The upgrade reflects the continued strengthening of Kazakhstan’s sovereign external balance sheet, low level of government debt and healthy growth prospects, as well as tentative steps towards cleaning up the banking system.

Sovereign assets saved in the National Fund (NFRK) afford a growing cushion against economic shocks. Fitch forecasts sovereign net foreign assets will reach 45% of GDP by end-2014, up from 37% of GDP at end-2011. Government debt is just 11% of GDP. Kazakhstan is already the second-strongest sovereign net external creditor in the ‘BBB’ category and the 12th-strongest among rated sovereigns. The NFRK saved more than half of oil-related inflows in 2011.

Fitch expects a surplus of around 3% of GDP in 2013 at an average oil price of US $100/b. The agency would expect the general government budget (including the NFRK) to remain in surplus even if the oil price falls to $80/b.

A slowdown in the extractive sector and in external demand, plus the impact of a drought on agriculture, will limit growth to no more than 5% in 2012, down from 7.5% in 2011. Domestic demand has partly compensated, thanks to strong wage increases and moderate inflation. Fitch expects growth to pick up in 2013-2014. Over the medium term, oil and mining production will increase, based on capacity increases underway.

The growth outlook and sovereign balance sheet outlook effectively outweigh risks emanating from the troubled financial sector, which continues to be a rating weakness. At 37% of total assets, non-performing loans (NPLs) are the highest of 50 emerging market banking systems for which Fitch collects banking system data and are particularly high in institutions rescued by the state and majority owned by state holding company, Samruk Kazyna. Banks are still recognising problem loans, and some potentially problematic exposures are still not treated as impaired. However, the banks have created provisions equivalent to 32% of total loans, added to a capital adequacy of 17.7% of risk-weighted assets, offering some loss absorption capacity.

Although the government has taken positive policy steps in 2012 to encourage banks to rid their balance sheets of bad assets, banks will likely write off NPLs slowly, and seek to deal with the problem via growth. Fitch believes it is unlikely that the government will inject major new resources into the banks, on top of the 8%-9% of GDP already deployed since 2008. One cost of this gradualist approach is slow credit growth, but since the extractive sector relies little on bank financing, the impact on the overall economy will be limited.

A smaller, less dollarized and less externally indebted banking system poses fewer risks to the sovereign than before the global financial crisis. Bank lending has shrunk to 38% of GDP in 2012 from 58% of GDP in 2008. Dependence on external borrowing has been reduced. A second restructuring of external debt owed by the third-largest bank, BTA, if accepted by creditors, will reduce its external debt to bondholders by US $8.4 bln (4.2% of GDP) and remedy its capital shortfall.

Rating outlook – Stable

Positive rating action would likely require substantial strengthening of the sovereign and external balance sheets over the medium term. Larger sovereign assets would provide greater buffers against commodity price shocks. A more effective clean-up of the banking sector would also be positive for the rating.

Developments that could lead to a negative rating action include:

• -A political shock. President Nursultan Nazarbayev is secure and largely unchallenged after winning a fourth term in April 2011 and the ruling party controls parliament. However, the long-term issue of succession is yet to be settled. Social tensions have surfaced in 2011-2012 and governance indicators are weak, increasing political risks.
• Substantial fiscal policy loosening. In 2012, the government has raised the ceiling on transfers of oil revenue to the budget from the NFRK by a manageable US $1.2 bln or 0.6% of GDP, but it maintains the ambition to consolidate the public finances over the medium term. Running down sovereign assets to fund increased spending by contrast would be negative for the rating.

Key assumptions and sensitivities

Kazakhstan’s creditworthiness is sensitive to commodity prices. Oil revenues account for half of general government revenue and 70% of export revenue. Fitch assumes that Brent averages $100/b in 2013 and 2014. The rating is robust to fluctuations around this but a severe and sustained commodity price shock that resulted in a weakening of the sovereign balance sheet could prompt a negative rating action.