OREANDA-NEWS. Allowing the tenge to float should help cushion Kazakhstan from external shocks it faces from lower oil prices and currency misalignments and will help preserve the sovereign balance sheet, Fitch Ratings says. But it highlights the economic pressures facing the country and presents risks, for example via the potential impact on banks and private-sector confidence.

The tenge lost 22% of its value against the dollar on Thursday after the prime minister and central bank governor said the dollar-tenge trading band was being scrapped. It hit an all-time low of KZT257.2:USD. Thursday's fall follows a 4.7% weakening (the largest since the 19% devaluation in February 2014) on Wednesday after the National Bank of Kazakhstan (NBK) widened the trading band.

The sudden switch under financial pressure to a free float contrasts with signals from the authorities that they would shift gradually to inflation targeting and allow controlled depreciation (NBK had raised the tenge's upper trading limit in July). Lower oil prices have led to deterioration in the current account, and devaluation expectations have put relentless pressure on the capital account as funds flow from tenge assets into foreign currency.

Exchange-rate pressure and its key long-term causes were factored into our sovereign ratings assessment when we affirmed Kazakhstan's 'BBB+'/Stable rating in May, when our forecasts incorporated a 20% KZT/USD depreciation by end-2015. But the further decline in commodity prices and the Russian rouble will add to the economic and financial pressures facing the country. Prolonged low oil prices could be negative for the sovereign rating.

A sharp devaluation will combat some elements of the severe terms-of-trade shock Kazakhstan has sustained, including the impact of the weaker rouble (whose depreciation versus the dollar has been about six times bigger than that of the tenge in the year to today's devaluation), which has put domestic producers under pressure from Russian imports. A more flexible exchange rate will also insulate public finances against the oil price decline.

We expect the draft 2016 budget, to be presented to parliament by 1 September, to be based on a prudent oil price assumption (as was the case with the 2015 budget) and adopt a more cautious fiscal stance. Bloomberg reported on Thursday that President Nazarbayev foresaw budget cuts and a lowering of the deficit to 1% of GDP by 2018, with the deficit financed from domestic sources.

More broadly, the de facto peg to the dollar has struggled to deliver macroeconomic and financial stability and has necessitated heavy interventions at times (although external liquidity is ample).

But such a large devaluation carries risks. It will push up inflation in the short term, and implementing the new inflation-targeting policy will be challenging. Growth has slowed sharply from 2010-2014 levels, and a combination of the devaluation and spending cuts increases the risk of a recession.

The banking system is vulnerable to an exchange rate shock via its impact on asset quality. Impairments across foreign-currency loans are likely to increase as unhedged borrowers struggle to repay (around 30% of assets held by Kazakh banks are foreign-currency denominated).

Widespread pressure on emerging-market currencies following China's yuan devaluation and falls in commodity prices may also limit the competiveness gains from the tenge's fall. The competitive advantage from the February 2014 devaluation was wiped out by August/September that year.

Scrapping the trading band should also reduce the cost of FX market interventions to support the tenge, although NBK may still intervene to reduce FX volatility. President Nazarbayev said on Thursday that NBK had spent USD10bn this year to support the tenge. Although reported reserves have been relatively stable, foreign-currency liabilities of the central bank have increased.

Our next scheduled review of Kazakhstan's sovereign rating is on 30 October.