Andrey Markov of Renaissance Capital -

Disliked by investors. Kazakh bank bonds are among the worst performers this year in the EMEA financials Eurobond universe. After spread widening appeared to stop in the second quarter, it started again in July. Ongoing negative newsflow on the banking sector was perceived by many as the reason for the sell-off.

• Major issues: Economy, state support, liquidity and asset quality. We address these issues below, as we believe they will define further industry development.

• State support: Coordinated and timely. President Nursultan Nazarbayev recently cited banking sector stability as a key priority. Banking sector health as well as solving problems in the construction sector, particularly with regard to prepaid apartments, will have a significant influence on the country's social stability, in our view. Support has been provided for the banks, and we see more on the horizon: a distressed asset fund will be set up by the end of the year, and changes to the banking law have been presented to parliament (allowing the government to buy stakes in banks that flout regulations and take over banks with negative equity). The latter is of primary importance because, in our view, the government would be prepared to exercise this option if a large bank is close to default.

• Liquidity is manageable on a system-wide level. Banks are currently sufficiently well positioned to meet foreign debt redemptions, even with international capital markets all but closed to them. The National Bank of Kazakhstan has extended refinancing options to the banks and is ready to introduce new capital routes if necessary, including uncollateralised loans. Local deposit base growth is mostly driven by placements by government-related entities. However, the growth itself is currently more important than the source, in our view. Small and medium-sized enterprises (SMEs) and construction support programmes are also directly and indirectly providing liquidity.

• Asset quality is likely weaker than reported. Very poor disclosure on loan portfolios and their quality make it hard for us to estimate the real scale of the problem. Reported non-performing loans (NPLs) vary from 2% to 7% and appear inadequate. We think asset quality issues are being masked by restructuring and the practice of granting loans with grace periods for interest and principal repayment. We expect the banks to reveal higher NPLs and increase the level of provisioning in the second half of this year and in 2009. Immediate recognition of bad loans and creating higher provisions might put excessive pressure on the banks' capital adequacy and result in breaches of regulations. However, as far as we understand, the banks will be allowed by the regulator to increase provisions gradually, charging earned income to loan loss reserves.

As bad as yields imply?

An almost ceaseless sell-off has resulted in Kazakh bank Eurobonds trading at deeply distressed levels. As a part of our periodic review of the sector, we have taken a detailed look at the banking system to determine if the situation is really as bad as yields imply.

Our research shows that the overall economy is doing well and if the current favourable pricing environment continues for key export products, like oil and metals, it should remain on a path to growth.

Liquidity issues, which previously caused investors concern, now appear more manageable. Our analysis on the banking system level shows that, even without pumping government funds into the system, the banks are able to repay their foreign debts. In addition, there is almost $50bn (more than all the banks' foreign debt) in foreign reserves and in the National Fund, which could be used to support the system. We do not think the government would need to use these funds; alternatively, we think it will make further use of budgetary or related funds to support the industry.

We expect more negative news to come from asset quality issues. As the banks reveal more bad loans, create higher provisions and report lower profits, the sell-off could be renewed. However, first, at current price levels, we think a lot of bad news is already priced in; second, banks could continue to hide the scale of the problem until the overall situation improves and the trend in portfolio quality turns around.

Negative rating agency actions might also trigger further turbulence and even early redemption of banks' foreign debts. Nevertheless, we don't believe the government will allow any of the top-three large banks (BTA, KKB and Halyk) to go bankrupt, because it would lead to social instability, which is highly undesirable and is easier to prevent by bailing out any troubled institutions. Having said that, we are fairly confident that none of the top three will go bust, but expect volatility to continue as more problems with asset quality become visible. Therefore, we would recommend bonds to unleveraged investors prepared to hold them with a medium-term horizon. Of the top three, we believe Halyk poses the least risk. In terms of BTA and KKB, we would choose the latter, as its problems are more visible and we expect fewer negative surprises on the asset quality.

Economic indicators

So far this year, the Kazakh economy has performed well and one would be hard pressed to find serious signs of an economic crisis. GDP growth has slowed somewhat in the first half, but is still underpinned by high oil prices and the 5.4% on-year real GDP growth is still higher than in developed countries. Other macro indicators also show that the economy is growing steadily, and are cause for little concern when looking at Kazakhstan from a macro level: industrial production continues to grow and companies are implementing investment programmes, thus creating the basis for further growth.

However, Kazakhstan's economy is relatively fragmented and while the oil and gas and metals sectors are reporting record profits on the back of booming prices, other sectors, including construction and SMEs, might feel significantly worse off. Anecdotal evidence indicates that, a year ago, if you wanted to eat in a restaurant you would have to make a reservation; these days, no booking is required.

However, the only negative macro statistics that worry us are the high level of inflation and the negative trends in real wages, due to slower-than-inflation growth in nominal wages. Although a high level of inflation in itself is not a negative factor for banking system development and conversely might lead to faster nominal asset growth, it forces people to spend more on current consumption and leaves them as less credible borrowers for the banks.

National Fund

The National Fund has three main targets:

• A stabilisation function, which means decreasing dependence on oil price volatility;

• Accumulating savings for future generations;

• Sterilisation of excessive dollar inflows, lessening pressure on the tenge to revaluate and inflation.

The National Fund's main source of income is in direct taxes on oil sector companies, namely corporate income tax, excess profit tax and royalties. On the positive side, we would note that a visible part of the National Fund's inflow is investment income.

National Fund assets are managed by the central bank and invested exclusively in foreign currency-denominated instruments of non-Kazakh issuers. Such an investment policy sterilises excessive foreign currency inflow into the system and reduces inflationary pressure, at the same time limiting growth of the money supply and banking system assets. The National Fund is subdivided into two portfolios: the stabilisation portfolio (approved guaranteed budget transfers) and the savings portfolio, which should secure investment income from portfolio management at a low level of risk. The stabilisation fund is invested in up to six-month maturity, highly rated fixed income securities; 75% of the savings portfolio is to be invested in fixed income securities and 25% in equities. We view this as a reasonable investment policy implemented by the Kazakh authorities that could result in a stable investment income from prudent portfolio management.

Redemption

As the basis for our estimate of how much the banks have to redeem in the next 12 months, we have taken a foreign debt redemption schedule published by NBK as of the first quarter. We have adjusted it for the debt attracted this year and interest that should be paid on this debt in order to assess how much banks will have to redeem in the next 12 months (October-September 2009). According to our estimate, the amount stands at approximately $11.5bn. It includes Development Bank of Kazakhstan's redemptions, but as they fall in the period after 2010, it would not alter our $11.5bn estimate significantly.

The banks acknowledge some deterioration in asset quality, but their reported nonperforming loans do not appear alarming. The other source of information on loan performance is disclosures by the regulator on loan classification. To assess the volume of overdue loans, we have taken individually assessed loans with overdue payments and provisions for collectively assessed loans. Since August 1, the agency has changed its methodology for disclosure of overdue loans and now reveals the amount of loans with overdue payments for the loan book as a whole. Overdue loans as disclosed by the regulator showed the following dynamics.

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