MACRO ADVISER: Nazarbayev puts it all on red

MACRO ADVISER: Nazarbayev puts it all on red
Agriculture output is already improving, with the grain harvest reaching 23.7mn tonnes in 2016 from 18.7mn tonnes the year before.
By Chris Weafer of Macro-Advisory March 20, 2017

Kazakhstan has a reputation for being very conservative in both monetary policy and budget management; so conservative indeed that the government has often been accused of focusing too much on drafting elaborate economic reforms and not enough on actually implementing them.

It has also been criticised for reacting far too slowly to changing events. For example, when the Russian Central Bank let the ruble fully free-float in early 2015, a move that severely impacted the Kazakh economy, it took the National Bank of Kazakhstan more than six months to follow suit.

So why has President Nursultan Nazarbayev's government abandoned its traditional conservative approach and gone for broke with a radical change to the budget and the way it manages the economy

The new approach, which came as a big surprise earlier this year, may not quite be akin to going to Las Vegas and throwing all on red, but it is a bold move nevertheless. If it works, Kazakhstan’s economy will pull quickly out of the slump of the past two years and growth may again reach 4-5% by 2019. If it does not work then the country will be straddled with a bigger debt load, a struggling economy and, most likely, with a lower international credit rating.

Other countries in the region, which are also struggling with the question of what strategy to use to try and boost growth, will be watching closely. This is especially the case in Moscow where the finance and economy ministries support the so-called “Fiscal Rule” – which aims to balance the federal budget using $40 p/bbl oil by the end of this decade – and a conservative approach to spending and debt.

That approach is heavily criticized by Boris Titov’s Stolypin Club, which is supported by many in the state sector and which advocates exactly what the Kazakhs are now doing; borrow and spend. If the Kazakh economy starts to grow on the back of this 180 degree budget change, then Russia, and other countries in the region, will probably follow.

The Kazakh government has boosted budget spending by 33% for 2017, from the previously approved budget.  It is making the assumption that revenues will rise by 21%, primarily on the back of a rise in the oil price assumption, from $35 per barrel to $50, and an expansion in corporate taxes and VAT as the economy recovers. Part of the new budget deficit, which is estimated at $5bn and which should equal more than 3% of GDP, will be funded by a bigger draw down from the sovereign wealth fund, and part will be funded with new borrowings. The sovereign wealth fund transfers will now contribute 46% of assumed budget revenues in 2017.

The government has also decided to issue more sovereign debt. It will raise the volume by 30% this year, to an estimated 20.6% of expected GDP, and to further raise it to 30% of GDP by 2020. For sovereign external debt that should mean a rise from under 11%, as at the end of last year, to over 15% of GDP within three years – a still comfortable number by international comparison.

A key assumption, which justifies the aggressive move, is that the average price of oil (Brent) will be $50 this year rather than the $35 used in the previous budget plan. Currently that higher price assumption looks safe as, for example, Saudi Arabia appears determined to try and keep the price at that level to support its ambitious Aramco valuation target later this year or early next.

In fact Kazakhstan, while advocating diversification, is actually increasing its oil dependency. Despite agreeing to cut production as part of the non-Opec countries contribution to the November Opec deal, in February oil output was some 38,000 bbl above the agreed limit. The very expensive and long delayed Kashagan field is now producing and exporting oil and is expected to add between 100,000 and 200,000 extra barrels per day by end 2017. In 2018 the volume should be some 400,000 bbl/d higher than today. Tengiz, the country’s biggest oil field, will see output double when the planned next phase comes on line in 2022.

The reality is that despite the many plans to reform the economy, Kazakhstan remains very dependent on, and vulnerable to, hydrocarbon revenues. The collapse in the oil price from the autumn of 2015 saw the pace of economic growth drop to only 1.0% last year. Contagion from the Russian ruble weakness and the recession in its big northern neighbour also weighed heavily on the Kazakh economy.

Old-new modernisation

So where will the extra spending go?  It will partly go to relieve the banking sector of problem debts and partly to fund what President Nazarbayev has described as the country’s third phase of modernisation.

Just over $6bn is to be placed into the problem loan fund, which will then buy more distressed assets from the country’s banks.  The government's bad bank will buy $7.5bn of non-performing loans from Kazkommertsbank (KKB), which has struggled since it rescued BTA Bank in mid-2015, and is now in the middle of being taken over itself by Halyk Bank. But, despite the huge cost of sorting out the bank sector’s problems, it is very clear that the modernisation programme cannot work without a normally functioning bank sector.

The core of the president’s “new” modernisation programme is the Nurly Zhol programme, which was announced in November 2014. The current version expands and extends the aims of that programme. At its core there are two key objectives:

♦ to raise the non-oil share of exports to 50% by 2015;

♦ to raise the contribution to GDP from SMEs to 50% within the same time frame.

The sub-objectives are to:

• improve the investment climate;

• create macro-economic stability;

• develop human capital;

• strengthen the country’s institutions; 

• the technological modernization of the economy. 

Further breaking down the programme we can identify agriculture, technology and transport services as being the more important target sectors. 

Agriculture output is already improving with, for example, the grain harvest reaching 23.7mn tonnes in 2016 from 18.7mn tonnes the year before. Food exports rose 10% last year and the programme aims to see that volume rise by 40% within five years. The government money will aid this by increasing subsidies to target sectors, helping 500,000 small farmers join more efficient cooperatives and increasing the area of irrigated land by 40%.

Transport services make sense given that Kazakhstan is a key route west for China’s ambitious One Belt, One Road programme. It means that several rail lines will cross Kazakhstan and open up opportunities for logistic centres as well as other transport services.

The “Why now?” is easy to understand. The death of President Islam Karimov, at 78 years old, in neighbouring Uzbekistan, has brought the succession issue to the forefront in Kazakhstan. Nazarbayev is 76 years old and clearly wants to ensure both a favourable legacy for his presidency and an orderly succession of his choosing. Both will be a lot easier with a growing economy and a positive longer-term outlook than would be the case with the existing hydrocarbon-based model.

He is nevertheless taking a big risk. If this expansion plan works then succession will be smooth and Kazakhstan will be a positive role model for Russia and others in the CIS-Eurasia region. If it fails and a stagnant economy is straddled with depleted resources and higher debt, then of course there will be more serious questions about succession and the economy will be a model for others, but one to avoid rather than to embrace.

Chris Weafer is a founding partner of Macro-Advisory, which helps investors cut though the noise & focus on underlying trends, real political risks, & opportunities in Russia/CIS, Eurasia Union, & Mongolia. Follow him on @ChrisWeafer.