Rinat Gainoulline of Alfa Bank -

If you look at the numbers, the Kazakh stock market is not in good shape by any means.

Although we have seen some recovery in locally traded names since the trough of August 20 when many Kazakh equities fell into a prolonged freefall along with other emerging markets on fears that the US and global financial system wouldn't be able to sustain multi-billion sub-prime losses, the market is still off 6% from the pre-crisis peak of 2,876 hit on July 17. The index closed at 2,702 points on February 29.

In terms of market capitalization, local equities have lost some $14bn over the same period, which represents a direct loss of value in a tune of $9bn after an adjustment for several names - such as AktobeMunaiGas and ATF Bank - that have dropped from the calculation for various reasons since then.

Turnover on the Kazakhstan stock exchange (KASE) was marginally thinner following the August turmoil and remained depressed at $10.5m per day on average in January-February 2008, down from $15.1m over the same period a year ago.

What drove the development and fantastic performance of local equities over the past five years - the banking stocks that have earned reputation of the market's "blue chips" - turned out to be the market's flaw amidst continuing uncertainty in the global financial system. Despite various attempts by Kazakh regulators in the past few years to chip away at the dominance of banks, the financial stocks represented as much as 36% of the local market's total free float as of the end of November. In my view, banking stocks will remain a cornerstone of the market at least in the next few years. Given the market's small free float, ie. approximately 13% as of the end of November according to Alfa Bank research of November last year, the performance of banks - either positive or negative - will continue to drive the KASE Shares Index going forward.

Keeping their heads above water

Whether a recent re-rating of Kazakh banks by investors both domestically or globally reflects a fundamental change in Kazakh banks' business model remains a key issue. For years, Kazakh banks have relied on wholesale funding from abroad and worked as giant conduits of cheap financial resources into local economy primarily local corporates with construction industries gaining a larger share in 2004-06. This explains a fantastic almost five-fold surge in bank assets to $95.3bn as of January 1. In parallel, external liabilities of Kazakh banks surged almost six-fold to $46bn as of January 1.

Local funding base however remained limited, not least because of the country's relatively sparse population of 15m. With the liquidity crunch in global markets extending into 2008 and traditional lenders becoming increasingly risk averse, the new external situation marks a fundamental change in the environment in which Kazakh banks will have to operate.

While refinancing seems not to be an immediate issue as long-term borrowings account for about 80% of banks' total foreign debt, the ability of the banking system to ensure dynamic growth at least in the short-to medium term has been questioned.

Under normal circumstances, the dependence of a country's economy and banks on global financial markets in itself should not be a problem as long as those financial markets perform efficiently. Foreign obligations including inter-company loans accounted for 95% of Kazakhstan's GDP and 48% of total bank obligations at year-end 2006, in line with 91.3% for Hungary and somewhat lower but still high 78.4% for Bulgaria. Among oil exporters, Qatar and Bahrain both had a substantial external debt of 47.2% and 40.3%, respectively at the end of 2006. Also worth noting is that inter-company loans - meaning loans provided by foreign parent corporates to their Kazakhstan-based subsidiaries - accounted for 33% of Kazakhstan's total external obligations at year-end 2006.

Since the start of the August crisis, Kazakh banks has performed relatively well in that there have been neither bank failures nor any signs of a run on banks. Some banks closed outlets and cut staff, but the system as a whole managed to perform business as usual. Surprisingly, while credit markets remained almost unavailable for Kazakh banks due to severely heightened rates of interest, total assets of the banking system began to pick up again in the fourth quarter having edged up 2.3% to $$95.3bn as of January 1 after a fall to $93.1bn by the end of last September. As of February 1, total bank assets were still little changed in dollar terms even though the tenge has been relatively stronger since the beginning of the year.

Moreover, credit to the construction industry that has been long dominated by private banks did not plunge in the aftermath of the August shocks as it had been widely expected but went up by $1.9bn to $10.4bn as of the end of December, from $8.5bn by end of June 2007. This is all despite the ongoing difficulties and a significant 20-30% decline in prices for residential real estate in Almaty from August to January, as reported by the local media.

We believe two main factors helped the banks to contain damage. First and foremost, support from the state. Of the $4bn the government had already committed to support construction and real estate sectors, although not aimed directly at banks, at least some if not most of these funds will eventually end up on bank balance sheets, in our view. Furthermore, the state has pledged to double the amount of its support package if needed. Second, external funding from traditional sources in the US and Europe is being partially replaced by multi-lateral institutions with EBRD, ADB, IDB being just a few examples as well as with funds that potentially would come from Asian and Middle East investors.

The above, however, is but a temporary solution and should credit terms in external markets extend well into second half of 2008, which is a likely possibility in our view given continuing uncertainty over the sub-prime aftershock effect in US economy, Kazakh banks will have to tighten belts and adapt to a new reality. This would entail a change in strategy, operations, funding structure and eventually result in moderation of growth. Should this be the case, we expect M&A activity particularly involving banks with assets exceeding $1bn outside of the top-four league (Temir, NurBank, CenterCredit, and Tsesna) to intensify as owners at some of these banks will likely prefer to quit rather than run the risk of a radical change in existing business models.

Yet a blessing in disguise could be if the consequences of the credit crunch force local lenders to downscale significantly the scope of credit expansion, local corporates who had long relied on Kazkommerts, Bank TuranAlem or Alliance as the main source of funding may instead turn to capital markets for financing. Local pension funds with total assets under management of $10bn as of January 1, up $2.9bn from a year ago, is one group of potential institutional investors who have blamed the lack of supply of quality assets on KASE over the past years for not being able to increase exposure to local equities versus corporate bonds.

With inflation surging to 18.8% on year last December, it is critical for local pension funds to achieve higher returns by re-allocating part of their investments from lower-yield instruments such as corporate bonds (currently 30% in aggregate portfolio) into equities (16%). This implies there is deferred demand for equities to the tune of $1.5bn-2bn for equities from local investors.

Internally, the macro environment should remain favourable in the short to medium term in our view, with annual crude oil and gas condensate output expected to reach 72m tonnes, up from 67.5m last year on the back of an additional 4m-tonne capacity planned at Chevron's Tengiz field. We expect total oil exports to reach some 59.4m tonnes in 2008 to generate some $29.4bn in revenues to Kazakh exporters.

Assuming weather conditions remain favourable in Kazakhstan, Kazakh wheat will sell at an average of $350 per tonne in 2008, generating some $3.6bn in above-average agricultural export revenues. This along with an expected improvement in Kazakhstan's service-payments balance following the expiration of several contracts in the oil and gas sector over 2008 should be beneficial for trade balance and current account. Should FDI flows remain strong at around $10bn a year, which is a likely possibility given forthcoming projects in the petrochemicals and metals sectors, a flat current account deficit of 6-7% by the end of 2008 is the most realistic scenario in our view. In turn, this would ease some of the pressure on tenge. However, given the central bank's unambiguous statement that taming inflation to a "one-digit number" is its key policy we still expect the local currency to decline by 5-7% against the euro starting later into the year. While we expect GDP growth to moderate to 7-9% from 8.7% last year, this scenario is seen as plausible only if wholesale funding markets begin opening up to Kazakh banks starting from the third quarter 2008 at the latest.

While highlighting the fact that underlying strengths in the banking system are still far from being exhausted, we believe that in the short term the external environment, primarily in the US, will remain a key factor governing investor perception of continued heightening risks associated with Kazakh assets.

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