Kazakhstan’s banks have been considered one of the country’s major successes, but are currently facing serious difficulties. Foreign loans have to be repaid, but bank assets are tied up in loans with longer maturities.  The government has begun to help the banks, but at the cost of fuelling inflation.  Further help could come from pension funds or the national oil fund, if restrictions on their investments were revised.  Will banks face a liquidity or a solvency crisis? If the former, then resources are available to resolve it albeit with some costs, but if the latter, then the country faces a serious challenge to its financial stability.

BACKGROUND:  Over the last decade, Kazakhstan’s economy has been the success story of Central Asia, with the Snow Leopard achieving East Asian Tiger growth rates.  The boom started in 1999 as a rebound from the Russian Crisis, driven by a large devaluation, and has been sustained in the twenty-first century by the oil boom.  Many observers have also credited the government with implementing economic reforms in the 1990s that have borne fruit in the 2000s, and with continuing the reform program.  Among the jewels of the market-driven economy have been the banks, sometimes claimed to be the most efficient in the CIS, and expanding first into the Kyrgyz Republic, where over 70 percent of the assets of the banking sector are Kazakh-owned, and more recently into Tajikistan.

The resilience of Kazakhstan’s banking sector is being tested in 2008 by a major challenge, which in the gloom-ridden international financial setting could turn into a crisis.  Integration into global markets offers large benefits but also brings risks, of which one is the increased volatility associated with liberalized financial sectors having access to global capital markets.  The problems arose because banks borrowed in international markets at shorter maturities to those on their loan portfolios.  In important aspects, the situation resembles that underlying previous crises, such as the 1997 Thai crisis when Bangkok, like Almaty and Astana in the mid-2000s, experienced a real estate boom.  The banks lent to borrowers eager not to miss out in the property market.

After the devaluation, the central bank reverted in May 1999 to a de facto exchange-rate anchor. Although there had been fluctuations, the exchange rate in February 2006 was 130 tenge to the dollar, the same as at the end of May 1999, despite strong pressures for currency appreciation.  With the expectation that there was little exchange rate risk, banks could make profits by borrowing in international markets at lower interest rates than they could charge eager borrowers at home.  By 2006 Kazakhstan’s banks were raising large amounts of capital abroad, where the cost of capital was less than the double-digit interest rates that they could charge borrowers at home.  In the first half of 2007 medium- and long-term debt-creating capital inflows more than doubled, largely due to external borrowing by the banking sector.

However, the economy had since 2003 been exhibiting signs of overheating due to demand pressure from large FDI-financed oil investments, fiscal and public sector expansion, and a credit-fuelled private boom.  The central bank accumulated foreign exchange reserves, including oil fund assets, amounting to over twelve months of imports by the end of 2006, implying pressure for exchange rate appreciation.  A move away from de facto exchange rate targeting began in the first half of 2006 and the dollar exchange rate was allowed to appreciate, reaching 120 tenge to the dollar in January 2008, but the net effect is unclear; between January 2006 and January 2008 the tenge depreciated against the euro (from 161 to 188), and to a lesser extent against the ruble (from 4.7 to 4.9).

Signs of stress in the financial sector emerged in 2007 when banks started to compete in making deposits more attractive.  At the same time they substantially increased the interest rates on loans, which by the start of 2008 had reached about 20 percent, double the rates of two years earlier.  In November 2007, the government provided support of around $4 billion, targeted at construction projects in danger of being abandoned half-finished, and the central bank raised the official refinancing rate, which had been unchanged at 9 percent since July 2006, to 11 percent.  The full amount owed by Kazakhstan’s banks to foreign creditors is unclear; according to the Financial Times, in October 2007 Kazakh banks' international borrowings totalled $40 billion, and conservative estimates put the banks’ foreign debt due in 2008 at around $12 billion.  International rating agencies began to downgrade their creditworthiness in late 2007.  Standard and Poor’s downgraded Kazakhstan’s sovereign debt to BBB-.

IMPLICATIONS: Among the consequences of the financial sector’s problems have been an acceleration of inflation, which had been fairly stable around 7 percent in 2000-5 rising to 9 percent in 2006.  Official year to December 2007 change in the consumer price index was 18 percent, but many consumers believe this is an understatement.  Particularly visible in 2007 were the doubling of bread prices and the over 50 percent increase in average house prices in Almaty, but the former was related to world wheat prices and the latter was a symptom of the asset bubble, not a consequence.  Nevertheless, the government pumped $4 billion into the economy in November, and the issue is not whether that was inflationary but by how much.

An indirect consequence is the increased pressure to accept higher tariffs on utilities.  Energy generators, for example, need continuous borrowing to upgrade facilities, but with higher interest rates they need to have tariff structures that reflect their costs.  As with the higher inflation, higher utility prices will undermine poverty alleviation efforts.

There could be external consequences.  Kazakhstan’s government has aimed at establishing Almaty as a regional financial center, and has encouraged cross-border expansion by the country’s banks.  Kazakhstan has also become home country to direct foreign investment in, for example, Georgia.  The most exposed country is the Kyrgyz Republic, whose financial sector is dominated by subsidiaries of Kazakh banks and whose economy is most closely tied to demand in Kazakhstan, but the Kyrgyz banking authorities appear to have maintained a higher level of prudential regulation since the 1998 banking crisis, when several Kyrgyz banks went under.

Kazakhstan’s banks, and the government, still have cards to play.  Some banks are looking for a white knight to help resolve the liquidity crisis or to take an equity stake.  The first substantial foreign investment in the banking sector was in November 2007 when the Italian bank UniCredit paid $2.1 billion for a 91.8 percent stake in ATF Bank, Kazakhstan’s fifth largest bank.

Potential domestic sources of financing include the pension funds, the oil fund and the central bank’s foreign reserves.  The pension funds have accumulated some $20 billion since the introduction of individual accounts in Kazakhstan’s 1997 pension reform.  At present these funds are not allowed to have more than 20 percent of their assets in any one company, but there is pressure to raise the ceiling to 30 percent so that the funds can take a larger stake in individual banks.  The National Oil Fund also has assets in excess of what is needed to resolve the banks’ problems; it accumulated over $20 billion between its foundation in 2001 and the end of 2007.  However, even more than with the pension funds, the oil fund is supposed to invest for the future, mainly taking foreign equity positions, and was not designed to bail-out companies in trouble.  Despite rising oil production and prices, Kazakhstan’s official reserves fell by over a fifth during 2007, from $23 to $18 billion, and these may have been used to assist the banks’ foreign obligations.

CONCLUSIONS: As with many incipient financial crises, the ultimate question is whether the banks have a liquidity or a solvency problem.  If it is a liquidity problem, sufficient options are available to avoid a crisis, perhaps at the cost of an inflation spike if the government becomes too involved in providing liquidity.  Depending on the solutions adopted, other potential costs include undermining of the integrity of pension funds or the oil fund.  On the other hand, a brief liquidity crisis which imposed some costs on banks would be a positive reminder that they had lacked sufficient prudence in lending to fuel a property boom; that should result in a healthier banking sector in the long-run.

If, however, too many of the banks’ loans become non-performing and the banks face a solvency crisis, then the outlook is bleaker.  That outcome most likely depends upon exogenous factors, above all the price of oil, which will determine the extent to which Kazakhstan’s high growth can continue despite blips.  With high growth the many building projects in Astana and Almaty, both commercial and residential, will find tenants; the banks’ loans based on optimistic projections will be repaid and the banks will be profitable, with cash to lend for future investment.  Without high growth many borrowers will be unable to meet their payments; the banks will foreclose on assets of diminishing value, and that will be a financial crisis.

AUTHOR’S BIO: Richard Pomfret is Professor of Economics at the University of Adelaide in Australia and Visiting Professor in International Economics at the Johns Hopkins University-SAIS Bologna Center in Italy.  His most recent book is The Central Asian Economies since Independence (Princeton University Press, 2006).