Heiner Klemm in Berlin -

Kazakhstan has long boasted the best banking system in the CIS, but at the start of October the government was staving off a financial meltdown as $4bn was set aside to bail out domestic banks.

Kazakhstan was the first country in the former Soviet Union to win an investment-grade rating years before anyone else. However, leading rating agency Standard & Poor's (S&P) on October 8 dropped Kazakhstan's sovereign credit rating down a notch to its lowest investment grade, 'BBB-', as it became increasingly clear that Kazakh banks, which had borrowed massively on international capital markets, had been the worst hit of any emerging market by the fallout form the US' sub-prime crisis.

Within days, Kazakh President Nursultan Nazarbayev stepped in to calm the situation and ordered the government to set up a $4bn special stabilization fund to support Kazakh banks. "Our banks have strong positions, and many of them will resolve problems unaided. If they experience any problems, the government will give them comprehensive support," Nazarbayev was reported by Interfax as saying October 11.

The launch of the fund smacks of desperate measures to shore up faulting confidence in the country's bank sector. Analysts welcomed this strong pledge of support, yet Nazarbayev's announcement the following day that he had instructed the government to consider buying out shares of Kazakh companies traded on international markets was met with less applause. Government officials blamed foreign hedge funds for instigating a massive sell-off of Kazakh securities for speculative purposes. Applying a classic corporate tactic at a national level to bolster share prices, Alfa Bank described the move as unlikely to be of much help in supporting a wobbly banking sector and at best a short-term catalyst for Kazakh equities.

Crisis? What crisis?

Despite the drastic measures, Nazarbayev maintains his country is not undergoing an economic crisis. "Our economy has strong positions, and there are no crises or dangerous phenomena here," said Nazarbayev, who also reportedly labeled the credit rating downgrade as "unfounded."

S&P has stuck to its guns and warned that, since July, falling domestic depositor confidence and difficulties associated with rolling over maturing international loans and cross-border interbank deposits had forced Kazakh banks to take some KZT1.3 trillion ($10bn) - equivalent to three-quarters of the country's monetary supply - of short-term funding to support their liquidity from the National Bank of Kazakhstan (NBK).

The NBK's international reserves have dropped like a stone, falling by some $5bn to $18.4bn by the end of September, while domestic interbank deposit rates rocketed from 6% to 9%. Deposits in local banks reportedly dropped 1% in August, followed by a 3% drop in September, which led Alfa Bank to estimate that the decline in deposits alone led to a liquidity outflow of $2bn from the Kazakh banking system during August and September.

S&P's downgrade came as a heavy blow to Kazakhstan's banking sector, which has been on fire for most of this decade. On an annualised basis, the banking sector has grown 100% per year for the last six years and, according to the Dutch bank ING, total assets have increased 5.5-times to some $92.6bn or nearly 90% of GDP. Especially over the last two years, banks have been booming and second-tier banks, targeting retail customers, have grown even faster - over 200% a year in some cases.

However, most of this fast growth has been paid for by borrowing on the international capital markets. The rating agency Moody's recently estimated that by the end of the first half of 2007, Kazakh banks had more than doubled their borrowing compared with last year and that total international borrowing had reaching approximately $40.7bn, or over $2,600 per head of population. Kazakh banks' external debt, as a percentage of GDP, was more than three-times greater than Russia's and twice the size of Ukraine's. When the international capital markets froze and the rug was pulled out from under their feet, the Kazakh banks hit the ground hardest of all.

However, rating agencies are divided on just how severe the problem is and on the same day that S&P lowered its rating, the other main rating agency Fitch took a more sanguine view and maintained the country's foreign currency rating at 'BBB', but downgraded the rating outlook form 'positive' to 'stable'.

Andrew Colquhoun, Fitch's lead sovereign analyst for Kazakhstan, stressed that Fitch's actions were an affirmation of its credit rating and reflected Kazakhstan's basic sovereign strengths, which he listed as: "very low government debt, large budget surplus, large net public external assets and a generous natural reserve in diamond."

These strengths were enough for Kazakhstan to hang on to Fitch's 'BBB' rating, however, the country's over-reliance on external debt cost it its positive outlook.

"In August, international capital markets and Kazakh banks' access to international capital markets more or less seized up, which threw the spotlight onto refinancing risks that Kazakhstan's banks might face," said Colquhoun during a conference call on the rating decision. Kazakh banks were unable to turn to the relatively undeveloped local bond market and, since most of the country's banks are still locally owned, no cash-laden international parents were waiting in the wings to bail them out. The burden has fallen squarely on the government's shoulders and the country's hard currency reserves.

"The central bank of Kazakhstan estimates that the Kazakh commercial banks have to refinance approximately $3bn of external debt per quarter out to the second quarter of 2008. Against that, the authorities have official international reserves of $18bn and savings in the national oil fund of about $18.7bn as at end of September," said Colquhoun.

The government's pledge to support the banking sector, combined with its generous stock pile of cash, prompted Colquhoun to conclude that: "The situation therefore, in our judgment, looks manageable under the authorities strategy out to around mid-2008, which in our view justified a stable outlook on the 'BBB' rating."

Local analysts are even more confident that Kazakhstan will pass through this storm without too much damage. Michael Carter, head of research at Kazakhstan's leading investment bank Visor Capital, reckons that the banking sector will, most likely, weather the storm.

"What's the worst that could happen? We may see bank assets stay stable or even shrink. A few banks may disappear as a result of M&A. Will we see a Kazakh bank default on a bond or an internationally syndicated loan? No. The government is committed to supporting them," said Carter.

However, since Kazakhstan's banks were heavily over-exposed to the construction industry, the credit crunch will do some real damage to the country's booming real estate sector. Indeed, the $4bn government fund is specifically targeting construction and development credits.

Renaissance Capital estimates that direct exposure to the construction sector stands at 20-25% of loan books, or a total of $15bn to $18bn. According to NBK chairman Anvar Saidenov there are estimates that up to 90% of construction companies' activities are being funded by borrowing, reported The Moscow Times in mid-October, in an article claiming that, unable to secure funding, many construction companies had cut their activities, bringing building sites to a standstill throughout the country.

Carter again sees the situation a little less melodramatically. "Before August, it was frenzied. Construction was going on 24/7. Work goes on but it's more like 12 hours a day instead of all day and night. Some projects that are in the early stages of development may have been dropped, but GDP is still expected to grow a health 8% in 2008 so there is still a huge demand for apartments, office space, factories and infrastructure and the banks are committed to getting the projects completed. Activity levels have maybe slowed down by 15% or 20%. It's not as if the cranes have stopped altogether."

Nonetheless, residential real estate prices dropped 2.87% in September and a further 5.06% at the start of October, reported Reuters. Some analysts estimate that, over time, real estate prices may decline some 40% and the depreciation of assets could pose a further serious threat to Kazakhstan's heavily leveraged banks.

Of course, while the financial cloud has subjected most of the country's banks to a dunk in cold water, some of the better-positioned fish have been swimming strongly against the current. Halyk, the bank that was least reliant on external debt, has been able to strength its position, reportedly adding some $1.23bn in deposits in August and September as depositors searched for a safe haven for their money.

And then there are the big fish. Lured in by the drop in valuations that the credit-crunch induced, Austria's Raiffeisen International and Hungary's OTP are both looking for acquisition targets in Kazakhstan, reported Reuters on October 16, following a Reuters Central European Investment Summit.

If the cloud over Almaty does disperse in the near term, then Kazakhstan's banking sector may yet see a silver lining to it. Colquhoun, in a move he describes as perhaps unusual for a credit analysts, argues that a slowdown was overdue and if the current financial market turbulence leads to a more sustainable pattern of financial sector development, it could turn out to be positive for the country's sovereign rating and the economy as a whole.

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