A GIANT COUNTRY WITH GIANT CHALLENGES
COUNTRY REPORT / KAZAKHSTAN

Vast hydrocarbon reserves and financial regulators known for their toughness are helping Kazakhstan ride out an abrupt economic slowdown and a housing crunch.
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Kazakh president Nursultan Nazarbayev at the opening of a hydrocarbon plant: The government has done an "exceptional job" of spreading wealth around.

Coming off a long stretch of consistent near-10% annual GDP growth, Kazakhstan might be forgiven for feeling its expected growth of 5% this year is a letdown. The continuing fallout from the global credit crunch is only part of the reason for the sharp decline in growth. Kazakhstan’s banking sector, which helped spark the past decade of economic growth and a dizzying pace of construction activity, is now struggling with large debt levels built up during successful capital raisings in the international markets during the mid-2000s. The construction industry, once part of a newly emerging services sector, has ground to a halt as property prices in some urban areas tumbled by nearly 25%.

Yet analysts are confident that the country and its banks can pull through this phase of economic turbulence. “If you face an external liquidity crisis as an oil exporter, it’s good to do it with oil at $130 a barrel,” says Andrew Colquhoun, director of emerging Europe sovereigns at Fitch Ratings in London.

“The country has done an exceptionally good job of spreading the new wealth around,” says Frederick Starr, chairman of the Central Asia-Caucasus Institute at the Paul H. Nitze School of Advanced International Studies in Washington, part of Johns Hopkins University. “There’s been a real middle class developed over the last five years, and the country has invested in education and is sending its brightest students to the West for training.”

“The big issue is diversification, and while they are not there yet, the country is not just oil and gas anymore. They’re pushing to diversify,” Starr adds, referring to the development of the services sector and the move beyond oil and gas to other natural resources, such as uranium and steel.

Colquhoun points to Halyk Savings Bank of Kazakhstan, which in April raised $500 million in eurobonds in London, as a sign that the banking sector’s problems may be turning the corner. Analysts also note the government’s decision earlier this year to step in with cheap money to help banks finance loans so builders could complete the construction of commercial and residential properties. This move helped boost banks’ asset quality—and prevented the skylines of Almaty and Astana becoming littered with construction skeletons.

Almaty, Kazakhstan’s capital from 1929 to 1998, remains the country’s major commercial center and largest city, with a population of more than 1.2 million. The new capital, Astana, is located in the north-central portion of this vast nation that stretches from the Caspian Sea near Russia to the western border of China. With 600,000 residents, it is Kazakhstan’s second-largest city.

“There was a large speculative component to the housing boom,” adds Colquhoun. “In tackling the subsequent bust, the government wanted to address the potential social problems. This also helped put a floor under the real economy.”
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Kazakh bank stocks have been hard hit by the global liquidity squeeze.

Yet the problems rippling through the banking sector did worry analysts at Standard & Poor’s enough to downgrade their ratings on the Republic of Kazakhstan’s long-term credit from stable to negative this spring. S&P; believes the banks’ deteriorating asset quality, coupled with today’s overall funding constraints, could weaken the country’s fiscal and external balance sheets. “We view the banks as a contingent liability to the sovereigns,” says Ben Faulks, associate director of sovereign ratings in S&P;’s London office. “The credit markets have tightened up, and it’s more difficult to access easy credit. There’s also a rise in stressed loans among the banks.”

Like banks in nearby Russia and Ukraine, leading Kazakh banks managed to remain stable up until this spring, as the domestic economy continued to expand and there was a strong demand for banking services. But while the global liquidity squeeze has had only a moderate impact on Russian and Ukrainian banks so far, the Kazakh banks have suffered more because of their over-reliance on the issuance of foreign debt, analysts at S&P; wrote this spring.

The potential for a severe downturn may be mitigated by the reputed steely reserve of the central bank authorities. Analysts agree that Kazakhstan has among the strongest and most transparent regulatory authorities in the Commonwealth of Independent States. Initiated more than a decade ago, the structural reforms in the Kazakh banking system have helped raise standards to international levels by improving transparency, adapting accounting standards to generally accepted international standards and putting risk management systems in place. The banking system has also consolidated to less than three-dozen banks, down from more than 180 banks in 1996.
Foreign Banks Eye Kazakhstan
“We are optimistic there won’t be any major issues in the marketplace. In the worst case, the government would likely step in and provide assistance to the financial sector, potentially even taking equity stakes in the local banks,” says Sergei Kotov, managing director and head of client management for Bank of New York Mellon’s Eastern European business. Bank of New York Mellon provides asset servicing as well as treasury and issuer services to financial institutions and companies operating in the central Asia nation.
But the tight credit markets will slow banks’ growth and, in turn, affect their ability to lend and support the domestic economy. One result of the banking industry’s economic woes and the subsequent drop in share prices could be interest among foreign banks. While Kotov doesn’t expect much consolidation among domestic banks, he says he would not be surprised if outside players, such as financial institutions from Russia or Western Europe, stepped in to buy stakes in the mid-size Kazakh banks. Adds Jonathan Schiffer, vice president and senior credit officer, and the lead analyst for Kazakhstan, at Moody’s in New York City: “Bank prices are lower, and the banks may be pushed into strategic alliances. They will be more attractive to foreigners.”

The country’s strong economy coupled with the global growth of the Islamic finance industry has sparked the interest of Qatar Islamic Bank, Qatar’s largest shariah-compliant bank. At a World Economic Forum meeting in Sharm el-Sheikh, Egypt, in May, a bank official acknowledged that the Gulf institution was in the initial stage of setting up an Islamic bank in Kazakhstan. The venture could have start-up capital of $100 million. About half of Kazakhstan’s 15 million people are Muslim.

As oil money floods into the Gulf region, the demand for banking services and investments that comply with shariah law’s ban on interest has jumped. According to the Islamic Financial Services Board, which is based in Malaysia, the assets under management by the global Islamic finance industry have grown by 15% a year and may have reached $1 trillion.

One of the first significant investments in a Kazakhstan bank by a major Western financial institution took place in November 2007 when Italian Bank UniCredit paid $2.1 billion for 91.8% of ATF Bank, the country’s fifth-largest bank by assets. The deal has been hampered with subsequent lawsuits filed earlier this year by minority shareholders.

Natural Resources Boost Economy
This sprawling former Soviet Republic also can fall back on its natural resources, including oil, gas, coal and uranium, to help its banking system manage the liquidity crisis. The windfall from higher world oil prices, for example, has increased government resources significantly and helped temper the country’s external borrowing needs for financing new investments. The National Oil Fund of the Republic of Kazakhstan, created in 2000 to prudently manage oil revenues and act as a savings fund for future generations, now tops $22 billion.
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New hope: Kazakhstan is diversifying beyond oil and gas into other natural resources.

In late May the Kazakh government took a significant step toward expanding the access of its oil exports into international markets—and securing its revenue base—when Kazakh president Nursultan Nazarbayev signed into law a treaty that will let Kazakhstan export oil through the Baku-Tbilisi-Ceyhan (BTC) pipeline. The treaty lays out the technical support for oil transportation from Kazakhstan to Azerbaijan across the Caspian Sea. Then, oil will be sent into the BTC pipeline and forwarded, via Tbilisi, Georgia, to the Turkish Mediterranean port of Ceyhan and onto global markets. Analysts say the deal not only will help ensure Kazakhstan has sufficient export capacity once oil production increases but will diversify export routes away from the Russian network.

The deal also calls for the construction of a 454-mile pipeline to move the oil from Kazakhstan’s western Eskene region to Kuruk port, where it will be transported to Baku via tanker. Once pumped into the BTC, Kazakh oil will boost the amount of oil arriving in Ceyhan to 75 million tons a year, up from the current 50 million tons.

The government’s efforts to boost its oil and gas production in coming years should push it to develop the nation’s transportation system, necessary if the country wants to diversify beyond the services sector into manufacturing. “The country is vast, the size of western Europe. That means its transport costs are significant and will shape its comparative advantages and what market niches can grow,” says Colquhoun.

Moody’s Schiffer believes the Kazakh government should follow the Australian model and move its economy slowly out of its commodity base. “The country has so much wealth,” he says, adding that the country is fortunate to be bestowed with oil reserves that are not buried under the Arctic Circle. “They are fortunate, and they have time to diversify their economy,” he notes.

While Kazakhstan’s pending accession to the World Trade Organization (WTO) has been a priority for President Nazarbayev, membership in the global trading organization could offer problems of its own. “Will [WTO membership] open the flood gates to inexpensive Chinese goods?” wonders Starr of Johns Hopkins’ SAIS. “They have good relations with China, but they are also cautious about being swamped with Chinese goods.”

Paula L. Green