MACRO ADVISOR: Uzbekistan – is this the opening of a new frontier?

MACRO ADVISOR: Uzbekistan – is this the opening of a new frontier?
By Chris Weafer of Macro-Advisory December 1, 2016

Uzbekistan will elect a new president on December 4.  It is a very safe bet that Shavkat Mirziyayev, the long-term prime minister and acting president, will be elected as only the country’s second leader since independence in 1991. Central Asian elections do not allow for a Trump or Brexit-style surprise.

Over the past three months, since he assumed the role as interim president, Mirziyayev has focused on both improving political relations with the country’s immediate neighbours and with Russia. He has also stressed the need for the country to press ahead with economic and structural reforms to attract more investment and reduce its reliance, and vulnerability, to cotton. Cotton, which has dominated the country’s economy since the Soviet-era, has been a factor in the country’s political isolation and is a major reason why the country is almost critically short of an adequate water and electricity supply.

The (interim) president has already signed into law new regulations to reduce unplanned inspections against private businesses and to ease criminal threats against entrepreneurs. He has published an ambitious investment programme aimed at economic diversification and created three new special economic zones to add to the three existing special zones. His economic plan can be summarized as:

  • Diversifying the economy away from the excessive and dangerous reliance on raw cotton exports;

  • Creating more jobs so as to reduce unemployment and reliance on worker remittances from Russia;

  • Boosting high value-added exports by processing more textiles and foods. This is also because only high value exports make sense for a country that is only one of only two double landlocked countries in the world. It means the cost of exporting is more expensive and the bureaucracy more time consuming;

  • Modernizing the country’s infrastructure, especially electricity and water irrigation.

However, there is a steep cliff to climb as Uzbekistan currently attracts the lowest volume of foreign direct investment amongst among all the former Soviet states, as a result of over a quarter-century of near self-isolationism and rampant corruption.

On the political side, it is reasonable to assume that the transition from the long rule of Islam Karimov, who ruled the country from 1989 until his death in early September, will not be easy. For sure it is in the best interests of the country’s main “clans” and the so-called elites to support a smooth transition and maintain the status quo. But the Karimov family, which is part of the politically dominant Samarkand clan, will hardly stand idly as their assets are taken from them and the Tashkent clan, which is financially the more powerful, seeks greater political power.

Chinese whispers

The country clearly has considerable potential to develop a strong economy. It is the most populous state in Central Asia with 31.2mn people and has been almost a closed economy since the Soviet-era. Uzbekistan is strategically well placed as a key part of China’s ambitious One Belt, One Road rail network. The route from China to Tehran is planned to transit through Uzbekistan’s two main cities. The delayed Line D gas pipeline from Turkmenistan to China is also planned across Uzbekistan. Chinese investors have the right to develop the world’s second biggest copper deposit in Afghanistan, but the project remains stalled until an agreement to transport the ore across Uzbekistan is reached.

China has been, and will remain, a very big financial investor in Uzbekistan. But Moscow has been very quick to engage with the new president and made clear it intends to build a strong political, economic and military relationship. So far that appears to be also reciprocated by Mirziyayev. For Moscow, the regime change offers the opportunity to expand its military presence in Central Asia (already the two countries have signed new military cooperation deals) and to start the process of bringing Uzbekistan eventually into the Eurasian Economic Union. China has made clear it has no intention of stationing any military in Central Asia.

For Uzbekistan, closer cooperation with Moscow also makes sense, as it has approximately 3mn migrant workers in Russia and their remittances account for almost 15% of GDP and make up a large portion of the country’s foreign exchange earnings. China will not allow any Central Asian workers into its eastern provinces because of a fear of Islamic terrorism. Closer cooperation with Russia is also key for Uzbekistan’s plan to reduce its exposure to cotton and to build up its agriculture sector, especially in the production and processing of fruits and vegetables. In 2015 Uzbekistan exported 48,000 tonnes of fruits and vegetables to Russia. The plan now agreed by both sides is to boost the export volume to 800,000 tonnes (no specific timeframe). This enhanced source of food would also permanently reduce Russia’s reliance on Western sources.

The US has been rebuilding its contacts with Uzbekistan and military cooperation growing, but based on statements of the US president-elect, it seems that there will be slower engagement and more of an acceptance that Central Asia is Moscow’s backyard.

The EU also looks set to improve its relationship with the new administration. Uzbek cotton and textile products have been banned from the EU market for many years due to allegations of the use of child and forced labour in the cotton industry. But the ILO has now reported that this is almost eliminated and the EU is expected to very soon drop this ban.

Radical problems

Uzbekistan is also considered to be ideologically the most vulnerable to attack from radical Islamist terrorist groups. In 2014 the IMU (Islamic Movement of Uzbekistan) pledged allegiance to Islamic State. While Uzbekistan has the largest security infrastructure in Central Asia, closer military cooperation with Russia, which already controls the Tajikistan-Afghanistan border, will be important in the years ahead.

The country has been criticized for having a well-managed economy in that the macro indicators have been remarkably steady and predictable. GDP growth has averaged a steady 8.0% annually for over ten years. Other trends, such as in inflation and unemployment, appear to be at odds with other indicators and anecdotal evidence available. Earlier this year, international agencies such as the World Bank and the IMF, cut their forecasts for growth this year and for 2017 to reflect the impact of lower commodity prices and lower remittances from workers in Russia. But all have had to return to the long-run average rates as official government data for the first nine months of the year show absolutely no impact.

The Bank of Uzbekistan tightly manages the currency. The som has lost a steady 10% (approx.) per annum each year against the dollar for the past ten years. In theory, there are no restrictions on foreign investors moving money into and out of the country; in practice, this can be very difficult, slow and expensive. The exchange rates which individuals and companies have to use are routinely set at a big premium to the official rate.

Offset against those macro concerns, and the one big advantage which Uzbekistan has in terms of its ability to fund investment programmes, is that it has a very low debt burden and a budget surplus. The level of sovereign debt to GDP has been hovering around 11% for many years and while it is expected to rise to 15% this year, that is still very low – especially when accumulated foreign currency reserves are over twice the volume of state debt. Also, the country has always reported a budget surplus.

There are lots of reasons for investors to be wary of Uzbekistan, some of which are cited above. But the process of change has begun. There is significant potential for those who carry out detailed due diligence and position themselves accordingly. There will be plenty of bumps and frustrations but the current cost of entry more than compensates for that.

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.