Republic of Kazakhstan: Staff Report for the 2015 Article IV Consultation
Author: International Monetary Fund. Middle East and Central Asia Dept.
Publication Date:
03 Sep 2015
eISBN:
9781513575247
Language:
English
Keywords:
ISCR; CR; financial condition; government; headline inflation; Kazakh government; oil price; broad money; growth outlook; stimulus package; medium term; Oil prices
Download PDF (10.3 MB)

Context: Over the past two decades, Kazakhstan has successfully harnessed its oil resources to bolster economic growth, increase buffers, and reduce poverty. However, in the face of recent large and likely long-lasting external shocks?lower oil prices, Russia slowdown, and corollary exchange rate (ER) movements (ruble depreciation, dollar appreciation)-growth has decelerated rapidly, financial conditions have tightened, and pressures on the balance of payments and exchange rate have built up. The shocks have also increased financial sector vulnerabilities, where nonperforming loans (NPLs), while declining significantly, remain high, and rising balance sheet risks and tight exchange rate management, have put further drag on banks' lending and economic activity. Nevertheless, more recently, and in response to reduced currency pressures and reduced spreads, the authorities successfully tapped the international capital markets and widened the ER band. Focus of consultation and key recommendations: The consultation focused on calibrating the policy response to address Kazakhstan's near-term challenges and long-term goals of becoming a dynamic emerging market economy. Principally, there is need to (i) identify credible medium-term fiscal consolidation measures to ensure sustainability; (ii) introduce greater exchange rate flexibility to help the economy absorb current and future external shocks; (iii) bolster financial sector resilience to limit adverse spillovers back to the real sector; and (iv) implement structural reforms to ensure durable growth and shared prosperity. Previous consultation: During the 2014 Article IV Consultation, Directors stressed the importance of restoring confidence in the post-devaluation environment and further strengthening the policy frameworks to bolster the economy's resilience to shocks. Specifically, Directors (i) urged appropriate supervisory actions to enforce the NPL ceilings effectively, while ensuring adequate provisions; (ii) highlighted the need to speed up the introduction of a new policy interest rate instrument; (iii) stressed the need to enhance fiscal coverage and integration into a consistent macro-fiscal framework; and (iv) noted the priority of strengthening human capital and institutions, and lowering the role of the state in the economy. Since then, the authorities' resolute efforts on lowering NPLs have begun to pay off, and important early steps have been taken to enhance monetary policy operations, ER flexibility, and communication. Progress in bolstering the fiscal policy framework, however, has been slow. The authorities have also embarked on an ambitious structural reform program and recently completed negotiations to join the WTO within 2015.

Abstract

Context: Over the past two decades, Kazakhstan has successfully harnessed its oil resources to bolster economic growth, increase buffers, and reduce poverty. However, in the face of recent large and likely long-lasting external shocks?lower oil prices, Russia slowdown, and corollary exchange rate (ER) movements (ruble depreciation, dollar appreciation)-growth has decelerated rapidly, financial conditions have tightened, and pressures on the balance of payments and exchange rate have built up. The shocks have also increased financial sector vulnerabilities, where nonperforming loans (NPLs), while declining significantly, remain high, and rising balance sheet risks and tight exchange rate management, have put further drag on banks' lending and economic activity. Nevertheless, more recently, and in response to reduced currency pressures and reduced spreads, the authorities successfully tapped the international capital markets and widened the ER band. Focus of consultation and key recommendations: The consultation focused on calibrating the policy response to address Kazakhstan's near-term challenges and long-term goals of becoming a dynamic emerging market economy. Principally, there is need to (i) identify credible medium-term fiscal consolidation measures to ensure sustainability; (ii) introduce greater exchange rate flexibility to help the economy absorb current and future external shocks; (iii) bolster financial sector resilience to limit adverse spillovers back to the real sector; and (iv) implement structural reforms to ensure durable growth and shared prosperity. Previous consultation: During the 2014 Article IV Consultation, Directors stressed the importance of restoring confidence in the post-devaluation environment and further strengthening the policy frameworks to bolster the economy's resilience to shocks. Specifically, Directors (i) urged appropriate supervisory actions to enforce the NPL ceilings effectively, while ensuring adequate provisions; (ii) highlighted the need to speed up the introduction of a new policy interest rate instrument; (iii) stressed the need to enhance fiscal coverage and integration into a consistent macro-fiscal framework; and (iv) noted the priority of strengthening human capital and institutions, and lowering the role of the state in the economy. Since then, the authorities' resolute efforts on lowering NPLs have begun to pay off, and important early steps have been taken to enhance monetary policy operations, ER flexibility, and communication. Progress in bolstering the fiscal policy framework, however, has been slow. The authorities have also embarked on an ambitious structural reform program and recently completed negotiations to join the WTO within 2015.

Context

1. Like other countries in the region, Kazakhstan was hit in 2014 by large external shocks that are expected to be mostly long lasting. Against the backdrop of these shocks, economic growth has decelerated sharply, financial conditions have tightened, and external imbalances are emerging. While both oil prices and the Russian ruble are off their respective lows reached at end-2014, improvements in sentiment are tempered by the realization that low oil prices and uncertainties surrounding the Russian economy are likely to persist.

2. The authorities’ large stimulus package has helped blunt the initial impact of the shocks, but recovery will likely be gradual. The stimulus package (“Nulrly Zhulu”), which went into effect in 2014 and which involves public investment programs supported by multilateral development banks (MDBs), is partially offsetting the impact of the shocks. The stimulus is enhanced by a structural reform program aimed at improving the business climate and public sector efficiency. However, the extent of the shocks, the appreciation of the tenge in real effective terms, and a weak lending environment could reduce the prospects for quick economic recovery. At the same time, Kazakhstan’s upcoming accession to the World Trade Organization (WTO) could provide a boost to investor confidence.

3. President Nazarbayev won early elections overwhelmingly, and has suggested devolving power to the parliament and the regions. The elections took place on April 26, 2015 (previously scheduled in 2016). The President won reelection with 98 percent of the vote, and has signaled his interest in strengthening the role of parliament in decision making, including speeding up the process of transferring new powers to parliament and, through it, to the prime minister. The “100 steps” reform program announced by the President shortly after his reelection includes a strong emphasis on decentralization and strengthening the rule of law.

Recent Developments

4. Economic growth has decelerated significantly, but remains positive, as a result of the external shocks. GDP growth slowed to an annualized 2 percent during the first quarter of 2015, down from around 4 percent in 2014 and 6 percent in 2013. In addition to weaker external demand, slower growth was driven by the impact of lower income and profitability (resulting from lower oil prices) and confidence effects (reflecting regional developments) on private consumption and domestic investment. Private consumption expanded by 0.5 percent in 2014 (vs. 11.8 percent in 2013), while investment contracted by 3.4 percent (vs. 9 percent growth in 2013). The stimulus package has helped absorb some of the impact on consumption and investment. In the face of slowing demand and limited exchange rate movements, headline inflation fell sharply, from 7.4 percent year-on-year at end-2014 to 3.9 percent at end-June, 2015—well below the authorities’ objective range of 6-8 percent. The recorded unemployment rate remained at 5 percent in 2014.

5. The fiscal stimulus aimed at supporting growth has increased financing needs. The overall fiscal surplus fell from 5 percent of GDP in 2013 to 1.7 percent of GDP in 2014. Among other factors, the decline reflects a 1.8 percent of GDP increase in expenditures and net lending (partly due to the stimulus) and a 0.5 percent of GDP fall in oil revenues. The non-oil fiscal deficit increased from 6.8 percent of GDP in 2013 to 9.6 percent of GDP in 2014, while the stock of government debt increased from 12.9 percent of GDP to 14.5 percent of GDP over the same period. On July 14, 2015, with aim of financing a growing fiscal deficit and in response to reduced spreads in recent months, the authorities issued $4 billion in 10-year and 30-year global bonds. The issuance was well received and oversubscribed, with spreads of 285 bps and 335 bps, respectively, over U.S. treasuries.

6. Monetary conditions have been tight for most of the past year, which have reduced pressures on the exchange rate recently, but, together with lower economic activity, slowed lending sharply. During the second half of 2014, due to rapid depreciation of the ruble, heightened speculation of tenge devaluation, and increased dollarization of bank deposits, domestic money market interest rates rose significantly. Since early 2015, with the use of overnight currency swap and repo instruments, the National Bank (NBK) has managed to stabilize money market rates below 10 percent and dampen pressure on the tenge. As a result, and following the successful global bond issuance, the NBK widened its exchange rate band from 170-188 to 170-198 tenge/dollar, on July 15, 2015. Meanwhile, while Kazakhstan’s sovereign bond spreads have declined somewhat, domestic lending rates remain elevated and overall private sector credit has grinded to a halt, contracting by 3.5 percent year-on-year as of May 2015 (vs. annualized growth of 6 percent in 2014 and 13 percent in 2013). Credit conditions are expected to remain anemic in the short term (Box 1 and Annex I).

7. The external position has weakened largely due to the fall in oil prices. Kazakhstan’s real effective exchange rate has appreciated over the past year, mainly reflecting the depreciation of the ruble and sharp appreciation of the U.S. dollar, against which the tenge is managed. The current account balance turned negative in the second half of 2014, although there has been some improvement in the first quarter of 2015, in part reflecting the recent appreciation in the ruble and the rebound in oil prices. Based on a range of approaches used by staff, the tenge could be considered modestly overvalued by 4-14 percent (Annex II).1 Based on the IMF’s Assessing Reserve Adequacy (ARA) methodology, NBK’s gross reserves (which exclude the national oil fund) remain below the suggested adequacy range of 100-150 percent of the ARA composite metric. At the same time, the oil fund, with an accumulated value of around $75 billion (35 percent of GDP), provides a significant buffer for the economy as a whole.

8. Administrative and prudential measures have succeeded in lowering NPLs significantly, but vulnerabilities in some segments of the financial sector have increased (Box 2 and Annex III). Recent preliminary estimate indicate that NPLs have fallen from 34 percent of total loans a year ago to 10 percent in July 2015 (preliminary data) following the revocation of BTA’s banking license—after the bank absorbed all the bad assets of the merged KKB-BTA entity—and the removal of tax, accounting, and other legal obstacles to write-offs and transfers to special purpose vehicles (SPVs). NPL write-offs lowered the system-wide capital to risk-weighted assets (CAR) marginally, from 18 percent at end-2013 to 17 percent at end-2014, still well above the regulatory minimum of 12 percent. Nevertheless, some vulnerabilities have increased. In particular, deposit dollarization and declining lending activity are impacting banks’ profitability and increasing currency and maturity mismatches. Banks are particularly vulnerable to indirect foreign currency risk, due to the prevalence of lending to unhedged borrowers. Moreover, despite limits on credit concentration, lending mostly takes place in a few non-oil sectors that are currently under stress.

9. Progress has been made in implementing FSAP recommendations (Annex IV). The NBK has started to undertake bottom-up stress tests for banks. The authorities have also revised legislation to exclude the requirement for depositor and creditor approval in P&A and bridge bank resolution. They are initiating discussions with bank supervisors in other jurisdictions to strengthen cross-border supervision. The authorities have also made legislative amendments to implement recommendations in the insurance sector and on pensions, and drafted a law to address regulatory shortcomings in the securities market. Progress, however, has been limited in adopting risk-based assessment tools and extending supervision beyond compliance with prudential norms.

10. The authorities have embarked on an ambitious structural reform program, bolstered by extensive MDB engagement. Public investment under the Nurly Zhulu program aims to address infrastructure bottlenecks and generate jobs. Moreover, following the recent Presidential election, the authorities have launched a wide ranging reform program (“100 steps”) aimed at improving the efficiency of public administration and the rule of law, diversifying the economy, and addressing governance challenges. MDBs’ increased engagement strengthens the structural reform component of the authorities’ crisis response, with projects targeting the labor market, civil service and public expenditure reforms, business climate improvements, and support to small- and medium-sized enterprises (SMEs). In June, 2015, Kazakhstan completed negotiations to become a formal member of the WTO.

Outlook and Risks

11. The growth outlook has weakened, with predominantly downside external risks (Annex V). Staff projects real GDP growth to decelerate to 2 percent this year despite the fiscal stimulus. Weaker demand from Russia and China, lower oil prices, confidence effects, and continuing delays in the Kashagan oil field are the main factors behind the projected slowdown. Next year, growth is projected to pick up to 3.25 percent driven by a gradual recovery in oil prices and output, and improved external demand. Still, the medium-term growth outlook is less favorable than projected last year, in light of lower projected medium-term oil prices and continued slow growth in Russia. Staff now estimates potential growth at around 4.75 percent (vs. previous estimates of 5.5-6 percent). Against this backdrop, staff has also cut its headline inflation forecasts to 5.2 percent this year and 6 percent over the medium term (from 6 percent and 7 percent, respectively). The current account is expected to gradually improve in the coming years, due to a projected increase in oil exports once Kashagan comes on line, but remain in small deficit over the medium term. Downside risks to the growth outlook are mainly external and related to oil prices and regional uncertainty, although the recent improvements in the outlook for oil prices and the Russian economy lessen the tail risks. The authorities’ real GDP growth projection for 2015 is 1.5 percent. For the medium term, the authorities broadly shared staff’s outlook, but viewed the risks as more balanced, including because of the recent stability in oil prices and the Russian ruble.

12. Under an adverse scenario, with further decline in oil prices, anemic growth and larger imbalances could persist over the medium term. In a downside scenario, where oil prices are assumed to decline by 25 percent (permanently)2 relative to staff’s baseline projections, growth rates are expected to remain below potential in the medium term. While the deviation from baseline growth is not large, the adverse cumulative impact on the current account, FX reserves, fiscal balance, and public debt is more severe.

Staff’s baseline vs. alternative scenarios

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Credit Intermediation and Economic Growth in Kazakhstan

Credit market characteristics

Despite occasional bursts of growth, the credit market remains shallow. Financial intermediation has been falling since the 2007/2008 crisis. At 34 percent, Kazakhstan has a low credit to GDP ratio compared to peers.

uA01fig01

Financial disintermediation?

Citation: IMF Staff Country Reports 2015, 241; 10.5089/9781513575247.002.A001

The credit market is narrow with key sectors relying on other sources of financing. Energy and extractives rely primarily on foreign financing. Construction and real estate relied on wholesale foreign funding until it stopped in 2007. Consumer oriented borrowing (households, trade, services) dominates with over 70 percent of outstanding loans. Most businesses are cut-off from bank credit altogether. According to the latest World Bank survey less than 20 percent of firms have a loan or a line of credit.

uA01fig02

Loans by sector January 1, 2014

(Source NBK, Staff estimates)

Citation: IMF Staff Country Reports 2015, 241; 10.5089/9781513575247.002.A001

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Loans by sector January 1, 2015

(Source NBK, Staff estimates)

Citation: IMF Staff Country Reports 2015, 241; 10.5089/9781513575247.002.A001

Given its limited depth and scope, the domestic credit market has had a modest impact on economic activity. Analysis of quarterly credit data since 2004 reveals some correlation between credit growth and non-oil economic activity and no clear causality. The correlation is stronger in the run up to 2007/2008 crisis as the real estate bubble inflated. Given the limited scope of the credit market the main causality chain may run from oil prices through the economy to credit growth. (Annex I).

Recent developments

Credit growth slowed significantly over 2014 and so far in 2015. Overall bank credit to the private sector in May 2015 was lower by 3.5 percent in nominal terms relative to a year ago with a shift from foreign to national currency loans and from corporate to individual borrowers.

The slowdown in credit is exacerbated by high interest rates, tight domestic liquidity, dollarization, and, to a lesser extent, prudential policies on unsecured consumer lending. Weighted average interest rates on tenge loans to corporations jumped from 10 percent at the end of 2013 to 18 percent during 2015Q1. Broad money (M2) shrank by 8 percent in 2014 and a further 2 percent in 2015 mainly due to dollarization of deposits. Dollarization is increasing currency risks (Box 3), further deterring lending. Tight domestic liquidity, high interest rates and dollarization are byproducts of a tightly managed exchange rate in the context of high devaluation expectations. Prudential measures enacted in 2013 to limit the growth of unsecured consumer credit also contributed to the slowdown.

uA01fig04

Debt is concentrated in construction and real estate

Citation: IMF Staff Country Reports 2015, 241; 10.5089/9781513575247.002.A001

uA01fig04a

Probability, conditional on financial variables

Citation: IMF Staff Country Reports 2015, 241; 10.5089/9781513575247.002.A001

The NPL overhang at 24 percent continues to restrict the banks’ ability to extend credit. Trade and services account for the highest share of NPLs (25 percent). The share of NPLs to total credit outstanding remains highest in construction, at almost 40 percent. NPL’s tie up client collateral and bank buffers which dampens credit activity.

The few businesses which have access to domestic credit are highly leveraged. Construction and real estate, which are still working though the fallout from the 2007/2008 crisis, have debt to equity ratios three times the average (chart). Real estate prices have remained stagnant.

Short-term prospects and policies

Staff expects credit to contract by 5.5 percent in nominal terms in 2015 but grow moderately, by 3.7 percent, in 2016. The forecast is broadly consistent with economic developments, taking into consideration the limiting factors described above. The IMF Macro-financial Forecast Consistency Template (Annex I) indicates that projected credit growth is broadly consistent with growth in other relevant variables.

Credit activity is likely to remain concentrated in trade and consumer lending. The prospect of a slowdown in real income growth could threaten these sectors and by extension private consumption.

Despite the weak link between credit and growth, anemic credit could trigger second round effects on economic activity and asset prices, further weakening banks’ balance sheets. Credit is essential for private sector led growth and diversification. The government’s program aimed at extending tenge 500 billion of subsidized loans to SME’s of which Tenge 250 billion have been disbursed so far seeks to mitigate the impact of tight credit on the economy. MDBs, including the ADB, are carrying out similar programs. It is too early to measure the impact of these programs. To reverse the fall in credit and strengthen the link between credit and growth it is necessary to address the key obstacle to growth: tight liquidity, high levels of NPL and lack of access to finance.

Lower Oil Prices and Financial Sector Vulnerabilities

As an oil exporting economy, lower oil prices have a negative impact on Kazakhstan’s financial sector and on economic activity more generally. This box describes the solvency stress test that was performed on Kazakhstan’s banks to assess the impact on bank solvency of two shocks: lower oil prices and exchange rate depreciation. Stress tests on bank balance sheets as of end 2014 (latest available) reveal that the banking system is in a weak position to withstand shocks, particularly severe shocks. In the baseline, before any shocks are applied, three banks have capital adequacy ratios (CAR) below the regulatory minimum of 12 percent. The downside scenario would have the same 3 banks below the regulatory minimum. The severe scenario, however, would bring 17 banks (89 percent of banking system assets) below the regulatory minimum, and recapitalization needs would amount to 3 percent of GDP. The results are subject to the usual uncertainties associated with this type of tests.

The assumptions underlying the stress test are:

  1. In the baseline scenario, estimates of oil prices reflect the WEO baseline, and real GDP growth and the exchange rate are based on staff’s macroeconomic projections. The projections assume further weakening in oil prices from the current $62.8pb to $58.9pb. Real GDP growth moderates from 4.3 percent in 2014, to 2 percent in 2015 and rises to 4.4 percent by 2019. The exchange rate depreciates from 179.2 (tenge/dollar) in 2014 to 185.8 in 2015 and to 188 by 2019 (i.e., within the current tenge/dollar exchange rate band).

  2. In the downside scenario, a 0.5 historical standard deviation on the oil price is assumed. Under this scenario, oil prices fall to $43.2pb in 2015 and $48.6bp in 2016. Real GDP grows by 1.2 percent in 2015 and by 2.7 percent in 2016. The exchange rate is subjected to a 1.5 standard deviation shock, which implies a depreciation to 198 in 2015 and to 200.5 in 2016. The larger standard deviation shock on the exchange rate compared to oil prices mimics the large currency swings during periods of stress.

  3. In the severe scenario, a 1.2 standard deviation from the baseline is assumed. Oil prices fall to $21.3pb in 2015 and $26.7pb in 2017. Real GDP grows by 0.1 percent in 2015 and by 2 percent in 2016. The exchange rate is subjected to a 3.5 standard deviation shock, which puts it at 15.5 percent depreciation from the current level in 2015. It depreciates to 215 in 2015 and to 217 in 2016.

The historical relationship between macroeconomic variables and NPLs is analyzed using a vector autoregression (VAR) model. The variables included in the VAR model are: the ratio of NPLs to total loans (NPL), the percent change in the oil price, Kazakhstan’s real GDP growth, partner countries’ real GDP growth, and the tenge/dollar exchange rate. Unit root and lag length tests were performed and adjustments made accordingly. The model was estimated on quarterly data from 2000 to 2014. The relationship shows that NPLs respond to shocks in macroeconomic variables. NPLs are most sensitive to changes in domestic activity, followed by the exchange rate and oil prices A percentage point increase in real GDP growth results in a 0.318 percentage point decline in NPLs; a percentage point increase in the oil price results in a 0.006 percentage point decline in NPLs; a percentage point increase (depreciation) in the exchange rate results in a 0.047 percentage point increase in NPLs. Single equation estimation shows similar but slightly larger coefficients on the exchange rate and oil prices.

The tests simulated balance sheets and profit/loss accounts for the individual banks given the NPL forecasts upon applying the effects of the shocks. In the simulation, liabilities are held constant. Given that historical balance sheet data are not available to staff, interest margins on current loans and liabilities, as well as net non-interest income are based on 2014 data. Given that estimates of collateral are unreliable, new NPLs are assumed to be provisioned for at 100 percent. This further dents profits. When net income is positive, the test assumes that 80 percent of profits are retained and the rest is paid out as dividends. A bank accumulates capital buffers when its capital ratio declined in the previous year. Capital covers the loss when net income is negative.

The results reveal that a number of banks are unable to withstand higher NPLs due the shocks described above. No adjustments were made on capital to take into account of the phase-out of capital instruments ineligible under Basel III as was done in the FSAP. Even without this adjustment, banks are still highly susceptible, especially in the face of severe shocks. The results are presented in the table below. The downside scenario brings system CAR down to 16 percent while the severe scenario brings it down to 6 percent, well below the regulatory minimum. Banks have low levels of profitability, thus, a low buffer against shocks. An exchange rate only shock of a 15.5 percent depreciation from the current level results in 10 banks being below regulatory CAR, while a 25 percent depreciation results in 17 banks below regulatory CAR. A reverse stress test reveals that an increase in NPLs by 16 percent brings the system wide CAR to the regulatory minimum of 12 percent (assuming a 70 percent level of provisioning). At this level, 6 banks would be below the regulatory minimum. NPLs decline over the projection period reflecting improvements in macroeconomic variable over time.

Stress Test Assumptions and Results

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Policy Discussions

13. Policy discussions centered on the near-term policy response needed to revive the economy and the progress in strengthening policy frameworks. Regarding the short run, staff’s assessment is that (i) the fiscal stimulus is justified on countercyclical grounds, provided credible medium-term consolidation measures are identified; (ii) the tight monetary policy stance, which helped reduce pressure on the exchange rate, may need to be loosened in view of rapidly falling inflationary pressures; (iii) further steps are needed to lower NPLs and bolster financial sector resilience; and (iv) more rapid implementation of structural reforms is needed. As for the longer run, staff highlighted the imperative of further bolstering the macroeconomic policy architecture to help the economy absorb current and future shocks and to ensure durable growth and shared prosperity. The authorities agreed with the staff on the proposed short-term policy response and broadly shared the view on the need to enhance macroeconomic policy frameworks.

A. Fiscal Policy

14. The fiscal stimulus is tailored to support growth. The 3-5 year Economic Support Package introduced last year includes $12 billion (5.8 percent of GDP) spending from the National Fund of the Republic of Kazakhstan (NFRK) and $7 billion (2.9 percent of GDP) in loans contracted from Multinational Development Banks (MDBs) (see table). The package is aimed at modernizing critical infrastructure, promoting SME lending via quasi-fiscal development institutions, and recapitalizing the PLF. While the large stimulus come at the expense of higher current account deficit and lower reserves in the oil fund, staff supported the package, given its’ growth-enhancing, countercyclical, structural, and frontloaded nature. It also urged the authorities to ensure transparency and high quality spending and welcomed the involvement of MDBs in monitoring and selecting the investment projects.

15. The authorities agreed with staff that medium-term fiscal consolidation should be an essential component for the success of the fiscal stimulus. Given the size of the stimulus, a credible medium-term plan, especially on the revenue side, is needed to ensure fiscal sustainability. Assuming unchanged policies, total revenues are expected to decline from 23.8 percent of GDP in 2014 to 19.7 percent of GDP in 2020. The non-oil fiscal deficit is expected to rise sharply this year, to 11.4 percent of GDP (from 9.6 percent of GDP in 2014), and to decline only gradually to 8.7 percent of GDP in 2020, or around 3 percentage points of GDP higher than staff’s estimated sustainable level of 5.5 percent of GDP. To close the projected gap, the authorities have suggested improvements in tax administration and unspecified large cuts in expenditures (equivalent to 5 percentage points of GDP over three years) that are not based on concrete measures. Staff suggested that to maintain a reasonable and credible path for expenditures, and in view of relatively low tax revenue as a share of GDP, the authorities should aim at raising the revenue base through implementing measures such as (i) strengthening the enforcement of tax collection; (ii) reducing tax exemptions; including in the Special Economic Zones; and (iii) making income tax rates more progressive.

Stimulus Packages 2014–2019

(In percentage of GDP)

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16. To support fiscal transparency and ensure medium-term sustainability, staff emphasized the urgent need to further strengthen fiscal accounting and the fiscal policy framework. While important steps have been taken in improving fiscal coverage, more work is needed to bolster the quality of fiscal accounting (Annex VI). Concerns remain regarding the treatment of the oil fund transactions, some revenue and expenditure items, and the definition of the fiscal anchor. Staff underscored the need for bringing fiscal accounts into compliance with the GFS 2001 manual, particularly in the context of the fiscal consolidation strategy. The authorities agreed to consider staff’s recommendations and if necessary request TA in this area.

17. Public debt is expected to rise in the medium term, with increased international borrowing, but overall levels would remain relatively low. To help finance the fiscal deficit, the government has requested a $2 billion Development Policy Loan from the World Bank and $1 billion Countercyclical Support Facility from the Asian Development Bank. In addition to borrowing from MDBs and domestic debt issuance, the authorities noted their plans to tap international capital markets again this year when external market conditions allowed. The first such issuance took place on July 14. The global issuance also aims at helping build a yield curve in the absence of a well-functioning domestic debt market. According to staff’s calculations and assuming unchanged policies, the general government’s external debt is expected to rise from 3.8 percent of GDP at end-2014 to 6.4 percent of GDP by 2020. At the same time, total government debt is projected to increase from 14.5 percent in 2014 to 30.7 percent in 2020 (Annex VII).

B. Monetary and Exchange Rate Policy

18. Tight monetary policy has helped lower inflation, but the authorities concurred with staff that weak output and credit growth require caution about allowing market interest rates to remain too high for long periods. In view of rapidly declining inflationary pressures, subdued output growth, and weak lending conditions, the authorities are carefully evaluating the tradeoffs between the need for a tightening bias to contain the pressure on the currency and the goal of reviving lending and economic activity and stabilizing inflation around its objective range. Staff also urged efforts to avoiding periodic heightened volatility in money market interest rates.

19. The authorities have taken important steps to overhaul the monetary policy framework in support of inflation targeting. These steps include strengthening communication, preparing the grounds for the imminent introduction of new policy interest rate instruments, and enhancing governance. In particular, the recently published monetary policy guidelines for 2015 and 2020 stress the planned introduction of a new policy interest rate, supported by open market operations, during the early phase of the transition to inflation targeting, which the authorities see adopting within 3-5 years. The NBK has also recognized the need to strengthen its governance structure, including by setting up a monetary policy committee (MPC) and achieving greater central bank independence in policy decision making. Moreover, the NBK plans to establish a money market committee responsible for the implementation of monetary policy, including the daily assessment of banking sector liquidity conditions and interbank market developments. Staff noted that modernizing the monetary policy framework will also help the recently announced plans to develop Astana as an international financial center.

20. Staff has stressed the need to gradually introduce greater exchange rate flexibility in tandem with improving monetary policy instruments, while avoiding a step-devaluation. Staff emphasized that greater exchange rate flexibility would (i) support a more independent interest rate policy; and (ii) help reduce imbalances. Staff supported the NBK’s opposition to another outright step-devaluation, given that previous episodes resulted in increased dollarization, re-fixing the exchange rate, and further expectation of devaluation. A large devaluation would also put immediate stress on private-sector balance sheets of unhedged FX borrowers (Box 3). In contrast, a gradual adjustment would give banks more time to address balance-sheet vulnerabilities, while correcting the exchange rate misalignment over time. In view of this, staff considered that greater flexibility could initially be introduced by gradually widening the exchange rate band, with the aim of removing it altogether when conditions allow.

21. The authorities agreed that greater flexibility would support the reform efforts underway and alleviate imbalances. In light of this, and given reduced pressures on the tenge in recent months, on July 15 the NBK widened its exchange rate band from 170-188 to 170-198 tenge/dollar. To ensure stability, the authorities also agreed to communicate their plans consistently and credibly and continue to strengthen monetary policy instruments.

C. Financial Policies

22. Staff and the authorities broadly concurred on the need to bolster financial sector resilience. Staff noted the progress made in halting the surge in uncollateralized consumer loans seen in recent years. However, three banks have capital below the regulatory minimum and banks’ balance sheets appear to be highly sensitive to shocks. Supervision should be strengthened and corrective actions be taken for the undercapitalized banks to bring their capital above the regulatory minimum. Furthermore, staff urged the authorities to shore up system strength by developing plans to bring capital up to shock resilient levels and improve governance and risk management to help reduce risks. There was agreement that exchange rate risk remains a concern for the banking system, especially given corporate sector exposure. Further, credit concentration remains high. Staff recommended introducing higher risk weights or exposure caps on corporate lending; reducing (or prohibiting) FX lending to unhedged borrowers; and tightening net open position (NOP) limits to mitigate exchange rate risk (Box 3 and Annex VIII). The authorities are considering raising risk weights on loans denominated in foreign currency to help reduce banks’ exposure to indirect foreign currency risk. However, they consider the current limit on the NOP to be sufficient in minimizing on-balance sheet currency mismatches and do not see the need to limit or prohibit lending to unhedged borrowers as this, in their view, will curtail lending. Staff shared the concern about the need to avoid undermining an already weak lending environment but stressed the consequences of excessive lending to unhedged borrowers. Staff also urged the authorities to enhance the quality of data on corporate and household balance sheets to allow for a more informed assessment of balance-sheet vulnerabilities. The authorities agreed to further assess vulnerabilities and argued that they are monitoring bank soundness.

23. There was agreement that further reduction of NPLs, especially of the newly merged KKB-BTA entity, is a necessary condition to improving banking sector soundness. Staff welcomed the efforts underway to reduce the level of system NPLs, including the efforts to achieve the 10 percent ceiling by end-2015. But it expressed concern that NPL provisioning may be overstated because it relies on underlying loan collateral that is overstated—mainly real estate that has not yet recovered from the 2009 bubble bust—and is not regularly revalued. Staff also welcomed the refocus of NPL resolution at the merged KKB-BTA entity, which accounts for 70 percent of the universe of NPLs and about 25 percent of banking system assets. In this regard, staff advised that the authorities develop a broad strategy to address the factors that resulted in weaknesses in these banks, including conducting an asset quality review (AQR) of the merged bank. The strategy should address the restructuring of the bank to ensure long-term viability and how any capital needs identified by the AQR will be addressed. Regulatory and supervisory standards should also be improved, and consideration should be given to sequencing of reforms with the AQR, and the specific standards against which the banks will be assessed.

24. Staff welcomed progress made in implementing FSAP recommendations. It urged for further progress in adopting risk-based assessment tools and supervision, which remains oriented toward compliance. The NBK prefers to maintain the current supervisory approach for the time being. The authorities plan to continue making progress toward finalizing legislative amendments in insurance, pensions, and the securities market.

Macroprudential Policies in Kazakhstan

Reducing exchange rate risk: Exchange rate risk remains one of the largest risks for the banking sector. FX risks are especially elevated in the corporate sector—the largest borrowers from the banking system—where leverage and the net open FX position to equity are very high. This sector has also experienced a significant slowdown in activity and is associated with already high NPLs to the banking system. To help limit risks emanating from high exposure to the corporate sector, the NBK should consider introducing risk weights or exposure caps for corporate exposures. This will help the banking system withstand corporate credit losses by building capital buffers (see IMF Staff Guidance on Macroprudential Policy). Risk weights can help build buffers by affecting the supply of credit indirectly while FX exposure caps curtail the supply of credit directly. Reducing FX lending to borrowers whose earnings are not in FX should also be considered. This can be done through higher risk weights on such exposures. Tighter net open position limits are recommended to help reduce exchange rate risk.

Reducing credit risk: Even with concentration limits, credit concentration remains a significant risk to financial stability. Though concentrated large exposures have fallen from levels during the global financial crisis, at 208 percent of capital, they remain large. In 2014, the construction sector received the largest share of new corporate sector credit (24 percent) while it also had the largest share of new NPLs (41 percent, rising from 15 percent the previous year). The NBK should restrict bank exposures to single counterparties or groups of connected counterparties.

Proper implementation and enforcement of macroprudential tools is critical. Inconsistent implementation of macroprudential measures, as has been in the past, could add to regulatory uncertainty and result in ineffective incentive structures and a loss in confidence in the domestic financial system.

D. Structural Reforms

25. The authorities recognized that the recent shocks to the economy reinforce the urgency of implementing structural reforms, to ensure durable long-term growth and shared prosperity. Diversification away from the extractive industry and the reduction of the state footprint in the economy are necessary to sustain improvements in public welfare and to help create jobs for the growing population. Addressing infrastructure bottlenecks, strengthening human capital, building institutions, bolstering the rule of law, enhancing financial intermediation, and improving business climate have been identified by both the authorities and development partners as key areas where further improvements are essential to achieve broad and inclusive growth. The authorities’ approach of working with MDB’s to implement public spending and structural reforms should ensure greater efficiency and focus on priority areas. Staff also noted that additional efforts were needed to reverse the slowdown in key social indicators and protect the most vulnerable from the impact of the economic slowdown. Despite the authorities’ declared commitment to ring fence social spending, budget cuts aimed at creating space for capital spending are adversely affecting key social programs (Annex IX).

26. The public investment and reform program offers an opportunity to balance the short-term need for countercyclical state intervention and the long term goal of private sector-led growth. Staff stressed that public investment should focus on areas beyond the reach of the private sector without expanding the state’s footprint in the economy. Moreover, staff noted that reforms aimed at improving the business climate should include easing liquidity constraints and improving access to finance. The authorities’ focus on large scale infrastructure projects and the SME subsidized loan program helps in this regard.

Staff Appraisal

27. Amid slower economic growth, tighter financial conditions, and emerging imbalances, policies should balance ensuring sustainability while alleviating the impact of shocks in the near term. In recent years the authorities have successfully harnessed oil resources to bolster economic growth and build buffers. However, economic growth has now decelerated largely as a result of likely long-lasting external shocks and is expected to remain subdued this year and next year. Moreover, the outlook for growth is subject to predominantly downside external risks. In view of weaker growth, the large and likely long-lasting nature of the shocks, and the accumulated buffers, the policy response in the short term should be geared toward supporting the economic recovery. Over the medium term, there is a need to further strengthen macroeconomic policy frameworks, to bolster resilience to shocks and promote durable growth.

28. To ensure fiscal sustainability, the stimulus must be accompanied by credible medium-term fiscal consolidation and more transparent fiscal policy framework. The stimulus is justified on countercyclical grounds and is appropriately frontloaded and tailored to support growth. However, to ensure a sustainable path for the non-oil deficit, the stimulus must be accompanied by credible medium-term consolidation measures, especially on the revenue side. In particular, there is scope to strengthen the enforcement of tax collection, reduce tax exemptions, including in the Special Economic Zones, and make income tax rates more progressive. Moreover, enhancing the fiscal policy framework is critical to ensuring transparency and medium-term sustainability. Key priorities include expanding the budget coverage to all fiscal activity, in line with GFSM 2001, and integrating fiscal policy into a broader macroeconomic policy framework.

29. Greater exchange rate flexibility in tandem with the introduction of new monetary policy instruments is needed to enhance the policy architecture and address imbalances. The authorities have taken confidence-building measures to overhaul the monetary policy framework in support of their medium-term goal of adopting inflation targeting, and have widened the exchange rate band. However, with the aim of more effectively managing liquidity and signaling the stance of policy, the authorities should speed up the planned introduction of a new policy interest rate, supported by open market operations. Moreover, strengthening the policy architecture requires further exchange rate flexibility, which will support a more independent interest rate policy and help reduce imbalances. To avoid undermining financial stability, and anchor expectations about policy intentions and operations, the authorities should communicate their plans openly and consistently.

30. In view of rising vulnerabilities, further actions are needed to bolster financial sector resilience. Efforts underway to reduce the level of NPLs are paying off. However, more needs to be done to bring down the level of NPLs to sustainable levels, while ensuring that the achievement of the 10 percent prudential ceiling by end-2015 does not compromise proper loan classification and provisioning. In this regard, while the recent plans to refocus the NPL resolution framework at the merged KKB-BTA entity is appropriate, weaknesses in the bank should be addressed and an asset quality review be undertaken within a broad strategy to ensure long-term viability. Strengthening financial sector resilience also requires introducing higher risk weights or exposure caps on corporate lending, limiting FX lending to unhedged borrowers, and tightening net open position limits to mitigate credit risk. Further steps in implementing the FSAP recommendations include adopting risk-based assessment tools and supervision and finalizing legislative amendments in insurance, pensions, and the securities market.

31. The structural reform agenda is appropriately ambitious, but effective implementation is essential to achieving sustainable and inclusive growth. Priority areas include strengthening human capital, building institutions, bolstering the rule of law, enhancing financial intermediation, and improving the business climate. Close collaboration with MDBs in these areas should facilitate greater efficiency in the procurement and implementation process. Moreover, diversification away from the oil sector and the reduction of the state footprint in the economy are necessary conditions to ensuring successful implementation of the broader private-sector-led growth strategy.

32. It is proposed that the next Article IV consultation take place on the standard 12-month cycle.

Figure 1.
Figure 1.

Kazakhstan: Economic Developments

Citation: IMF Staff Country Reports 2015, 241; 10.5089/9781513575247.002.A001

Sources: Kazakhstani authorities and IMF staff estimates.
Figure 2.
Figure 2.

Kazakhstan: Banking Sector Developments1/

Citation: IMF Staff Country Reports 2015, 241; 10.5089/9781513575247.002.A001

Sources: Kazakhstani authorities, GFSR, and IMF staff estimates.1/Authorities did not provide systemwide CAR data during BTA’s second debt restructuring, hence the gap in the CAR graph.2/Accounting for exchange rate valuation effects.
Figure 3.
Figure 3.

Kazakhstan: Key Financial Soundness Indicators, Cross-Country Comparison

Citation: IMF Staff Country Reports 2015, 241; 10.5089/9781513575247.002.A001

Sources: IMF FSI database and World Economic Outlook.
Figure 4.
Figure 4.

Kazakhstan: Capital Markets and Expected Default

Citation: IMF Staff Country Reports 2015, 241; 10.5089/9781513575247.002.A001

Source: Bloomberg.
Figure 5.
Figure 5.

Kazakhstan: Monetary and External Sector Developments

Citation: IMF Staff Country Reports 2015, 241; 10.5089/9781513575247.002.A001

Sources: Kazakhstani authorities, Bloomberg, and IMF staff estimates.
Figure 6.
Figure 6.

Kazakhstan: Fiscal Sector Developments and Outlook

Citation: IMF Staff Country Reports 2015, 241; 10.5089/9781513575247.002.A001

Sources: Kazakhstani authorities and IMF staff estimates.
Figure 7.
Figure 7.

Kazakhstan: Business Environment and Governance Indicators

Citation: IMF Staff Country Reports 2015, 241; 10.5089/9781513575247.002.A001

Table 1.

Kazakhstan: Selected Economic Indicators, 2012–20

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Sources: Kazakhstani authorities and Fund staff estimates and projections.

The base year for real GDP calculations has been changed from 1994 in previous Fund documents to 2007.

Private sector includes nonbank financial institutions, public and private nonfinancial institutions, nonprofit institutions, and households.

Does not include NFRK.

Gross debt, including arrears and other short-term debt.

Based on a conversion factor of 7.6 barrels of oil per ton.

Table 2.

Kazakhstan: Balance of Payments, 2012–20

(In billions of U.S. dollars, unless otherwise indicated)

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Sources: Kazakhstani authorities and Fund staff estimates and projections.

Estimates and projections are based on GDP at market exchange rates.

The number reflects months of same year’s imports of g&n.f.s. in 2019.

Table 3.

Kazakhstan: Financial Soundness Indicators of the Banking Sector, 2008–141/

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Source: NBK.

Data include BTA unless otherwise indicated.

Core and encouraged set of indicators. Indicates available aggregate data for all banks.

Excluding BTA and credit cards.

Table 4.

Kazakhstan: Monetary Accounts, 2010–14

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Sources: Kazakhstani authorities and Fund staff estimates.

Private sector includes nonbank financial institutions, public and private nonfinancial institutons, non-profit institutions, and households.

Does not include oil fund resources.

Commercial banks only.

Table 5.

Kazakhstan: General Government Fiscal Operations, 2012–20

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Sources: Kazakhstani authorities and Fund staff estimates and projections.

Includes staff’s estimates of the announced lending package from the NFKR for the period 2014-16.

National Fund of the Republic of Kazakhstan. (-) is accumulator in the Fund.

General government, including republican and local budgets.