Improving Creditworthiness in the Republic of Kazakhstan
Sharon Raj, senior director in the sovereign team, Fitch Ratings
Kazakhstan’s sovereign creditworthiness has strengthened steadily since the late 1990s and the sovereign rating has been upgraded four times, most recently in December 2005 when the Foreign Currency Issuer Default Rating (IDR) was upgraded to ‘BBB’ and the Local Currency IDR was upgraded to ‘BBB+’. This move raised the Foreign Currency IDR to the same level as the Russian Federation’s, and put Fitch’s rating for Kazakhstan one notch above its main competitors. The improvement in creditworthiness has been underpinned by a very strong macroeconomic performance, prudent fiscal policies, progress with structural reforms, a good track record in responding to external shocks and the ongoing development of the oil and gas sector.
The economy has been growing rapidly. During 2000-2005, the real economy expanded by an average of 10% per year – one of the strongest growth performances of any country rated by Fitch – and the authorities continue to manage oil revenues prudently. The consolidated fiscal position has been in surplus since 2001 and the World Bank estimates that roughly 60% of the total oil windfall received since that time has been saved in the National Fund of the Republic of Kazakhstan (NFRK). At the end of 2005, Fitch estimates that it held around $6.7bn, or 13.3% of GDP. Reflecting the combination of rapid GDP growth and a tight fiscal stance, the general government debt burden has declined steadily and is currently equivalent to less than 10% of GDP – the lowest in the ‘BBB’ peer group and far below the ‘BBB’ median of 35%. The public finances also compare very well on the external side: the public sector’s net external creditor position remains the strongest in the peer group with a net asset position of 41% of current account receipts or 26% of GDP.
Of course these positive trends have been partly underpinned by the recent high oil prices since the fiscal position, the balance of payments and growth are all closely linked to developments in the oil and gas sector. Even so, a major oil price shock, while painful, would be manageable. The NFRK provides a large buffer against shocks and, as noted above, the authorities have a good track record of responding effectively to negative events. The low debt burden provides considerable fiscal flexibility and rising oil and gas production would partly offset the effect of falling prices on GDP growth. However, this is not a scenario that Fitch regards as likely over the next couple of years. In fact, the Sovereign Group’s working assumption is that the annual average Brent oil price will remain above $48pb in 2006-2007.
Future economic prospects are bright, underpinned by Kazakhstan’s vast mineral wealth. Key oil and gas projects are due to start coming on-stream over the next two to three years and, by 2020, output levels are expected to be running at 3.5m-4m bpd, on a par with current levels in Mexico and Iran and placing Kazakhstan in the world’s top 10 oil exporters. Against this background, the outlook for the current account is good, although final outturns will depend on oil prices and the size of dividends paid by the oil companies active in the country. The assets of the NFRK should continue to mount and the government’s net creditor position should strengthen further, providing additional support to the rating.
Nonetheless, as a land-locked country in a volatile neighbourhood some 1,500km away from world oil markets, market access and transport costs are major issues for the industry. Transport capacity constraints are not currently binding but, if Kazakhstan is to fulfil its future export potential, a steady increase in export capacity will be necessary over the medium term. Progress towards meeting this need is well under way: both of the existing oil pipelines in use are being upgraded and a further pipeline linking Kazakhstan to China is due to start operations in 2006. It is also probable that Kazakhstan will be able to use the BTC pipeline that has recently been completed, linking Azerbaijan and Turkey. These projects will also diversify the pipeline network away from Russia. However, while this will limit dependency risk, Kazakhstan’s location suggests that pipeline security will remain a key issue.
The expansion of the oil and gas sector will also create additional policy pressures and challenges. Despite the strong economic performance of recent years, income per head remains far below the peer group median and Kazakhstan has significant regional inequalities and high social needs. The government has been working to address this and it has been successful in engineering a very rapid reduction in the number of people living below the poverty line. Nonetheless, with oil revenues set to rise rapidly, the greatest medium-term risk on the fiscal side is probably that the government succumbs to ever-greater spending pressures.
Some signs of this are already evident. In 2004 the number of companies that were required to pay into the NFRK was cut so that the government could spend a greater share of the oil windfall, and it has already pledged to boost wages and pensions further over the medium term. While the currently low debt burden suggests that it would be possible to finance even a large rise in spending, this would complicate monetary and exchange rate management, making it harder to reduce inflation. Moreover, by boosting permanent spending on wages and pensions, the government may limit its room for manoeuvre later if there is a large and sustained fall in oil prices.
Recognising the challenge of managing the country’s oil wealth in a way that minimises the associated economic risks, the authorities have recently revised the framework underpinning the NFRK. The changes, which will take effect in 2007, aim both to strike a balance between meeting current development needs and providing a savings vehicle for future generations, and to enhance the transparency of the oil fund. Nonetheless, the key to future success will be for this transition to be well managed, and for any resulting increase in spending to be made with an eye on macroeconomic management as well as fiscal sustainability.
The development of the oil and gas sector will also make diversification of the economy more difficult as it is likely to put strong upward pressure on the exchange rate over the medium term. Meeting this challenge will be tough. The business environment remains difficult and is arguably harsher than in most of Kazakhstan’s rating peers, with the probable exception of Russia. Key shortcomings include excessive bureaucracy, uncertainties over the legal environment, poor transparency and corruption.
In contrast to the government’s solid balance sheet, the broader country’s external balance sheet is another area that appears to compare less well with Kazakhstan’s rating peers. However, more than half of the country’s total debt stock is inter-company debt related to the development of the oil and gas sector. This is common practice in the oil industry, as debt investment carries more tax benefits than equity investment. The servicing schedule of this debt is not clearly defined (it tends to rise and fall with the oil price) and parent companies typically roll over obligations during difficult times. Excluding this debt, Kazakhstan’s debt ratios would compare well with those of its ‘BBB’ rating peers.
Because of the assumptions made about FDI debt servicing, the debt service ratio is above the ‘BBB’ median and the liquidity ratio – the ratio of liquid external assets to liabilities – is far below it. However, the government’s debt servicing obligations are low, at less than 3% of current account receipts, and the liquidity ratio is improving. Indeed, it has risen to over 90% compared with just 52% in 2001, and is expected to rise further over the coming period, reaching 103% in 2007. If the assets of the NFRK were included in the calculation, the ratio would look far stronger, at 141% this year and rising to an estimated 149% in 2007 – in line with the ‘BBB’ median – which is forecast to hover close to 150% during 2006-2007.
Political risk is also a significant factor for the rating. On the positive side, President Nazarbayev’s continued dominance and the smooth passing of the 2005 presidential elections – in stark contrast to some other elections in the region – has ensured that the domestic political scene has remained stable since independence. In turn, this has underpinned the stable and pro-reform economic policy stance.
However, more negatively, such a centralised system means that succession risks are higher in Kazakhstan than in most of its rating peers. As President Nazarbayev is relatively young and appears to be in good health, uncertainty over Kazakhstan’s future leadership is more of a long-term issue than a near-term concern. However, rumours of rivalries and rising tensions within political inner circles suggest that a damaging power struggle between potential successors at some point cannot be ruled out. In addition, while Fitch’s central expectation is for the broad social stability that has characterised the past decade to continue, underpinned by government efforts to meet social needs, the possibility of rising unrest and/or spillover effects from less stable neighbours cannot be completely dismissed.
Sharon Raj is a senior director in the sovereign team at Fitch Ratings, one of the big three international credit rating agencies. Fitch has over 1,700 employees with offices worldwide and is dedicated to providing high quality credit analysis to over 6,200 subscribers around the world. Coverage on the Commonwealth of Independent States is coordinated through its Moscow office and is expanding rapidly. Fitch currently rates over 90 sovereign governments, 3,800 banks and financial institutions and 1,700 corporations globally, including over 100 rated issuers in the CIS region, 15 of which are in Kazakhstan.
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