CBS Weekly Review: Kazakhstan’s policy response to crisis; Azerbaijani banking

Kazakhstan: One problem solved, but is another emerging?

After several weeks during which the Kazakh government’s scattershot response to the deepening of the credit crisis served to fuel negative sentiment (as we discussed here), the government has now taken several steps designed to restore confidence in its banking sector.

The most important measure announced so far is a recapitalisation of the main banks – in the form of a government purchase of US $3.5 billion worth of new shares in the country’s four largest banks. Questions remain about the details of how this recapitalisation will be structured, particularly as concerns BTA Bank which will be getting two thirds of this money. But there is now at least a clear sense that the state is moving decisively to support the major Kazakh banks. This measure should remove any concerns in the near term about these banks meeting repayment obligations on their foreign debt. And for the moment, they appear to have put a floor under the share prices of Kazakh banks (although how long this floor holds is of course another matter).

Meanwhile the government has announced the appointment of foreign investment banks as consultants on the banking recapitalisation program (JP Morgan, Credit Suisse) and establishment of the proposed Distressed Assets Fund (Citigroup). This addition of outside expertise will be helpful, but more important than the reality is the perception: this is the sort of signal that the markets like to see.

Given the recent strength in Kazakhstan’s public finances, the government has faced a relatively simple challenge in restoring confidence in the banking sector: it merely needed to make clear that it had the inclination and the organisational capability to support the major Kazakh banks. That it has the financial resources to do so has been assumed.

But is this still true? The emerging view on Kazakhstan – as reflected, for instance, in the downgrades of several Kazakh banks by Fitch Ratings last week – is that the capacity of the sovereign to provide sufficient support for Kazakh banks is now in doubt.

How real is the threat?

The most obvious change to the outlook for Kazakhstan’s public finances is related to the collapse in world oil prices which began in July (along with the concurrent decline in metals prices). The new tax code set to take effect on 1 January 2009 – which, significantly, has not yet been finalized – decreases taxes for non-extractive sectors while increasing the tax burden on the oil and mining sectors. This tax reform is certainly good policy for the longer run. But given the immediate circumstances it may be poorly timed, particularly given the reliance of the proposed new tax regime for the oil sector on an export duty which is highly sensitive to oil prices.

Whatever happens with the tax code, a much lower oil price will inevitably result in much lower flows into Kazakhstan’s National Fund in 2009. The government has already signalled that the level of reserves in the National Fund will go down rather than up in 2009; and indeed the outflow could be rather large. Although the National Fund is often thought of as an extra-budgetary fund, it in fact provides substantial revenues to the budget, as we pointed out in August: during the first half of 2008 it provided fully 36 per cent of budget revenues. If this ratio is maintained for 2009 (which might indeed be optimistic) the result would be a net outflow from the Fund to the state budget of US $8.5 billion.

For comparison, total inflows into the National Fund in 2004 – a year during which the average price for Dated Brent was around US $55 per barrel – were only US $2.5 billion. This should not be taken as a solid indicator for 2009, since the government tax take will be higher, and the production volumes at the enterprises whose taxes flow into the National Fund are now higher. But it does give some insight into the fiscal problems that Kazakhstan may face.

Kazakhstan’s FX reserves declined by US $691 million in October, or 3.5 per cent; meanwhile the National Fund declined by 4.5 per cent or US $1.23 billion. Total reserves (including gold) now stand at US $47.4 billion. From this total approximately roughly US $10 billion has already committed to support the banking sector and the economy; but this figure includes an almost certainly insufficient amount of US $430 million for the distressed assets fund; and it does not take into account support for smaller banks. Prime Minister Karim Massimov has also spoken of an additional US $5 billion which will be "kept on hold", ready for deployment.

From these figures Kazakhstan would appear to have more than enough reserves to deal with the situation. But the major new uncertainty for Kazakhstan – as now for Russia – concerns the currency. Thus far the downward pressure on the tenge has been described as "manageable" by the chairman of the National Bank of Kazakhstan; and in important ways Kazakhstan is structurally less vulnerable to depreciation pressures than Russia, since the ability of the political leadership to block capital outflows using informal levers is greater than it is in Russia.

But downward pressure on the tenge may emerge anyway: and Kazakhstan’s recent experience shows that defending the currency can be expensive. FX reserves declined by $6.1 billion during the period August-October 2007 when the National Bank of Kazakhstan was intervening massively on currency markets to hold the tenge stable.

If serious pressure on the tenge lies ahead, Kazakhstan will face its own version of the policy choice being faced now by Russia. Should it choose to defend the tenge as it did last year – and there are good reasons why it might choose to do so – then suddenly legitimate questions might start to be raised as to the sufficiency of the country’s reserves and the ongoing capacity of the sovereign to defend the banking sector.

Azerbaijan and the credit crisis: Mostly unscathed

Azerbaijan is one of the countries in emerging Europe that has been least affected by the global financial crisis and the freezing up of credit markets. Of course there has been some impact, not least because declining global oil prices are contributing to a slowdown in economic growth. Some tightening can also be seen in the domestic banking sector, as Azerbaijani banks have begun to restrict their lending in recent months. However the situation is far from critical, and healthy public finances (including FX reserves plus Oil Fund money totalling US $17 billion) mean that the state has the capacity to manage any difficulties that might arise.

Azerbaijan finds itself in the fortunate position of being insulated to a considerable extent from the situation in global credit markets. In contrast to Kazakhstan or Ukraine, Azerbaijan’s relatively unsophisticated banking sector had not borrowed from abroad in large quantities before credit conditions started to tighten last year. The total foreign liabilities of the entire banking system are approximately US $2.0 billion, representing roughly 25 per cent of bank funding; and half of that is with the majority state-owned International Bank of Azerbaijan.

Part of the reason why Azerbaijan’s banks borrowed relatively little from abroad was that their main source of funding – retail and corporate deposits – has been growing by 49 per cent annually since 2003, driven by rising incomes and growing trust in the banking sector among consumers. This has allowed the banks to dramatically increase lending in recent years, consumer lending in particular. However this growth began from a very low base, and the banking system overall remains underdeveloped even by post-Soviet standards, with total loans standing at just 18 per cent of GDP (as compared with about 40 per cent for Russia and roughly 60 per cent for Ukraine and Kazakhstan).

But even if the Azerbaijani banking system has been relatively untouched by the credit crunch in terms of the liquidity and solvency of its banking system, its banks have in any case constrained their lending (at least sporadically) over the course of the past 15 months. The chart below shows month-on-month growth in total bank lending in Azerbaijan (as a three-month moving average) from March 2007 through the end of September 2008.

Month-on-month growth in aggregate bank lending in Azerbaijan: March 2007 through September 2008

It is difficult to explain the gyrations between periods of faster and slower lending growth during this period. But broadly speaking there are two dynamics being reflected here. First of all, even if the foreign borrowing of Azerbaijani banks has been relatively modest, it did represent a rapidly growing share of their funding until recently, and many Azerbaijani banks were getting ready to borrow more aggressively from abroad in recent months when tightening credit markets caused them to cancel these plans. For certain banks, therefore, aggressive growth plans have therefore had to be postponed.

The second factor is the strong arm of the government, acting via the National Bank of Azerbaijan (NBA), which regulates the banking sector. Effective 1 July 2007, the NBA introduced new minimum capital requirements on the banks; meanwhile it reportedly has started to enforce its regulations more effectively than in the past. There have also been reports in the local media that banks were informally instructed to reduce their lending in mid-2008. This cannot be confirmed, but it does fit the data.

The most recent reduction of bank lending starting in July 2008 – which is actually not a reduction but just a decrease in the rate of growth – has had a significant impact on the local economy, according to anecdotal evidence. Prices for items frequently bought on credit (first of all, automobiles) have declined considerably in recent months. And after several years of booming credit, the overall impact has been to cool down an Azerbaijani economy that had arguably been in danger of overheating.

Unlike some of its peers, Azerbaijan is not looking at recession or even slow growth: after three years of annual GDP growth in the range of 23 to 30 per cent, Azerbaijan is now seeing growth slow to something closer to 15 per cent annually for 2008 and probably 2009 as well – which will still make it one of the fastest growing economies in the world. This minor slowdown is in fact a positive development in the long run.

Reforms needed

Even if it is surviving the current crisis in reasonably good shape, the Azerbaijani banking sector will continue to be constrained going forward until further reforms are made in the direction of openness and transparency. With minor and insignificant exceptions (for instance, state-affiliated banks from Iran and Pakistan), foreign banks have consistently been denied licenses to operate in Azerbaijan. Several years ago Azerbaijan refused to give Kazakhstan’s BTA Bank a license despite high-level political support from President Nazarbayev, who is a key partner for Azerbaijan. This unwillingness to face competition is negative in the long run.

The ownership of Azerbaijan’s local banks tends to be less than transparent. The largest bank, International Bank of Azerbaijan, with about 35 per cent of total system assets, is owned 50.2 per cent by the state, with the other 49.8 per cent is held by unnamed "other state entities" (11.2 per cent) and unnamed "natural persons" (38.6 per cent). There are long-standing tentative plans to privatise the state share in IBA, but no timetable as yet. The privatization of previously state-owned Kapital Bank, which was carried out in two stages in late 2007 and spring 2008, did not set a particularly good precedent: it led to ownership being divided awkwardly split between four of Azerbaijan’s leading business groups – all of whom have high-level political support – in a deal that reflects a political compromise rather than any commercial factors.

In an August note, we discussed the possibility that Azerbaijan’s largest privately held bank, Bank Standard, might end up changing hands as a result of what we argued was a turn for the worse in the political fortunes of its main shareholder, then Economy Minister Heidar Babayev. Babayev was indeed sacked following the mid-October presidential elections; but even before that, according to our sources, ownership of the bank had been stripped from him and passed to others. To state the obvious, this episode represents not just another negative signal about Azerbaijan’s banking sector, but about its business climate more generally.

Best regards,
Laurent Ruseckas
Director, Eurasia Research
Trusted Sources

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