Kazakhstan has succeeded in stabilising its economy and keeping inflation at low levels; however, the economy is experiencing a slowing in activity after near double-digit growth in 2000 and 2001. The reasons for this are not only lower levels of foreign direct investment (FDI), but also weaker global demand. Although we expect global growth prospects to improve into 2003, a slower pace of structural reform in Kazakhstan suggests gross domestic product (GDP) growth will moderate from almost 8% to a still impressive 7% or so. The government is expected to present new reform initiatives soon, which are likely to include development of the non-oil industrial sectors, higher investment in infrastructure and further fiscal consolidation, which would help insulate the economy if a slump in world oil prices were to occur.
Statistics for the first half of this year point to softer growth in the Kazakh economy. Real GDP growth, although still strong compared with neighbouring Russia, was 9.2% year on year (yoy) in 1H02, down from 14.0% in 1H01, and 12.4% in 2H01. Figures for industrial production (IP) and exports, the key drivers of demand, also confirm a slowdown. IP increased 8.7% yoy in 1H02, compared with 13.6% in 1H01, and exports have dropped 7% yoy so far this year. These trends led to the government recently reducing its 2002 GDP growth forecast from an initial 10.2% to 7-8%. The factors that led to rapid growth in the economy in 2000 and 2001 have had some reverse effect recently. More than 20% of Kazakhstan’s exports are destined for Russia, and nearly 60% of its exports are oil and related products. During 2000- 01, Russia enjoyed a period of political, macroeconomic and financial stability, fuelling a rise in activity in the region. However, Russian GDP growth slowed to 3.7% in 1H02, down from 4.7% in 2H01, while world oil prices were 13% lower in the first half of this year compared with the same period in 2001.
We believe GDP growth should remain vigorous, supported by solid domestic demand growth. Indeed, the outlook for private consumption is favourable. Consumer demand accounts for more than 60% of national income and, within the past few years, has been supported by higher oil earnings. Indeed, real wage growth remains strong at 10% yoy, according to first quarter numbers. One negative factor regarding future consumption is that a large proportion of savings is channelled directly into pensions. The prospects for fixed investment also remain good, but some slowing from the high growth rates of 2000 and 2001 is likely. As for exports, the slowdown witnessed so far this year remains a concern and is a risk to the forecast. However, the Russian economy has shown signs of stabilising recently, and we expect a pick-up in domestic demand there in 2H02. This should bring some renewed impetus to Kazakh external trade and in turn should keep overall aggregate demand robust. Real GDP growth should also gather support from still-high oil prices and low domestic interest rates. In sum, we forecast GDP growth of 7.8% in 2002, dipping to 7.0% in 2003, only as oil prices finally begin to fall back.
Kazakhstan relies heavily on oil to drive economic growth. Since 1995, annual oil production has increased every year, per capita production overtook Russia in 2000. This should enable the Kazakh economy to grow strongly in future years, but this also requires the continuation of heavy foreign investment in the oil sector, the development of the Caspian Sea and the ability to increase oil exports. In this respect, there have been several important developments this year.
Kazakhstan signed a bilateral agreement with Russia on the division of the northern part of the Caspian Sea, which helps clarify ownership of the proven oil reserves, most important was the confirmation of the volume of oil at the Kashagan field, the fifth-largest in the world, after three years of drilling. However, there are concerns about the government’s changes to the foreign investment climate and revision of overseas oil development contracts. Although Kazakhstan’s oil reserves are too attractive to be ignored, a law change could hurt future foreign investment flows, as large companies that have already invested there become unwilling to increase their exposure.
Another important element in the country’s long term growth prospects is structural reform. Certain areas have continued to shine, particularly the financial industry, while the creation of the Oil Reserve Fund is a step towards fiscal sustainability and insulation against future oil price fluctuations. However, progress on industrial restructuring and privatisation has been too slow.
Until the 1998 Russian crisis, inflation in Kazakhstan was high; even hyperinflation was experienced in 1992-94, when the collapse of the Soviet Union led to the removal of most price controls and subsidies in Kazakhstan. However, since the rapid devaluation of the tenge in 2H98 and 1H99, the pace of currency depreciation has moderated and inflation has been heading lower, stabilising at around 10% per annum between mid-2000 and mid-2001, and easing to around 5-6% in 1H02. This disinflation process has been facilitated by strong oil-related capital inflows, which in turn have lent support to the exchange rate and have provided backing for an increase in domestic liquidity. Indeed, in 2001, the monetary base grew 30% to Kzt175bn, and broad money (M3) increased 43% to Kzt570bn. This success with deepening in the financial sector helped reduce inflation, but, for a time, rapid growth in the monetary aggregates delayed the move back to single-digit inflation.
The improving economic climate, coupled with the credible economic policies and transparency of the National Bank of Kazakhstan (NBK), has also helped reduce inflation expectations. As for the official 2002 forecasts, the NBK forecast annual inflation of 5-7%, while the national budget assumes an average inflation rate of 6.2%. On the basis of 1H data, inflation has fallen from the top of the NBK’s range (6.6% last December) to a bottom (5.0% in April), we expect an average of 6.2% this year. In 2003 we see a pick-up as the currency depreciates at a faster rate, but CPI should still remain in the single digits.
NBK monetary policy has two key goals: the maintenance of low inflation and the promotion of growth through an increase in the money supply. Consequently, the good inflation story has allowed room for substantial monetary easing. The benchmark interest rate, the refinancing rate, fell 500bp in 2001 and an additional 100bp in March 2002. NBK governor, Grigory Marchenko, has said that if inflation continues to drop there is room for additional rate cuts this year. We believe that some extra monetary easing is possible, but, given our view that inflation will head higher in 2H02, at most we see interest rates falling 50bp by December.
Balance of Payments
Kazakhstan’s current account (C/A) registered a large deficit in 2001, equivalent to 7.8% of GDP, after two years of running no deficits. This stemmed from a substantial narrowing in the trade surplus. The trade balance is likely to narrow further over the forecast horizon, keeping the C/A in deficit to the tune of around 5% of GDP. This outlook remains highly dependent upon the oil price, which will affect export revenue. We are forecasting that oil prices will ease in 2003, but, given the possibility of conflict in Iraq, oil prices remain unpredictable.
Total exports fell 11% yoy in 1H, despite continued strong growth in oil production. This weakness is likely to have been the result of a decline in world oil prices (they averaged $23.5/bbl in 1H02 for Brent crude compared with $27/bbl in 1H01), but also of weaker economic activity in the country’s main export markets (Russia and the EU). We expect the export outlook to improve in the months ahead, but demand is likely to be contained in 2003, given that we are forecasting that oil prices will come down next year ($23/bbl for Brent crude in 2003, and $18/bbl in 2004).
There are some other factors to consider in the export outlook however. External trade is likely to be bolstered by the opening of the Caspian Pipeline Consortium (CPC) conduit linking one of the country’s main oil fields (Tengiz) to the Russian Black Sea port of Novorossiysk. Another development that should have an eventual, positive impact is membership in the World Trade Organisation (WTO), Kazakhstan is on course to join by late 2003 along with Russia. As we expect stronger world GDP growth in 2003, we believe the export trend will be mildly positive over the forecast horizon.
Strong import demand has also been to blame for the smaller trade surplus. Although it was a little softer in the 1H02 due to slower domestic demand, we expect imports to continue to grow at a more rapid rate than exports. Consequently, the trade surplus is likely to continue to narrow over the forecast horizon, from $900m in 2001, to $700m this year and $200m in 2003. On the back of this, the C/A deficit is likely to remain high, at the equivalent of 6% of GDP.
The flip side to Kazakhstan’s C/A deficits are the surpluses on the capital account, indeed they have been entirely covered by record flows of FDI. Net FDI was $2.8bn in 2001, boosted by completion of the CPC export pipeline and work at newly discovered offshore fields in the Caspian Sea. Although the huge untapped oil reserves in the Caspian suggest continued high levels of foreign investment over the medium term, ongoing corruption in the economy remains a potential deterrent. Indeed, net FDI inflows of $166m for the first quarter were down substantially from $931m in the same period of 2001, but, as our projections show, FDI flows should continue to cover the C/A deficit and allay concerns of balance-of-payments pressures.
Modest Currency Depreciation
Since floating the tenge in April 1999, the currency has remained relatively stable, largely supported by strong oil-related capital inflows. In 2001, the tenge ended the year at 150 Kzt/Usd, down only 3.7% on levels a year prior. The performance in 2002 has been similarly impressive, with the currency only 2.0% weaker against the dollar over the first eight months of the year.
This is in line with the official policy of targeting a modest 4% depreciation in the exchange rate each year. Although we expect no change to this policy in the foreseeable future, the eventual move to inflation targeting could present a potential conflict in terms of the present exchange rate policy. If the C/A deteriorates as oil prices fall back, the NBK may prefer a weaker exchange rate. This, however, would pose a risk to the inflation targets. For now, this should not be a concern, since the exchange rate is at a competitive level. Since the float, the tenge has appreciated in real terms against the US dollar and the euro, but high inflation in Russia has helped to offset this, keeping the real effective exchange rate stable and competitive. Indeed, it is currently more competitive than prior to the sharp appreciation experienced in 1997, which came before the large devaluation of 1999.
A potential conflict surrounds exchange rate policy in Russia. More than 50% of Kazakh trade is with Russia and former CIS countries and the rouble has been steadily appreciating in real terms since the 1998 financial crisis. If, however, Russia was to countenance a depreciation policy to improve export competitiveness, this would pressure the tenge. In light of this, and given slightly less favourable macroeconomic conditions, we forecast the tenge will slip to 156 to the Usd by end-02. In 2003, we believe that a moderately faster pace of nominal depreciation is likely (our end-year forecast is 164), especially with oil prices seen reverting to their lower long-term trend.
Kazakhstan’s fiscal position suffers the same sensitivity to the oil price as its balance of payments. Oil sales account for 25% of budget revenue, largely in the form of taxes on the oil companies, which represent half of total export revenue. However, structural changes such as establishment of the National Oil Fund in April 2001, and completion of the CPC pipeline promise to provide some insulation from all but the sharpest and most prolonged of oil price declines. This year’s state budget deficit target was initially set at 2.3% of GDP, which, relative to last year’s modest deficit of 0.2%, points to a deterioration in state finances. Budget figures for the first half of this year show a surplus of 1.0% of GDP however, and suggest that the 2002 target is too conservative.
However, the target hinges on some key assumptions, most importantly oil prices, which need closer examination. The 2.3% deficit target assumed an average oil price of $19/bbl. Our oil price forecast is much higher at $24bbl. Sensitivity analysis enables us to see the impact of this difference in the oil price on budget revenue and on the overall fiscal position. We calculate that a $1/bbl change in the oil price leads to a $50m change in revenue for the budget. Hence, our oil price assumption of $24/bbl, vs the official target of $19/bbl, would reduce the 2002 deficit by $250m, or 1% of GDP.
A couple of other factors suggest, however, that the budget is unlikely to undershoot the official target by this full amount. Although the official budget is based on a realistic GDP growth assumption of 7%, we forecast 7.8% growth, revenue growth has been disappointing. At the same time, since most expenditure occurs in 2H, the 1H budget performance of a small surplus is unlikely to be a true representation of the overall 2002 outcome. Consequently, we estimate that 2002 will end with a fiscal deficit of 1.5% of GDP.
Kazakhstan is rated Ba2/BB/BB as per Moody’s Investors Service, Standard & Poor’s (S&P) and Fitch. The latest change came in June, when S&P changed its outlook for the country from Stable to Positive. The reason for the change was the recent strength of public finances. This move finally placed S&P on the same rating outlook as Moody’s, which had upgraded Kazakhstan and assigned it a Positive outlook more than a year ago. Moody’s, in its annual report this April, confirmed a similar picture to that of S&P, highlighting the tight budget policy, improved external liquidity and reduced medium-term debt obligations. However, the key concern of Moody’s was the lack of competitiveness of Kazakhstan’s manufacturing sector and the threat of a slowdown in structural reform in the non-energy sectors. The rating agency Fitch is lagging behind, with a Stable outlook citing limited progress in terms of structural reforms.
Given that Kazakhstan has been on a Positive outlook from Moody’s for more than a year and the economic situation has generally improved during that time, we believe an upgrade is on the horizon. Provided that oil prices remain relatively firm, real GDP growth continues to be faster than 5% per year and policies remain market-friendly, we believe an upgrade by Moody’s and even by S&P is likely within the next 12 months.
As for sovereign debt assets, reforms of the state pension system in 1998 have provided Kazakhstan with a small, but fast-growing, non-bank financial system, which has in turn led to an increase in domestic demand for sovereign debt. Roughly half of the outstanding stock of government Eurobonds, amounting to $500m, is reportedly held by domestic pension funds; however, pension fund assets are growing at a pace of just $30m per month. The government has refrained from issuing in the Eurobond market this year, despite a peak in debt payments, choosing to meet refinancing needs from the state budget and with financing from the World Bank. If need be, the authorities are likely to consider first borrowing in the domestic market before moving to the international markets.
However, growing demand from the pension system for new assets to invest in could result in Eurobond issuance occurring sooner than this, in our opinion. The improvement in the country’s fundamentals have allowed the spreads on sovereign Eurobonds to narrow from 1,000bp over US Treasuries at the time of the 1998-99 Russia crisis to less than 100bp over US Treasuries, the low point this year. Indeed, Kazakhstan sovereign debt trades well inside what one might typically expect for a BB-rated country because of its scarcity value. In our view, the bonds will continue to trade unusually tight to US Treasuries.
Kazakhstan has succeeded in stabilising its economy and in keeping inflation at a low level. This has resulted in a more favourable investment climate than in other CIS countries. We have a positive view on Kazakhstan’s growth prospects. Given the year-to-date evolution of world oil prices, the assumption made for the purposes of the 2002 budget will be exceeded. As for domestic demand, the prospects appear relatively solid, which should see the economy through some recent mild slowing in activity. A key factor that is likely to help is strong growth in real wages, currently close to 10% yoy.
This does not mean that the outlook is without risk. The economy remains heavily dependent upon oil prices and FDI. Indeed, in 1H, the economy has experienced some cooling off in reflection of what has been occurring in the country’s main trading partners. Although future development of the oil sector should keep annual GDP growth above 6%, FDI has slowed recently. We believe that this reflects lack of momentum in the structural reform process. The fiscal position is also highly vulnerable to external shocks, given that 25% of budget revenue is oil-related. However, public debt levels are exceptionally low, and so the country is not, like Russia, dependent upon international markets to meet debt obligations. The important test for the government, however, will be to bring renewed vigour to the reform process, especially in the areas of privatisation, industrial restructuring and the development of non-oil sectors.
Zsolt Papp is head of EMEA Economics at ABN Amro in London.