Oil in the CIS: Economic and Sovereign Rating Implications
Special Report of Fitch Ratings Agency*
*Fitch Ratings Ltd. grants the permission to publication of this report in our magazine.
The Commonwealth of Independent States (CIS) is ? major player in world energy markets, accounting for an estimated 13%-14% of global oil supply and around 28% of natural gas production. Russia is the world's second-largest oil exporter, after Saudi Arabia, and the world's largest gas exporter. Other countries in the region are also becoming more important: the discovery of the Kashagan oil field in Kazakhstan in 2000 was one of the largest oil discoveries for several decades. This Special Report aims to explore the importance of the oil and gas sectors in Russia, Kazakhstan and Azerbaijan — the three key CIS oil and gas producers that have ? Fitch sovereign rating. It will look at the contribution that each makes to their respective economies, as well as the economic and policy challenges that ? large hydrocarbons sector creates. Finally, it will outline the relevant sovereign rating implications of such ? significant endowment of natural resources.
How Important is Oil and Gas?
Russia, Kazakhstan and Azerbaijan are the three largest oil producers in the CIS and account for roughly 95% of the region's oil production. Russia also accounts for over 80% of its natural gas production.1 Almost all CIS energy exports go to Europe. US Energy Information Administration (EIA) data show that Western Europe accounted for over 60% of CIS oil exports in 2003, while Central and Eastern European countries (excluding Turkey) imported ? further 25% of CIS exports. Less than 4% of oil exports went to the US and only 2% of CIS oil exports went to China.
1. Most other oil and gas output in the CIS is produced by Turkmenistan and Uzbekistan
Unsurprisingly, oil and gas dominate the economies of all three CIS producers mentioned above. Indeed, research by the World Bank and the IMF suggest that the hydrocarbon sector accounts directly for 25% of GDP in both Russia and Kazakhstan and roughly 35% in Azerbaijan. Including sectors that are indirectly linked to the hydrocarbons industry, oil and gas may actually be responsible for around 30% of Russian GDP, 30%-40% of the economy in Kazakhstan and more than 45% in Azerbaijan. As the table illustrates above, oil and gas earnings also account for more than half of all merchandise goods export earnings and ? significant share of general government fiscal revenues.
This dominance by the hydrocarbons sector is likely to continue for some time. Production has been rising in all three countries and major development projects are set to boost output significantly in Kazakhstan and Azerbaijan over the next 5-10 years. While there is evidence that GDP growth in both Russia and Kazakhstan has become more broadly based recently, albeit helped by the circulation of oil revenues, strong growth in the oil and gas sector has caused its importance to rise. In addition, the trend in fiscal policies has been to increase the tax burden on natural resources.
RESERVS, OUTPUT AND PIPELINES
Reserves are Vast...
Russia, Kazakhstan and Azerbaijan all have significant oil and gas reserves. Russia's resource endowment is largest with proven oil reserves of 69bn barrels.2 Most of these are located in Western Siberia, though there are also sizeable reserves on Sakhalin Island in the far east of the country. Output has risen sharply in recent years, from ? post- independence low of around 6m barrels per day (bpd) in 1996 to 9.3m bpd in 2004.
2. BP Statistical Review of World Energy, June 2004.
However, while most observers agree that Russian oil output will continue to rise slightly in the near term, the longer-term outlook is less clear. Production levels at existing fields have been boosted by the use of new techniques, but uncertainty over property rights following the Yukos affair and new initiatives to limit foreign investor involvement in the sector may slow future exploration and development projects. Nonetheless, even given these uncertainties, it is clear that Russia will remain ? key player in the global oil markets for the foreseeable future.
Russia also holds the world's largest natural gas reserves which, at 1,680 trillion cubic feet (tcf), amount to morethan one-quarter of the global total and are almost twice the size of the next largest reserves (held by Iran). Even so, its gas industry has not been as successful as the oil industry. Indeed, natural gas production has been relatively flat since independence owing to ageing fields, state regulation, export pipeline capacity constraints and Gazprom's monopolistic role in the sector. The bulk of Russia's gas output comes from three fields in Western Siberia — Urengoy, Yamburg and Medvezhye — that are now in decline and most industry experts are not expecting much, if any, output growth in the next five years.
Kazakhstan's natural resource endowment is smaller by conventional measures, but it is still significant. Indeed, on ? per capita? far greater oil endowment than Russia, though its gas endowment is lower. Proven oil reserves are currently estimated by the US Department of Energy at 9bn-18bn barrels, but the market consensus of proven plus probable reserves (based on existing recovery technology and development plans) is higher at around 30bn barrels. On the basis of current production estimates, this would allow the country to produce and export for 30-40 years. basis, Kazakhstan has
However, this picture many underplay Kazakhstan's full oil potential since exploration work in many parts of the Caspian is in the early stages and further discoveries are possible. In addition, in view of the challenging environment, estimated recovery rates are currently quite low and could be boosted considerably by advances in technology. In fact, taking into account the likely discovery of new fields and enhanced recovery rates, it is thought that Kazakhstan's potential oil reserves could reach 50bn-60bn barrels.3 Output is currently running at ? little over 1m bpd, but by 2020 it is expected to have reached 3.5m-4mbpd, on ? par with current levels in Iran and Mexico and placing Kazakhstan comfortably within the world's top 10 oil exporters.
3. Republic of Kazakhstan: Selected Issues, IMF, November 2004.
Proven gas reserves are also large at 65tcf to 70tcf, placing Kazakhstan in the top 20 countries in the world. The large Karachaganak field alone holds 16tcf to 20tcf. Most of Kazakhstan's natural gas is associated gas, meaning that it is ? by-product of oil extraction and, as such, it is likely to rise sharply as oil output increases. Reserves are estimated to last more than 40 years.
Azerbaijan's oil and gas reserves are much smaller than those of Russia and Kazakhstan but, again, compare well if measured on ? per capitabasis. Total proven oil reserves in Azerbaijan are reported to be 7bn barrels and the bulk are located in the Azeri-Chirag-Guneshli (ACG) fields.4 Technological advances could boost this total further, but hopes of additional large oil finds have fallen following disappointing exploration efforts. Annual output is currently just ? little over 320,000 bpd, but major projects now under way are set to boost production to 1mbpd by 2010. On the basis of current production plans, Azerbaijan's proven reserves would be sufficient for roughly 20 years of output and the oil sector will be in secular decline by 2025.
4. BP Statistical Review of Energy, June 2004
Azerbaijan is also home to the Shah Deniz field, one of the largest natural gas discoveries of the last two decades. Although Azerbaijan has been ? natural gas importer for many years, it has proven gas reserves of 50tcf, and actual reserves could be far higher.5 These resources are now in the process of being exploited and gas from the Shah Deniz field is expected to begin coming to market in 2006. Once the necessary infrastructure is in place, Azerbaijan's annual production is expected to increase from around 200bn cubic feet (bcf) to 500bcf, of which almost half should be available for export.
5. BP Statistical Review of Energy, June 2004
...but Exploitation in Azerbaijan and Kazakhstan is Dependent on FDI...
However, as has been demonstrated on numerous occasions, ? natural resource endowment is of little benefit unless it ??n be exploited. In the case of both Azerbaijan and Kazakhstan, this is dependent on vast inflows of foreign direct investment (FDI) as the domestic financial resources of both countries are limited. Inflows into the hydrocarbons sector in Kazakhstan, for example, are now running at $3bn-$4bn per year and Fitch expects them to remain solid for the foreseeable future. In Azerbaijan, gross cumulative FDI inflows for 1997-2004 totalled an estimated $9bn.
In contrast, as Russia's oil sector was already well developed at the time of the Soviet Union's collapse, the need for foreign investment in the sector was far lower. In fact, although ? recent decision to limit foreign involvement in natural resource projects to minority stakes has attracted significant attention, in reality, foreign involvement in the hydrocarbons sector has always been far morelimited than in Azerbaijan and Kazakhstan.
...and Reliant on Better Export Capacity
In addition to securing the necessary finances to tap the existing oil and gas reserves, the long-run success of the hydrocarbons sector in all three economies hinges on the development of further export capacity. The challenge is particularly pressing for Azerbaijan and Kazakhstan owing to the expected sharp rise in oil and gas exports from both countries over the medium term.
Russian crude exports are the responsibility of the state-owned pipeline monopoly Transneft. The pipeline system is extensive but, owing to bottlenecks, only around three-fifths of Russian oil (mostly crude oil) is exported via its pipelines. The remainder is transported by ship and rail, including all crude oil exports to China. However, this is more expensive than transporting oil by pipeline and could become less viable if prices fell sharply.
In view of this, the government, along with Transneft, has started to look at how to improve the existing pipeline infrastructure, but most projects remain in the early stages. These include expanding the capacity of the major Druzhba Pipeline that links Russia to Central Europe and Germany and further expansion of connections to the Baltic Sea. In late 2004 President Putin also confirmed that the government would build the much-debated Far Eastern Oil Pipeline, which will link the Russian city of Angarsk to Nakhodka near the Sea of Japan and provide an export route to Asia. Although this option was chosen over an alternative to build ? cheaper pipeline to China, links to the rapidly growing Chinese market are still under discussion. In ? similar vein, Gazprom is exploring several options to improve gas export capacity, including the North Trans-Gas Pipeline, which would provide ? direct link to Finland, the UK, Sweden and Germany.
Azerbaijan currently exports oil via the Northern Export Route, terminating at Novorossiysk on the Russian Black Sea; and the Western route, which runs through Georgia to Supsa (also on the Black Sea). However, ? major new pipeline — the Baku-Tbilisi-Ceyhan (???) pipeline — which will link Azerbaijan to Turkey and the Mediterranean is currently being built by BP to ensure that sufficient capacity exists to handle the expected rise in oil exports in 2005-10. The pipeline, which is due to be completed in the coming year, will have an initial peak capacity of 1mbpd, but this could be boosted to 1.7m bpd with the use of flow enhancers and additional pumping stations. ? further pipeline undertaken by the Shah Deniz gas consortium will complement the ??? infrastructure. It will follow the same route until it reaches Turkey, but will terminate at Erzarum and will ensure that gas exports also reach the Turkish market.
In view of its location as ? landlocked country in ? volatile neighbourhood some 1,500km away from world oil markets, market access and transport costs are especially serious for Kazakhstan. Oil exports are currently transported north via both ? pipeline from Atyrau to Samara in Russia, which forms part of the Transnefl pipeline system, and the Russian rail system; west through both the 980-mile long Caspian Pipeline Consortium (CPC) pipeline, which links local fields to Novorossiysk, and by barge to Azerbaijan; and south via swap agreements with Iran.
Including rail usage, export capacity constraints are not currently binding. However, with oil output rising steadily, and expected to step-up significantly when the Kashagan field starts to comeon stream in 2008, it is clear that further pipeline capacity will be needed over the longer term if Kazakhstan is not to run into export capacity constraints. Various steps are in hand to address this challenge:
· Work is under way to boost capacity in both the CPC and the Atyrau-Samara pipelines, to 1.4m bpd and 0.5m bpd respectively.
· ? new pipeline is currently under construction in ??-operation with the China National Petroleum Corporation that will link west Kazakhstan, to China's Xinjiang region. It is due to be completed in 2005 and will have an initial capacity of 0.4m bpd, rising to 0.6m bpd.
· Talks are also ongoing regarding the use of spare capacity within the ??? pipeline. However, in view of the scale of oil flows involved, this project would probably necessitate the construction of ? new pipeline under the Caspian Sea to link into this network.
Completion of these projects should boost medium-term oil capacity significantly, but will not eliminate the need to export by rail and barge as well. However, the construction of further pipelines to China remains ? possibility and Kazakhstan may also be able to increase swap agreements with Iran from the current 30,000 bpd. In addition, President Nazarbayev has suggested that ? pipeline through Iran to the Gulf be considered, though this idea is in the early stages.
These projects will also help to diversify the pipeline network away from Russia. However, while this limits dependency risk, Kazakhstan's location in such ? difficult neighbourhood suggests that pipeline security will remain ? key issue. In addition, its ability to depend on Iran for oil exports could be constrained by that country's relations with the rest of the world.
With regard to natural gas, Kazakhstan serves as ? transit route for exports from Turkmenistan and Uzbekistan to Russia and beyond. It is developing the ability to export its own output via the Russian natural gas pipeline system though, since it will be ? competitor with Russia, it has recognised that alternative gas pipelines and export routes should also be investigated.
IMPLICATION FOR THE ECONOMY
With Kazakhstan and Azerbaijan on the verge of ? sharp take-off in oil and gas production and earnings, and Russia still benefiting from more modest increases in output and continuing high global oil prices, the near-term economic outlook appears fairly bright for all three countries. However, easy wealth from natural resources has proved to be ? curse in many countries and many resource-rich economies have failed to reach their potential.
An unequal distribution of income can lead to ? concentration of ownership, conflict and corruption. Moreover, rising oil earnings — especially at ? time of high oil prices — can drive up the real exchange rate too rapidly, eroding the competitiveness of the non-oil sector and hampering economic development and diversification.
The graph below highlights the challenge now facing the Russian authorities. The real exchange rate has appreciated to levels last seen before the 1998 crisis and, although the non-oil sector has performed relatively well in recent years, growth in the oil sector has outpaced growth in other industrial sectors, suggesting that Russia is becoming more dependent on oil and gas rather than less. Moreover, one of the most successful elements within the non-oil sector has been the metals sector, which has also benefited from strong global prices and rising export earnings, and which is also contributing to upward exchange rate pressures.6
6. Owing to limited data, the real exchange rate indices used in this report are CPI-based and may differ from those based on unit labour costs.
The Central Bank of Russia (CBR) operates ? managed floating exchange rate and tries to strike ? balance between its primary objective of reducing inflation (which remains in double-digits, far above annual rates in Azerbaijan and Kazakhstan) and moderating the real appreciation of the rouble (RUB), which it believes it can influence in the short run via the nominal exchange rate. However, trying to meet these dual objectives in the face of large current account surpluses and capital inflows has proved difficult. Since 2000, the CBR has intervened in the foreign exchange market to limit upward pressure on the rouble, but the resulting accumulation of foreign exchange reserves has been difficult to sterilise and monetary policy has loosened. In addition, the CBR's credibility has been weakened by the fact that the relative importance of its conflicting inflation and exchange rate objectives has appeared to shift from time to time. This balancing act is set to get tougher during 2005-06 as fiscal policy is loosened and it is doubtful that the CBR will be able to achieve its inflation objectives without accepting greater nominal exchange rate appreciation.
Real exchange rate appreciation has been less of ? problem in Kazakhstan and Azerbaijan, which also operate managed floating exchange rates. Nonetheless, both countries had ? far less diversified economic base to start with, particularly so in the case of Azerbaijan. With oil earnings set to rise sharply in the next decade, both are likely to experience greater upward pressure on their exchange rates, which will make it harder for each of them to broaden their economic bases. Kazakhstan has ? moredeveloped policy framework to address this challenge, which has included the creation of ? number of development agencies and research and education initiatives. And the monetary authorities in both countries will attempt to slow the pace of exchange rate appreciation.
However, while monetary policy may help to contain exchange rate pressures in the short term, over ? longer time horizon it will not be able to determine the real exchange rate, but only whether changes occur through the nominal exchange rate or inflation. For all three countries, this highlights the underlying need to press ahead with structural reform and improve the business environment.
The operating environment throughout the CIS remains hampered by excessive bureaucracy, uncertainties over the legal environment, poor transparency and the relatively low incomes of the population. Against this background, FDI outside the natural resource sector has been limited. In each case the authorities are taking steps to improve the business environment. For example, in Kazakhstan the government maintains ? dialogue with investors through the Foreign Investors Council. World Trade Organization (WTO) entry could also boost opportunities for the non-oil sector and Russia hopes to be admitted in 2005. Membership negotiations with Kazakhstan and Azerbaijan are also ongoing, though it is unclear when they will be completed.
Vulnerability to Shocks
Because of the dominance of the oil and gas sectors, all three economies are vulnerable to swings in oil prices. In the near to medium term, this vulnerability would appear greatest for Russia. Indeed, it has been estimated by the Russian Ministry of Economy that, on average, ? $1 pb change in the oil price alters the Russian GDP growth rate by 0.2-0.4 percentage points owing to multiplier effects. However, this relationship between GDP growth and the oil price is unlikely to be linear and ? fall in global oil prices from $50pb to $40pb would probably have less effect on growth and be easier to cope with than ? fall from $30pb to $20pb.
In contrast, while ? sharp fall in oil prices would undoubtedly cause GDP growth to decelerate in Kazakhstan and Azerbaijan, the near-term impact would be partially offset by large investment projects and rapidly rising oil output. Investment in the sector is unlikely to slow unless prices fall below $15pb and stay there for ? prolonged period and the two countries' oil funds (see below) could act as ? buffer on the fiscal side. For example, even with Brent oil prices at $15pb, Fitch doubts that GDP growth would fall below 4% in Kazakhstan.
The Fiscal Position
Rising oil incomes have supported ? strong fiscal position in all three countries. The authorities have complemented the boost to revenues with prudent spending control; as ? result, the consolidated general government fiscal balance has been in surplus since 2000 in Russia and Azerbaijan, and since 2001 in Kazakhstan. Against this background, and in view of strong GDP growth and US dollar weakness, the general government debt burden has been falling steadily and, in all three countries, it is now far below the '???' and '??' rating medians of 37% and 52% of GDP respectively.
The decline is most pronounced in Russia, where general government debt fell from 101% of GDP in 1999 to an estimated 25% last year. However, the debt ratio has also been falling steadily in Kazakhstan and Azerbaijan, and is now running at around 13% of GDP and 22% of GDP respectively. Moreover, all three have accumulated sizeable resources in oil funds, providing ? further fiscal buffer.
While fiscal loosening is planned by all three governments this year, in each case it is due to be done within ? fairly cautious framework and, in addition, is based on fairly conservative oil price assumptions. In contrast, Fitch currently expects the Brent oil price to average $43pb this year, up from $38pb in 2004, and the Urals oil price to average $39pb.7 In light of this, the agency is confident that all three budget balances will remain in surplus in 2005, underpinning further reductions in the government debt burden.
7. The Urals oil price typically trades 10% below the Brent price
These fiscal improvements have also been accompanied, most notably in Russia, but also in Kazakhstan and Azerbaijan, by an increasing tax burden on the natural resource sector. While it makes sense to increase taxes on the most successful economic sectors, particularly if they were previously relatively under-taxed, this increases the vulnerability of the budget to an oil price shock, all other things being equal. And getting the balance right between avoiding under-taxing the sector and imposing too heavy ? tax burden can be difficult. However, in each country, the heightened vulnerability of public finances caused by changes in tax composition has been partially offset by the creation of ? national oil fund.
THE RISING IMPORANCE OF OIL FUNDS
In their most common form, oil funds accumulate financial resources when oil prices exceed ? target level and dispense funds when prices fall below that level. Thus, they limit the opportunity to boost current spending when prices are high and make additional income available when oil prices are depressed, thereby limiting the need to cut government spending sharply. Many are also open-ended, thereby helping to accumulate and redistribute oil wealth for future generations. As they are typically invested in overseas assets, the oil funds also help to limit upward pressure on the exchange rate. Azerbaijan was the first of the three countries to set up ? fund, establishing the State Oil Fund of the Republic of Azerbaijan (SOFAZ) at the end of 1999. Kazakhstan followed with the creation of the National Fund of the Republic of Kazakhstan (NFRK) in 2001 and Russia set up ? formal oil fund — the Stabilisation Fund (SF) — at the start of 2004. However, it had maintained an informal fiscal support fund (? fiscal reserve) since 2001.
The three oil funds are set up in different ways and serve different purposes. Both SOFAZ and the NFRK are savings vehicles, so that current oil wealth can be shared with future generations, but they also have ? stabilisation function. There is ?? upper ceiling on the size of the funds and they have both grown steadily since their creation. Indeed, at the end of 2004 assets in the NFRK and SOFAZ totalled $5.1bn (12.5% of GDP) and $971m (11.3% of GDP) respectively. However, the operating framework of each one differs significantly.
SOFAZ receives the government's share of oil and gas profits from the Production Sharing Agreements (PSAs) related to current development projects. Income tax paid by the sector, derived from both Soviet-era oil fields (operated by the state oil company SOCAR) and from the new PSA agreements, flows instead to the state budget. In contrast with the NFRK and the SF, SOFAZ does not have ? formal stabilisation objective as net flows are not explicitly related to the oil price or budget position. Nonetheless, since part of SOFAZ's annual income can be spent on public sector social and infrastructure projects (albeit within annual limits on spending by the Fund), it effectively fulfils ? stabilisation role.
The stabilisation role of the NFRK and the SF is much clearer since, in each case, inflows are linked explicitly to the oil price. The NFRK receives 10% of planned budget receipts from taxes on the major oil companies each year irrespective of the actual oil price. In addition, extra payments are made from excess receipts from the oil industry when the oil price exceeds ? trigger price — currently set at $19pb. Finally, it also receives one-off flows from bonuses and privatisations in the mineral sector. Some $600m is set aside for ? stabilisation component (although it is probable that additional assets from the larger savings component would also be made available in ? prolonged period of low oil prices). If the oil price falls below the trigger price, transfers are made from the stabilisation component to the government budget.
The SF was set up to work in ? similar way, but it differs from the NFRK in that it does not have ? formal long-term savings function. It was intended to accumulate oil revenue surpluses resulting from ? Urals oil price above $20pb until ? cap was reached. This is currently set at RUB500bn, the equivalent of roughly 2.5% of GDP, and is sufficient to cover around two years of external debt repayments. With oil prices so high, the ceiling was reached earlier than expected. By the end of 2004 the SF held RUB522bn and by late February 2005 it had risen to more than RUB700bn. ? debate is now under way within the administration over what to do with these excess funds, as well as additional future revenues from the continuing high oil prices. Rather than building assets in the SF indefinitely, it seems likely that at least part of the excess funds will be used to pay down external debt. However, some will also be used to fund ? higher pension fund deficit following cuts in social security contribution rates.
For Russia, Kazakhstan and Azerbaijan, mineral wealth has been ? clear rating strength. Rising oil revenues, in part boosted by high global oil prices, have been used prudently in stark contrast with someother oil producing nations such as Venezuela. General government budgets have been held in surplus for several years, supporting ? steady reduction in government debt burdens. In addition, sizeable inflows of foreign exchange have enabled the accumulation of central bank reserves and foreign assets in oil funds.
Against this background, sovereign creditworthiness has improved in all three countries. Kazakhstan became the first CIS member country to receive an investment grade from Fitch when it was upgraded to '???-' in October 2004. Fitch upgraded Russia to '???-' the following month and Azerbaijan also receive ? rating upgrade in November, taking its sovereign rating to '??'.
Future prospects are supported by vast oil and gas resources. Not only do all three countries have sizeable reserves, but in the case of Azerbaijan and Kazakhstan they are now well on the way to being fully exploited. Nonetheless, for all three countries, whether or not the hydrocarbons sector achieves its full potential hinges on the maintenance and, in some cases, development of additional pipeline capacity. Even in Russia, where the oil and gas infrastructure is most developed, greater investment in the area would prove beneficial as most major pipelines are now operating at, or close to, capacity. Indeed, reflecting these constraints, around 40% of Russian oil exports are currently transported by rail and ship, ? share that is set to rise further over the near term if oil output continues to rise steadily.
In Azerbaijan and Kazakhstan, where transport needs are most pressing, major steps to address this key weakness are already in hand. Even so, in the case of Kazakhstan, while local pipeline projects are now under way and ? successful conclusion to negotiations regarding access to the spare capacity in the ??? pipeline will boost export pipeline capacity significantly, further pipeline construction (including projects which are currently under discussion but not confirmed) is likely to be necessary over the long term in order to reduce pressure on moreexpensive transport methods.
Despite some fiscal loosening now under way in all three countries, the windfall from high oil prices is continuing to be used fairly prudently. Overall fiscal positions remain comfortable and Fitch expects oil fund assets to rise further in Kazakhstan and Azerbaijan. While the ceiling on the Russian SF make it unlikely that it will continue to accumulate assets indefinitely, public finances are still set to benefit from the ongoing high oil prices. Indeed, based on Fitch's current oil price assumption of an average Urals price of $39pb this year, the Russian authorities could have as much as $25bn in additional oil windfall revenues by the end of 2005, which could potentially be used to pay down external debt over the coming period. If oil prices remain at current levels, this could be even higher.
The magnitude of the actually pre-payment, along with its timing, will depend on other domestic fiscal priorities and negotiations with creditors. All $3.3bn of Russia's outstanding obligations to the IMF were repaid on the 31st January 2005 and the government has been negotiating the early repayment of at least part of its $44bn Paris Club debt for some time.8
8. In Q304 Russia owed $40bn in Soviet-era Paris Club debt and ? further $4bn in more recent obligations. Paris Club debt pre-payment negotiations are reported to be hampered by ? dispute over the appropriate payment rate. The Russians are said to want ? 10% discount, while some official creditors believe that ? small premium on the payment would be more appropriate.
The sharp rise in oil income has also boosted the external position. Fitch estimates that the Russian current account surplus exceeded 10% of GDP in 2004 and CBR foreign exchange reserves hit ? new peak of $112bn at the end of February. The current account positions are less comfortable in Azerbaijan and Kazakhstan. Kazakhstan's current account is close to balance, while Azerbaijan's is in sizeable deficit. However, in both cases this reflects the cost of developing the hydrocarbons sector and it is almost entirely FDI financed. Foreign exchange reserves are on ? rising trend and, in all three countries, the public sector is now ? net external creditor. In fact, Azerbaijan is one of only five speculative grade credits where the public sector is ? net external creditor and, as the chart illustrates, Russia and Kazakhstan compare well within the ???' rating category.
Nonetheless, such vast mineral wealth and the recent oil price windfall have created some extra challenges.
· ? high dependence on commodities leaves all three economies vulnerable to oil price shocks, albeit to varying degrees. Moreover, shifts in the tax composition have further heightened the exposure of public finances to commodity price swings and raised the importance of the stabilisation function provided by national oil funds.
· Upward pressures on the exchange rate, resulting from vast oil earnings and FDI flows into the hydrocarbons sector, have complicated monetary policy management. This has proved especially problematic in Russia, where ? confused policy response to the dual challenge of reducing inflation and containing exchange rate appreciation has undermined the credibility of the CBR. In the near term, further real exchange rate appreciation appears inevitable in Russia, and it will become ? more serious policy challenge in Azerbaijan and Kazakhstan as oil exports continue to rise.
· The appreciation in the real exchange rate will make the development of the non-oil sector moredifficult. While the authorities in Kazakhstan have been proactive in responding to this challenge, and there have been some efforts to accelerate the pace of structural reform in Azerbaijan in recent months, the pace of reform in Russia appears to be slowing with negative implications for the country's long-term growth potential.
· Finally, while the vast oil revenues have improved the public sector balance sheets, the private sectors in both Russia and Kazakhstan have been riding the wave of improving overall country creditworthiness to step-up their external borrowing. Consequently, country balance sheets have not improved as significantly. Non-bank private sector debt has always been high in Kazakhstan and the majority represents loans from parent companies to their subsidiaries in the oil and gas sector that are related to its development. However, over the last two years, local banks have started to issue increasing amounts of international debt, while corporate sector external debt is rising rapidly in Russia. This trend brings new risks at the corporate and bank level, which could have implications for economic performance and sovereign risk if they are not well managed.
In conclusion, while mineral wealth has been ? rating strength for Kazakhstan, Azerbaijan and Russia, future prospects for their sovereign ratings hinge partly on how the oil wealth is managed and how the authorities cope with the additional economic challenges that it brings. Other factors, such as political developments, will have ? major bearing on the ratings too. Our '?+' rating for Venezuela illustrates that vast oil reserves and income by themselves are not sufficient to guarantee strong sovereign creditworthiness.
?? date, all three countries have shown signs of using their oil wealth prudently. Nonetheless, the debate now raging within Russia over the use of the excess funds in the SF highlights the political pressures and tensions that can arise. ? sharp step-up in Russian government spending, financed by excess oil revenues, would have negative implications for macroeconomic stability. Similarly, while ? gradual reduction in the tax burden may be good for Russian business, rapid cuts in taxes financed by temporarily high oil prices run the risk of ? sharp deterioration in the fiscal position when oil prices fall, unless they lead to greatly improved tax compliance and GDP growth. And the threat of Dutch disease is ever present. How well Russia, Kazakhstan and Azerbaijan rise to these challenges remains to be seen.
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