Fitch Ratings -

Fitch Ratings assigned a Negative Outlook to Kazakhstan's sovereign Issuer Default Ratings in December 2007 after a dramatic tightening in the banking system's access to global capital markets led to a sharp fall in official FX reserves and left the economy exposed to the risk of a broader financial and economic crisis. Kazakhstan's external finances have strengthened in 2008 and reserves are rising again, partly because of high energy prices. But the external funding squeeze has driven a sharp slowdown in credit and GDP growth, and banks' asset quality is suffering in a deteriorating macroeconomic environment, itself a negative credit development and leading to an additional risk that the sector may require sovereign support. The Negative Outlook on Kazakhstan's ratings remains in place as the credit crunch continues to work through the economy.

What could trigger a downgrade?

· Further deterioration in bank asset quality leading to a requirement for state support to the banking system would impose a drain on sovereign resources and would be negative for the sovereign ratings. While bank deposits are growing, significant bank losses could eventually cause a loss of private-sector confidence in the banking system, leading to a deposit run and/or a rush to convert KZT deposits into FX, which would be severely negative for the rating.

· More macroeconomic deterioration, such as a further acceleration in inflation or a much sharper slowdown in output than projected, would add to negative pressure on the ratings.

· Increased commodity price volatility could undo some of the improvement in Kazakhstan's external finances, which would be negative for the ratings.

External finances improving...

Improvement in Kazakhstan's external finances so far in 2008 is easing concerns that Kazakhstan could face a balance-of-payments crisis, although risks have not yet entirely abated. Kazakhstan's banks ran up external debts worth $46bn by end-June 2007 (44% of 2007 GDP). Problems ensued when Kazakhstani banks' access to international capital markets tightened in the second half of 2007 amid heightened global market volatility, leaving the banks facing external debt maturities of about $9.1bn in the second half of the year to refinance or clear.

The authorities opted to make FX available from official reserves to hold the KZT level against the dollar and shore up confidence in the heavily dollarised financial system. This strategy has avoided a balance-of-payments crisis so far. However, official international reserves fell $5.8bn (25%) over July-December 2007, eroding Kazakhstan's sovereign net foreign asset position – a key rating strength – relative to end-2006 in terms of GDP (from 34% to 32%) and to imports (from 61% to 53%).

Kazakhstan's external finances have since strengthened. Reserves rose $3.6bn or 20% in the six months to end-June 2008. Kazakhstani borrowers, including Halyk Bank ('BB+'/Negative) and KazMunaiGaz ('BBB'/Negative), have returned to international markets. External-debt data show that Kazakhstani banks' foreign debts have remained roughly constant at around $45bn since end-June 2007, suggesting that the banks have been able to refinance a high proportion of borrowings falling due. Meanwhile, Kazakhstan has continued to build savings in the oil-financed National Fund (NFRK). Taken together, official reserves plus NFRK savings were $46.9bn by end-June, up $5.4bn on the end-July 2007 figure.

The current account deficit swung into surplus to the tune of $3.9bn in the first quarter, narrowing the four-quarter-rolling deficit to 2.6% of GDP from 6.8% in 2007.

Kazakhstan's current account has benefited from rising global commodity prices, in particular oil prices – the country exported about 1.2m barrels per day (b/d) of oil in 2007. Fitch projects oil prices will average $100 in 2008 and $75 in 2009, which could send Kazakhstan's current account back into deficit. However, slowing domestic demand restrained merchandise import growth to just 12% on year in the first quarter (compared with 58% a year earlier), which should in turn support the current account balance.

The latest estimates suggest foreign debt service may have peaked in the second qurater, although estimates are subject to uncertainty. Fitch projects Kazakhstan's external liquidity ratio at 152% in 2008, almost unchanged from 151% in 2007, below the 'BBB' range median for 2008 of 166%, as high debt service expected in 2008 outweighs reserves and NFRK growth.

...but deteriorating macro outlook will weigh on sovereign ratings

Banks' asset quality is deteriorating in a worsening macroeconomic climate, a development that Fitch has warned is exerting downwards pressure on Kazakhstani banks' ratings. A continuation or acceleration of asset quality deterioration could start to erode banks' loss absorption capacity, potentially leading to a requirement for sovereign support. Fitch downgraded Alliance Bank's Individual Rating to 'D/E' from 'D' on July 3, and warned of greater downside pressure on Individual Ratings of Alliance and other banks coming from asset quality deterioration. However, IDRs have not been downgraded yet as Fitch regards the sovereign's propensity to support stricken banks as high, owing to the priority the authorities attach to safeguarding financial stability and avoiding contagion.

As discussed in Fitch Ratings' April 2008 report "Kazakh Banks' Asset Quality," published numbers on non-performing loans may understate the extent of the problems for various reasons. In particular, Fitch is concerned that banks may be extending repayment periods on loans to afflicted corporates, rather than declaring the loans as non-performing.

The annualised three-month-on-three-month credit growth rate has been flat since March, contributing to the economy's slowdown. Fitch is reassured by the return to KZT deposit growth since January 2008, although the agency notes that FX deposits are growing faster, reinforcing dollarisation of the financial system and leaving the economy more exposed to risks from FX volatility. The risk of deposit flight leading to a financial crisis has eased as total deposits have grown month on month since November 2007.

Decelerating lending has contributed to the bursting of the property bubble that had emerged in Kazakhstan's bigger cities. Residential property prices had fallen from their peaks by 31% in Astana and 45% in Almaty by June 2008, according to official data. Default rates on mortgage lending are already rising. Loan-to-value ratios are protected to some extent by the long "tail" of loans extended when prices were well below the peak, although Fitch bank analysts note negative equity on some home loans made in the first half of 2007.

CPI inflation accelerated to 20% on year in June. The Kazakhstani authorities face a difficult economic conjunction of rising inflation, slowing growth and banking-sector weakness. Further deterioration in the macroeconomy would undermine the fundamentals of the credit and exert more negative pressure on the ratings.

However, Kazakhstan's longer-term prospects remain bright. The country's proven oil reserves of 40bn barrels are 3% of the world total. Kazakhstan's reserves are half as large as the figure for Russia ('BBB+') in absolute terms, and far larger relative to population and GDP. The Kashagan field alone is projected to add a further 1.3m b/d to Kazakhstan's output when operating at full capacity, although the target date for full operation has been repeatedly postponed and is now 2013.

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