S&P AFFIRMS RATINGS OF THE REPUBLIC OF KAZAKHSTAN AT "BBB-/A-3", OUTLOOK "STABLE"

/Standard & Poor's, September 6, 2019, heading by KASE/ – Overview After over 30 years under a single president, Kazakhstan elected a new president in June, marking a significant step in the transfer of power. We expect a continuation of broadly stable and effective policy-making that has favored a largely prudent fiscal stance. We are therefore affirming our 'BBB-/A-3' foreign and local currency sovereign credit ratings on Kazakhstan. The outlook remains stable. Rating Action On Sept. 6, 2019, S&P Global Ratings affirmed its 'BBB-/A-3' long- and short-term foreign and local currency sovereign credit ratings on Kazakhstan. The outlook is stable. We also affirmed our 'kzAAA' national scale rating on Kazakhstan. The transfer and convertibility assessment on Kazakhstan remains 'BBB'. Outlook The outlook is stable because we expect Kazakhstan's government and external balance sheets will remain robust over the next two years. We also expect continuity of policy-making under the new President. We could raise the ratings if we see significant and tangible devolution of power to the cabinet and parliament along the lines suggested by the March 2017 constitutional amendments, which could support an improvement in policy-making effectiveness, in our view. A meaningful improvement in the health of the banking sector, for example supported by further advances in regulatory oversight or reduced concentration in lending to single borrowers, could also improve our view on government and monetary policy effectiveness. A prolonged and sharp fall in oil prices or production, beyond our expectations, could put the ratings under pressure if it led to deterioration of Kazakhstan's external performance, for example should gross external financing needs exceed 100% of current account receipts plus usable reserves. We could also consider a downgrade if destabilizing factors re-emerged, such as a spike in dollarization of resident deposits. Rationale Our ratings on Kazakhstan remain supported by the government's strong balance sheet, built on past budgetary surpluses accumulated in the National Fund of the Republic of Kazakhstan (NFRK), primarily during the latest period of high commodity prices that ended in late 2014. We project that Kazakhstan's liquid external assets will exceed external debt through 2022, which also supports the ratings. The ratings remain constrained by our view that future policy responses may be difficult to predict, given the highly centralized political environment and moderate economic wealth as measured in GDP per capita. Remaining challenges to monetary policy credibility, such as the central bank's limited independence and the overall weakness of the banking system, also constrain the ratings. Institutional and economic profile: Kazakhstan's first new president in thirty years will likely follow the policies of his predecessor. - We expect broad policy continuity after Kazakhstan's first transfer of power. - Former President Nazarbayev will retain significant influence over government decision-making. - We expect real economic growth will remain steady at about 3.6% on average over 2019-2022, supported by the government's spending programs and rising oil production after 2019. After over thirty years under President Nursultan Nazarbayev, in June 2019 Kazakhstan elected a new president, former Speaker of the Senate Kassym- Jomart Tokayev. President Tokayev is part of the ruling political party Nur Otan, which Mr. Nazarbayev heads. In our view, despite the transfer of power, Mr. Nazarbayev still retains significant influence over decision-making in Kazakhstan. Parliament passed a bill in 2018 that grants Mr. Nazarbayev lifetime chairmanship of the security council, elevating the body's powers and providing him with a lifetime veto over decisions relating to domestic stability and foreign and defense policy. We note, however, that in March 2017, at then-President Nazarbayev's behest, Kazakhstan's parliament passed constitutional changes aimed at increasing the role of the cabinet and parliament. The election of President Tokayev could lead to an acceleration in the practical implications of these changes, possibly supporting a devolution of power, diversifying decision-makers within the government and improving the transparency and accountability of institutions. In our view, these factors bear directly on sovereign creditworthiness because they reinforce the stability and predictability of institutions and the political framework. Our expectation is that under new leadership, the government's prudent and generally effective policy-making will continue. Despite protests around the election, Kazakhstan has benefited from having one of the most stable political environments in the region since the breakup of the Soviet Union. Oil is the key sector in Kazakhstan, directly accounting for about 15% of GDP, over half of exports, and more than 40% of general government revenue. Although oil revenue supports the economy when prices are high, in our view, it also exposes Kazakhstan to fluctuations in the terms of trade and a volatile revenue base. The government continues to work on diversifying the economy through such programs as Nurly Zhol and Nurly Zher. Non-oil growth was the main driver of economic growth in the first half of 2019. We expect economic growth will be 3.5% in 2019, after a strong first half in the services and industrial sectors, despite lower oil production because of OPEC cuts, which coincided with maintenance works at the Kashagan fields. Growth in the later years of our forecast horizon through 2022 should be supported by small increases in oil production and exports. We expect oil production will increase modestly, reaching about 1.8 million barrels per day (bpd) in 2022 from about 1.7 million bpd in 2017. However, lower oil prices over the forecast horizon could weigh on economic activity (see "Brent Crude Price Assumption For 2019 And 2020 Raised To $60 Per Barrel", March 19, 2019, on RatingsDirect). Flexibility and performance profile: New government stimulus should keep fiscal accounts in deficit for the next two years, but the government's overall net-asset-stock position will continue. - We expect a fiscal deficit in 2019 resulting from lower oil prices and production along with the extension of government spending programs and deficits averaging 0.25% over 2019-2022. - We expect liquid external assets will exceed external debt by about 40% of current account payments on average in 2019-2022. - We include in our assessment of government debt the cost of assets purchased from Tsesnabank through the Problem Loans Fund, worth Kazakhstani tenge (KZT) 450 billion in 2018 and KZT604 billion in 2019. Our government debt estimates include KZT1.708 billion (about $4.3 billion or 2.7% of GDP) of debt related to government support for the banking sector. This consists of debt of KZT1.054 billion raised by the Problem Loans Fund to support Tsesnabank, which had funding problems starting in August 2018. The remaining KZT654 billion of debt consists of subordinated debt provided by the National Bank of Kazakhstan's (NBK's) subsidiary Stability Fund of Kazakhstan, to five Kazakh banks in 2017, which the banks then used to buy NBK notes. Under our criteria, when a central bank issues debt for nonmonetary policy purposes, we typically include the debt in our general government debt measure (see "Credit FAQ: What's The Link between Central Banks and Government Debt" published June 22, 2017). The government is a net creditor and, despite the anticipated fiscal deficits, we forecast the net asset stock position will average around 19% of GDP over 2019-2022. We estimate general government liquid assets at about 41% of GDP in 2019. Kazakhstan's assets consist mostly of those of NFRK, which are predominantly invested abroad. We expect the government's interest costs will remain just over 5% of revenue on average over the forecast period. Our debt- service ratio is subject to currency depreciation effects on the government's inflation-indexed debt, which accounts for about 12% of its total debt. Under our approach, the consolidated general government balance showed a deficit of about 1.2% of GDP in 2018, following a deficit of 4.1% of GDP in 2017. We forecast that the fiscal balance will be in deficit in 2019 and 2020 before returning to small surpluses over the later years of our forecast horizon. Our 2017 estimate includes the approximately 5% of GDP equivalent that the government spent to recapitalize the banking system. In our fiscal forecasts, we assume no further government support for the banking system in 2019 (outside of the support to Tsesnabank in January 2019) or thereafter. However, there are risks to the fiscal forecast should government spending needs arise from the ongoing asset quality review in the banking sector. We expect the new tax code will support government revenue over the period through 2022. The tax code update presents an opportunity to reduce distortions and raise revenue by rationalizing exemptions and preferential treatments, thus broadening tax bases and helping support fiscal consolidation. Changes include increases in excise taxes, expansion of the value-added-tax system, and amendments to natural resource taxation. Notwithstanding the authorities' significant efforts to strengthen the banking sector, we continue to view it as weak. We expect credit growth will be broadly flat again in 2019, further extending the period of weak impetus from financial intermediation on economic activity that began in 2015. This is partly due to the lack of creditworthy borrowers in the country, in our view. We currently classify Kazakhstan in group '9' 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 Jan. 10, 2019). We assess the banking sector as having still high problem loans, at 20%-25% of systemwide loans (including restructurings). Kazakhstan's current account was almost balanced in 2018, thanks to higher oil prices and production. We expect a deficit in 2019 because of lower expected oil production and our assumption of lower oil prices, as well as consistently high income payments to foreign oil companies. Nevertheless, on a stock basis, Kazakhstan's external asset position is strong. We note, however, that about $101 billion of inward foreign direct investment (FDI) of a debt-like nature was outstanding in April 2019 (61% of the total inward FDI), which is close to 63% of GDP or 158% of current account receipts. These, in our view, constitute a foreign liability of the economy and could weigh on the balance of payments. We note that FDI tends to be more stable than portfolio flows, and the debt-like FDI is principally concentrated in Kazakhstan's strategic oil and mining sectors. In our view, the NBK's switch to a more freely floating exchange rate and inflation- targeting in 2015 has resulted in an exchange rate adjustment, thereby easing external pressure. However, the still-relatively-short track record of the float constrains our assessment of monetary flexibility. We note that the NBK's exchange rate policy allows it to intervene to prevent large fluctuations in the tenge exchange rate and to ensure financial stability. The NBK intervened once in 2018, in September, selling approximately $520 million to halt the depreciation of the tenge. In aggregate, the NBK made net purchases of about 10% of gross reserves in 2016, dampening the value of the domestic currency, and made net sales of 2% of gross reserves in 2017, which supported the tenge. There are still challenges to monetary policy credibility, in our view, including periods of excess tenge liquidity amid weak bank lending growth. Nevertheless, we note that inflation has fallen from double-digit rates in 2016 to within the NBK's 5%-7% annual target range in 2018. We expect inflation in 2019 within the NBK's target corridor of 4%-6%. In April 2019, the NBK lowered its policy rate to 9.0% from 9.25%. In our view, the NBK could be subject to political influence, as seen in some of its activities in recent years, which we believe fall outside the usual remit of a central bank. These include the April 2018 presidential decree for the NBK to establish a company to provide liquidity to banks by purchasing their mortgage loans. Past examples include the NBK becoming a shareholder of state-owned oil and gas company KazMunayGas, and compensating owners of tenge-denominated deposits after the local currency depreciated in 2015. Before the transition to a more freely floating exchange rate in September 2015, the share of foreign currency deposits to total deposits increased as a potential hedge against falls in the tenge's value. Dollarization peaked at almost 70% of total deposits in January 2016. However, since then, the NBK has undertaken various measures to stabilize markets and improve liquidity, including easing reserve requirements and raising the recommended ceiling for interest rates on tenge deposits. A pick-up in oil prices and a more stable tenge, along with the NBK's various measures, has resulted in deposits being converted back into tenge from dollars, with the dollarization rate at about 42% in June 2019. * The full press release is available on the rating agency's website. [2019-09-09]