Kazakhstan: Rising External Borrowing by Banks and Sovereign Rating Implications
Sharon Raj, Director, Sovereign Ratings department, Fitch Ratings (London)
Sharon Raj joined Fitch Ratings in 1999 and is a director in the sovereign ratings group. During her time at Fitch she has worked largely on the analysis and ratings of sovereigns in transition countries and she is now responsible for research on sovereigns in the Commonwealth of Independent States.
Before joining Fitch, Sharon worked as a country risk economist for the Canadian investment bank, CIBC World Markets, where she monitored economies from Eastern Europe and the CIS, Africa and the Middle East. Prior to that she worked as an economist for the Lloyds TSB Group where she undertook research on most key emerging markets, including those of Latin America and Asia, and on general country risk methodology.
Sharon has both a BSc and an MSc in economics from the London School of Economics.
Overview of the Banking System
The banking system in Kazakhstan is small and highly concentrated. Although there are currently more than 30 commercial banks in operation, the three largest banks – Kazkommertsbank (KKB), Bank TuranAlem (BTA) and Halyk Bank – account for over 60% of bank assets. The next three largest banks – ATF Bank, Bank CenterCredit (BCC) and Alliance Bank – jointly account for a further 16%. All of the large banks are privately owned. In fact, following the privatisation of Eximbank in 2004, only one commercial bank – the House Construction Savings Bank, which was founded in 2003 with the ultimate goal of financing housing construction – is owned by the state. However, it is small and its operations are currently limited to accepting deposits in order to build a funding base. Nonetheless, the government also plays a role in the provision of development finance through several state development agencies. These have been established in recent years to support the expansion of the non-oil sector. As such they are designed to operate alongside the commercial banking system, but their operations may overlap with it on occasion.
There are several foreign banks operating within the local system, most notably ABN AMRO, Citibank, HSBC and Russia’s Alfa Bank; and there has also been some foreign investment in local banks. For example the EBRD holds a 15% stake in KKB. Nonetheless, foreign involvement in the system is far lower than in those of Kazakhstan’s rating peers from Central and Eastern Europe (CEE). The National Bank of Kazakhstan (NBK) estimates that, including minority as well as majority stakes, foreign investors own just over a third of the total system’s assets compared with 91%, 85% and 60% in Croatia, Bulgaria and Romania respectively. However, none of the six largest banks in Kazakhstan has a majority foreign shareholder. Moreover, as ownership information is limited, it is possible that some minority foreign-owned stakes may actually be held by offshore holding companies with local beneficiaries.
Against this background it is likely that any future problems in the sector would create pressure for sovereign support, especially in the case of the larger banks. However, this risk is countered by the relatively small size of the system: private sector credit and broad money are both currently less than 30% of GDP, while banking system assets are equivalent to roughly 49% of GDP.
Regulation and Supervision
Standards of regulation and supervision compare well with the rest of the CIS and, since the start of 2004, have been the responsibility of the Agency for the Regulation and Supervision of Financial Markets and Financial Supervision (FSA). The FSA hopes to have all legislation in line with EU guidelines ahead of full capital account liberalisation in 2007, and a Financial Sector Assessment Program (FSAP) Update in August 2004 by the IMF concluded that significant advances have been made. The assessment found that Kazakhstan was compliant or largely compliant with a majority of the Basel Core Principles. Some areas of concern remained at the time of the FSAP’s publication, particularly with regard to large exposures, market risks, consolidated supervision and cross-border supervision, but efforts to address these issues are under way.
Health of the System
Overall, the banking system appears healthy by CIS standards. Nonetheless, while KKB and Halyk Bank both have an Individual bank rating of ‘C/D’, the other banks in Kazakhstan that are rated by Fitch all have weaker ratings.1 In view of this, Fitch estimates the average Individual bank rating for the system at ‘D’ (weak), suggesting that the overall health of the system is weaker than those in many of the major CEE economies.
1. Fitch has not published a rating on BTA
The banks are liquid and profitable, and at the end of 2004 the average capital adequacy ratio was 15.9%, comfortably above the 12% local minimum. However, this figure is boosted by high ratios at some of the smaller banks, which are more vulnerable and therefore should have higher capital ratios. Capital ratios are lower, but adequate, among the larger banks, though several have needed additional subordinated debt and preferred stock issuance to maintain these.
Figures from the NBK show that loss loans are low. Indeed, at the end of 2004 they accounted for just 2.9% of the total loan portfolio. Nonetheless, impaired loans (NBK doubtful loan categories 2-5) were larger, accounting for a further 9% of total loans. An additional 32% of loans had a watch status, but were being serviced on time (NBK doubtful loan category 1). However, differences in definition make it difficult to compare these ratios with those existing in other countries. The share of the loan book that is impaired or non-performing has remained flat over the last couple of years. The proportion of loans on watch status has risen, but this is partly due to the introduction of a stricter classification scheme in early 2003. Provisioning (reserve) requirements for the NBK doubtful loan categories 2 to 5 are set at 10%, 20%, 25% and 50% respectively. Watch loans are 5% reserved and loss loans are 100% reserved.
The banks’ performance in recent years has been set against the backdrop of a strong economic environment. GDP growth has been running at more than 9% per year since 2000, underpinned by high levels of investment in the oil and gas sector as the country’s vast resources are developed. The non-oil sector has also performed well, supported by positive trends in agriculture and the spillover effects of high oil and metal prices on domestic demand. Inflation ticked up during 2004 – the annual average rate rose from 6.4% in 2003 to 6.9% – but it remains comfortably in single digits, supported by a steadily-strengthening exchange rate against the US dollar. Fitch is forecasting the annual average rate to remain close to 7% during 2005.
Nonetheless, while the macroeconomic situation has been favourable, the business environment within Kazakhstan remains challenging. Key weaknesses include heavy bureaucracy, uncertainties over the legal environment, poor transparency and a small, and still relatively poor, domestic population.
High Credit Growth
From the perspective of the sovereign rating, one of the most noteworthy features of the banking system in recent years has been its rapid expansion. Private sector credit growth has averaged 57% per year over the last five years and at the end of 2004 it was still running at 54%. Consequently, it has risen from 8.2% of GDP in 1999 to the, albeit still modest, level of 28.2% at the end of 2004. Traditional business with large companies has continued to expand, but new growth areas such as SME loans and residential mortgages are now becoming more important.
Rapid credit growth is common in emerging markets and often follows the easing of previous constraints on development, such as limited access to longer-term finance. Nonetheless, the continued rapid growth of credit in conjunction with the fairly high level of impaired loans and the short history of the system, and therefore limited experience of many bankers, does raise some questions over the quality of lending decisions and the likely impact on loan losses of a sharp economic downturn. It also underlines the rising contingent liability for the sovereign in the event of a crisis. Some banks have been issuing "express loans" as one method of expanding their loan books. However, in the case of Bank Caspian, which is one of the institutions spearheading this practice, the loans are supported by very high margins, suggesting that a modest hit to the loan book, while not ideal, would be manageable. Moreover, most of the banks are taking steps to strengthen their risk management systems further.
Furthermore, there is little evidence that the sharp rise in credit has generated an inflationary boom. Consumer price inflation is moderate at around 7% and is running at far lower rates than it was at the start of the decade. In addition, the real exchange rate does not appear overvalued. Data on asset prices are limited, though there has been anecdotal evidence of rising house prices in and around Almaty and Astana. Nonetheless, it is likely that the ongoing government policy of increasing provision of state housing is helping to offset part of the upward pressure on house prices and, in view of the shortage of information, it is difficult to conclude that the rises that have occurred have been excessive.
Funded Increasingly by External Borrowing
As this rapid credit growth has outpaced growth in the deposit base, particularly at longer maturities, several of the larger domestic banks have been increasingly funding this through external borrowing. In 2003 the banking system raised more than US$2bn, largely via Eurobonds, Medium-Term Notes and syndicated loans, and NBK data show that bank external borrowing increased by a further US$3.6bn in 2004.
The bulk of this funding is long term and appears rational, since demand for long-term bank loans is rising in Kazakhstan, while long-term funding is not available domestically in the same volumes. Nonetheless, it does raise some concerns since it has contributed to a rapid worsening of the net external position of the banking sector as a whole. Indeed, while the non-bank private sector remains the largest external debtor in Kazakhstan, with more than twice as much external debt as the banks, this is due to large inter-company obligations related to the development of the oil and gas sector. Excluding this inter-company debt, the banking sector is now the largest debtor in the country.
The rise in external borrowing by banks introduces a new element of risk for the country, since many of these recently-issued bonds mature at or around the same time and, as such, the repayment schedule of the banking system’s external debt has become increasingly lumpy. For example, all the bank bonds falling due in 2009 mature in October-November. Similarly, all the debt falling due in 2014 matures in March-April.2 In view of these concerns, the authorities are considering new regulations such as changing the reserve requirement rules to try to contain further growth in bank bond issuance.
2. 2014 is also the year in which the US$1.1bn KazTransOil bond that was issued in late 2004 matures.
With long-term prospects for the economy bright, supported by the country’s vast oil wealth, the rollover challenge on existing levels of external debt for the country as a whole is likely to decline over time, all other things being equal. The domestic banks are not closely involved with the oil and gas sector directly, as this tends to fund itself from outside the country, but they still stand to benefit from its development via the positive spillover effects on other sectors. Nonetheless, the banking sector’s lumpy repayment schedule increases its vulnerability to external shocks and could put pressure on the country’s balance of payments in the event of rollover difficulties. However, it is worth noting that in such a scenario, the non-bank private sector could act as a pressure valve since the servicing schedule on its inter-company obligations is not clearly defined (it tends to move with the oil price) and is arguably more flexible as parent companies will typically roll obligations over during difficult times.
In addition to the banks’ external funding, over 40% of domestic deposits are dominated in foreign currency. However, the direct foreign exchange risk that the banks face is contained by the fact that a large share of their loan book is foreign exchange denominated or indexed. Indeed, roughly half of all domestic bank loans are denominated in foreign currencies and almost 60% of long-term loans. Nonetheless, to the extent that not all of the banks’ clients have secure foreign-exchange revenue streams, the banks face a higher credit risk on these loans. In the event of an exchange rate adjustment asset quality could therefore be adversely affected, though this risk is mitigated by Fitch’s expectation of long-term exchange rate appreciation.3
3. The NBK operates a floating exchange rate regime, but stands ready to intervene to prevent sharp fluctuations. Recently it has been active in trying to prevent a rapid appreciation of the tenge in the face of sizeable investment inflows and rising oil earnings.
In view of Kazakhstan’s narrow economic base and the fact that historically most banking business has been with large enterprises, the banking system also faces risks related to high concentrations of loans to and deposits from specific industries and companies. This difficulty is amplified by the fact that the transparency of ownership structures of large industrial groups is poor and many business relationships appear to be based on personal ties – a weakness that was highlighted by President Nazabayev in his 2005 State of the Union address.
However, loan concentration appears less of a problem than in many other countries in the CIS and, as mentioned earlier, direct exposure to the oil and gas sector is limited. Over time, these risks should fall further as the banks diversify further into servicing households and SMEs, though less experience in doing business with these sectors and a limited database will bring new risks.
Finally, the banks face additional risks related to their expansion into other markets within the CIS. BTA has been expanding most aggressively. It has bought minority stakes in small banks in Russia, Ukraine and Belarus and a majority stake in a bank in the Russian city of Omsk. It is also looking for opportunities for expansion into Armenia, Georgia and Kyrgyzstan. Other banks have also expanded within the region. KKB started to expand in 2002 and now owns a Russian bank based in Moscow as well as a small bank in Kyrgyzstan. ATF also owns banks in Russia and Kyrgyzstan. However, these banks are very small relative to the size of their Kazakhstani shareholders and, with the exception of BTA and KKB, they have been used more to facilitate existing business rather than to expand the loan book to date. Nonetheless, the strategy is an evolving one that may generate greater challenges over time.
Conclusion and Sovereign Rating Implications
The banking system is currently healthy by CIS standards. Banks are liquid and profitable and Fitch considers that standards of regulation and supervision compare well with other CIS countries. From an economic perspective, the system is growing rapidly and becoming better able to fulfil its role in financial intermediation. Nonetheless, such a fast expansion inevitably raises questions over the quality of lending decisions and the likely impact on loan losses of a sharp economic downturn.
The tendency of several of the larger banks to fund this expansion increasingly from external borrowing is understandable since demand for longer-term bank loans is rising in Kazakhstan and long-term funding is not available domestically in similar volumes. Nonetheless, this borrowing has contributed to a rapid worsening of the net external position of the banking sector as a whole and has generated an increasingly lumpy external debt repayment schedule, thereby raising the sector’s vulnerability to external shocks.
However, this worsening of the net external debt position needs to be put in perspective. Relative to GDP or current account receipts, the net position of the Kazakhstani banking system is not much weaker than those of its ‘BBB-’ peers Croatia or Romania, though it is significantly worse than Bulgaria, Russia and Mexico. Moreover, the deterioration in the external position of the banking sector has coincided with an even more rapid improvement in the public sector’s external position. Thus, the country’s overall net external debt position has continued to strengthen.
Thus, from the sovereign rating perspective, the deterioration in the banking system’s net external position is not currently exerting downward pressure on the Long-term foreign currency rating. Although it is above the ‘BBB’ rating range median, the banking system’s net debt position is not out of line with those in some other similarly-rated credits in the region and, despite its rapid growth, the banking system remains relatively small. As such, it represents a manageable contingent liability for the sovereign, which currently has a smaller debt burden than all of its ‘BBB’ peers and therefore flexibility to take on additional liabilities if necessary. Indeed, at the end of 2004 general government debt was less than 11% of GDP, compared with a ‘BBB’ median of 36%, and the public sector’s net asset position was equivalent to 47% of CXR, compared with a net debt position of 4% of CXR for the ‘BBB’ median.4 Nonetheless, the banking sector’s increasing reliance on external funding does create some additional risks that need to be well managed and Fitch will continue to monitor the situation. If the banking sector’s external position was to continue to weaken at the pace set in 2004 it could start to become a larger concern.
4. ‘BBB range’ refers to ‘BBB+’. ‘BBB’ and ‘BBB-’ rated credits
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