OREANDA-NEWS. May 04, 2016. Fitch Ratings has downgraded Kazakhstan's Long-term foreign currency Issuer Default Rating (IDR) to 'BBB' from 'BBB+' and local currency IDR to 'BBB' from 'A-'. The Outlooks are Stable. The issue rating on Kazakhstan's senior unsecured foreign currency bonds has also been downgraded to 'BBB' from 'BBB+'. The Country Ceiling has been revised to 'BBB+' from 'A-' and the Short-term foreign-currency IDR affirmed at 'F2'.

KEY RATING DRIVERS
The downgrade of Kazakhstan reflects the following key rating drivers and their relative weights:

MEDIUM
Off-balance sheet spending, in response to low oil prices, has resulted in Fitch's broader measure of the budget deficit widening sharply to 5% of GDP in 2015, compared with a surplus of 3.5% over the previous five years, as the government funded infrastructure investment out of the NFRK (National Oil Fund) and supported troubled state-owned enterprises (SOEs). Fitch expects the budget deficit to narrow to 4.2% of GDP in 2016, above the 'BBB' median of 2.6%, largely due to lower planned off-balance sheet spending. Downside risks arise from state support for banks as well as SOEs.

Buffers are being drawn down to finance wider fiscal deficits. The NFRK's assets were USD63.5bn (34% of GDP) at end-2015, from USD77.2bn in August 2014 and Fitch expects them to fall further to around USD59bn by end-2016. However, the ratio of oil fund assets to GDP will rise further because lower oil prices have depressed the nominal value of GDP. Government debt jumped to 22.1% of GDP in 2015 from 13.9% in 2014, due to increased external borrowing as well as the sharp depreciation of the tenge. Despite the deterioration, Kazakhstan's sovereign net foreign assets exceed 40% of GDP, well above the peer median of 0.8% of GDP.

The macroeconomic dislocation following the introduction of a free floating exchange rate in August 2015 (the tenge has fallen 77% against the US dollar) is expected to persist over the coming months. Inflation (15.7% in March) reached its highest level in nearly seven years. While Fitch expects inflation to moderate to 10% by end-2016, as the exchange rate pass-through fades, inflation is forecast to remain well above the 'BBB' median of 3.3% over the forecast horizon. The effectiveness of the monetary transmission mechanism is limited by high levels of dollarisation as well as limited longer-term tenge liquidity. The re-introduction of the base rate in February 2016 and the effective implementation of the interest rate corridor (+/-2%) are improving money market liquidity.

Dollarisation reached a peak of 69% in January 2016, more than double the 'BBB' median reflecting limited confidence in the domestic financial system and the tenge. The recent stabilisation of the tenge has resulted in modest de-dollarisation. The National Bank of Kazakhstan (NBK) estimates that dollarisation of 50% would allow for a more effective monetary transmission mechanism.

Fitch expects the economy to contract by 1% in 2016, well below the five-year average of growth of 4.6% and the 'BBB' median of 3.3%. Declining real wages and a sharp fall in dollar income will cut consumer spending. GDP per capita has fallen sharply from USD14,828 in 2013 to USD7,102 in 2016 - below the 'BBB' median. The contraction in investment will be muted by the state programme of infrastructure development, 'Nurly Zhol', funded by the NRFK. Part of the fall in spending will be absorbed by a further sharp contraction in imports, particularly consumer goods. Raising medium-term growth prospects above rating peers will depend on successful implementation of the government's reform initiatives, including privatisation and the '100 Step Programme', as well as diversifying the economy away from oil.

The banking system remains a rating weakness, with a Fitch Banking System Indicator of 'b'. Kazakh banks' asset quality and capital will remain under pressure in 2016 from still large un-provisioned problem loans, estimated at double NPL's (8% end March 2016) and the tenge devaluation, which will hurt foreign-currency borrowers' ability to service debt.

Kazakhstan's 'BBB' IDRs also reflect the following key rating drivers:

The authorities maintain a cautious stance to fiscal policy, under the assumption that oil prices are expected to remain lower for longer, scaling back non-priority infrastructure projects and limiting foreign borrowing. The 2016 Republican Budget sees the deficit narrowing to 2% of GDP, from 2.2% in 2015, as real expenditure contracts sharply. Improving the efficiency of public investment and tax collection, including reducing tax loopholes, is expected to support fiscal consolidation. By 2018, the authorities expect to run a deficit of 1%, assuming an oil price of USD35/b. In order to preserve the oil fund, the government has indicated its commitment to not increase annual guaranteed withdrawals from the oil fund, from the current USD8bn.

The drawdown in reserves has reversed, with the NBK adding to international reserves in February and March as households liquidate dollar deposits. Gross reserves have increased to USD28.4bn in March from USD26.8bn in January. The NBK has reiterated its continued commitment to allow the tenge to float freely, although Fitch expects that the NBK will continue to pick up dollars as de-dollarisation continues in order to improve the structure of reserves. Fitch expects the deficit on the current account (3% of GDP) to be fully financed by external borrowing as well as foreign direct investment.

Structural factors are an important determinant of Kazakhstan's sovereign ratings. The current ratings acknowledge that commodity dependence is high, while Kazakhstan scores weakly on World Bank indicators for governance and institutional strength.

RATING SENSITIVITIES
The following risk factors individually, or collectively, could trigger negative rating action:
- Policy mismanagement and/or prolonged low oil prices leading to a further weakening in the sovereign external balance sheet.
- Renewed weakness in the banking sector, which leads to contingent liabilities for the sovereign.

The following factors, individually or collectively, could result in positive rating action:
- A sustained recovery in external and fiscal buffers.
- Steps to reduce the vulnerability of the public finances to future oil price shocks, for example, by reducing the non-oil deficit.
- Substantial improvements in the business climate and governance supporting diversification and a sustained recovery in Kazakhstan's economy.

KEY ASSUMPTIONS
Kazakhstan's ratings are based on a number of key assumptions:
- Continued commitment to the policy framework.
- Political stability is expected to continue.
- Fitch assumes that Brent crude will average USD 35/b in 2016 and USD 45/b in 2017.