Clare Nuttall in Almaty -

The downturn in the global economy is starting to trickle through even to Uzbekistan's largely isolated banking industry. This, together with the intrinsic weakness of the country's banks, has led Moody's Investors Service to assign a negative outlook to the sector.

While the impact of the global crisis is still limited in Uzbekistan, and liquidity squeezes are unlikely, an increase in non-performing loans (NPLs) and a fall in banks' income are expected.

According to Moody's, the negative outlook reflects the rating agency's view that "banking in Uzbekistan remains constrained by the structural weaknesses of the national economy, the banks' still underdeveloped corporate governance and risk management practices and the volatile operating environment." On May 21, Moody's placed the ratings of three Uzbek banks - National Bank for Foreign Economic Activity of the Republic of Uzbekistan (NBU), Ipoteka Bank and Alokabank - on review for a possible downgrade.

Uzbekistan saw stellar GDP growth of 7-9% annually for the last five years, and according to the IMF is likely to achieve 7% growth in 2009. Meanwhile, the banking sector has lagged behind the rapid growth of the rest of the economy. At the end of 2008, the banking sector accounted for only 31.0% of the country's GDP in terms of assets and 16.4% in terms of total loans, down slightly from 32.2% and 16.5% a year before (see graph 1).

Uzbekistan has just 29 banks, a small number in comparison with other CIS countries, and many are sector-specialised, which has raised concerns about their exposure to risk. The main factors boosting risk within the sector are the underdeveloped governance and risk management practices, and lack of financial market infrastructure. "We believe that the major constraints capping the banks' further expansion and the strengthening of their financial intermediary function include the scarce resource base (mainly corporate customer accounts and various sorts of funding provided by the government - in the form of both liquidity and capital), the lack of foreign and domestic investment in the banking system and the historically limited range of products and services offered to both corporate and retail clientele," the report says. Moody's forecasts that these factors will exert negative pressure on the growth of the Uzbek banking sector over the next 12-18 months.

Company blues

In addition to the sector's internal weaknesses, the global recession has started to affect Uzbek companies. International demand down for a number of Uzbekistan's commodities has fallen, and domestic consumption has not risen fast enough to compensate. "This has adversely affected certain industries and corporate borrowers, potentially leading to weakening profitability and asset quality and giving rise to capitalisation problems in the long term," the report says.

While it is difficult to evaluate the precise level of NPLs, Moody's estimates they will reach 10-15% of Uzbek banks' total gross loans by the end of this year, but could be as high as 25% under a worst-case scenario. Banks are also expected to see a fall in operating profits, as fee and commission income from remittances sent home by Uzbek labour migrants declines. Bottom-line profitability is expected to be eroded by higher provisioning charges.

The Uzbek government has always played a strong role in the banking system. In autumn of 2008, the government announced plans to inject additional around 400bn soum ($285m) into the six banks deemed to be systematically important. This increased the ownership by state-controlled institutions in the banking system from 56% to 71% (see graph 2). Three fully state-owned banks account for 49% of the system's total assets. Even among the privately-owned banks, the government still exerts a strong influence. Privatisation had previously been on the agenda, but banks are unlikely to find buyers in the current economic climate.

The injection of funds into the sector means that the system as a whole is fairly resilient, including under a worse-than-expected scenario, according to Moody's. However, the impact of this support could be limited. "The local economy is unlikely to remain completely immune to the downturn, which could potentially limit the government's resources and which will need to be spread among a large number of local financial institutions and other recipients requiring state support," the report warns. "In addition, the current hostile economic conditions may potentially reveal latent problems that may absorb a proportion of the facilities expected to stem from the government."

Higher state-ownership within the sector also raises fresh concerns about asset quality. Some 15-20% of loans have been made (mainly by large state-owned banks) to borrowers and investment projects pre-approved by the state authorities and for which state guarantees were often issued. These have generated a higher NPL rate (up to 20%) than the purely commercial loans, which have an NPL ratio of just 5-10%, although this may increase due to the crisis. "The asset quality of commercial banks generally appears to be better than that of state-owned banks. In this respect, we express concern that several institutions' credit underwriting policies and decisions may come under pressure as a result of receiving the government's capital injections in 2009-10," Moody's says.

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