness of the consolidated
group without taking into account the potential for extraordinary government
support. The revision of the unsupported GCP reflects our view that KazAgro’s
sustainably high balance sheet foreign currency mismatch, amid the
unpredictable operating environment in Kazakhstan, exposes it to potentially
high losses in case of an unexpected sharp depreciation of the local currency
(although it is not our base case). In particular, KazAgro’s short open
currency position amounts to around 60% of its total equity, which compares
poorly with peers. Our view of the KazAgro group’s moderate risk position also
balances slightly better asset quality than peers’ (the KazAgro group’s
problem loans comprise 18% of total nonbank lending versus around 30% in the
Kazakh banking sector) and lower single-name concentrations than other
financial institutions in Kazakhstan (the top 20 borrowers accounted for about
12% of loans to nonbank customers as of Dec. 31, 2016), against the structural
risks inherent in the cyclical agricultural sector.

All other factors contributing to the unsupported GCP remained unchanged,
including the anchor of ‘b’ for finance companies operating in Kazakhstan, as
well as a one-notch entity-specific anchor adjustment; the adequate business;
capital, leverage, and earnings positions; moderate funding; and adequate
liquidity.

We adjust our ‘b’ anchor for a financial company operating in Kazakhstan up by
one notch to reflect the ongoing benefits of the KazAgro group’s government
funding and the group’s dominant position in its agricultural niches. The
KazAgro group’s function and mission of supporting the agricultural sector is
important in Kazakhstan, as a large part of the population works in rural
agricultural areas. The volumes and capacity of Kazakhstan’s agricultural
sector is high, while KazAgro group’s borrowers are currently of a relatively
low interest for banks in Kazakhstan, which often lack sufficient experience
to work with small and medium size agricultural producers.

We assess the KazAgro group’s business position as adequate. The group is the
key provider of financial services in Kazakhstan’s agricultural sector. Its
market share in total lending to the agricultural sector is about 50% as of
year-end 2016, according to management’s estimates. Although the group lacks
revenue and business diversity, we positively view its operations in different
subsegments of the agricultural sector, which somewhat lowers revenue
concentration. At the same time, we note that stability of operations might be
negatively influenced by a huge foreign currency mismatch on the balance sheet
and the unstable banking sector in Kazakhstan. In particular, we understand
that KazAgro has unprovisioned exposure to the failed Delta Bank (D/–/D)
amounting to KZT43.6 billion.

We understand that in the long run, the KazAgro group plans to focus more on
lending to the agricultural sector via other commercial financial
institutions, primarily banks. Despite potentially problematic exposure to
Delta Bank, in general this approach could help to improve the risk profile
and therefore the stability of KazAgro’s operations, if the group lends to the
most creditworthy institutions rather than just to the general agricultural
sector.

Positively for the group’s capital, leverage, and earnings, the government
decided to provide KZT76.7 billion additional paid-in capital in 2016, which
partly compensated KazAgro’s high devaluation losses that occurred in 2015. It
also supported improvement in the KazAgro group’s leverage ratio to 2.4x as of
year-end 2016 from 2.9x a year ago. Our base-case expectations imply this
ratio would be in the 2.5x-3.5x range over the next 18 months, which is based
on the following assumptions:

15%-20% asset growth in 2017 and flat (0%-5%) annual growth in 2018;

KZT45 billion capital injection in 2017 (of which about KZT30 billion is
the value of grain to be injected as equity);

Annual credit losses of about 3% of average nonbank gross loans and
leases;

Additional KZT43.6 billion provisions to be created to cover the Delta
Bank exposure;

Given KazAgro’s large short open currency position and expected
strengthening of local currency in our base case, we do not expect losses
from foreign currency revaluation, although we note high sensitivity of
profits to unforeseen weakening of the tenge; and

Losses on average assets of about 0.5%-1.0% in 2017 and return on average
assets of about 0.5%-1.0% in 2018 (including 20% dividend payout).

Although the group’s stable funding ratio of 124% as of year-end 2016 is
relatively high, our assessment of the KazAgro group’s funding is limited to
moderate due to the high portion of liabilities issued in hard currency, which
is not adequately matched with foreign currency assets. As of year-end 2016,
KZT531 billion of the group’s liabilities were denominated in foreign currency
(around 60% of the total funding base). Positively, we understand that KazAgro
is working to minimize its foreign currency gap via numerous mechanisms and
the group won’t attract any additional net foreign currency funds in the
future. It is negotiating with several international financial institutions
regarding additional financing. The expected capital injection in 2017 is also
intended to help reduce the open currency position as a percent of equity.

In our view, KazAgro group can manage its liquidity requirements on an ongoing
basis and in periods of stress in 2017-2018. Our view is based on the
liquidity coverage metric of 6.8x as of year-end 2016, ongoing support from
the government, and that there are no significant debt repayments until 2019.

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

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

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