OREANDA-NEWS. On 26 May 2009 was announced, that an International Monetary Fund (IMF) mission visited Kazakhstan to conduct discussions for the 2009 Article IV consultation. The mission reviewed recent economic and financial sector developments and discussed the government’s policy response to the economic crisis. The following statement reflects the views of the mission.

1. The global recession and the ongoing difficulties in the domestic banking sector are negatively affecting Kazakhstan’s economy. Activity has continued to weaken, and our current expectation is that the economy will contract by 2 percent this year before recovering modestly in 2010. We see risks on both sides of this forecast. Higher oil prices could lead to stronger growth, particularly in 2010, while the failure to deal forcefully with the problems in the banking sector or a more protracted global recession would lead to a deeper and longer contraction. Nevertheless, despite the current problems, medium-term prospects remain favorable with a significant expansion in oil production expected over the next decade.

2. Against this background, economic policies need to deal with the impact of the crisis and establish the basis for a resumption of growth. We support the general direction being taken under the government’s Anti-Crisis Program, and note that implementation of the plan is moving ahead quickly in a number of key areas. In our view, however, a clearer and more comprehensive solution to the ongoing difficulties in the banking sector is needed to restore confidence in the system, establish the basis for a sound financial sector going forward, and contribute to improving the investment climate. Our views are set out below.

3. A comprehensive strategy is needed to strengthen the banking sector. The recent steps to raise provisioning levels at the large banks are welcome as this provides a clearer picture of the financial situation at these institutions. However, with the economy contracting, a further deterioration in asset quality is inevitable, and we believe that a full diagnostic assessment, including of the off-balance sheet and overseas assets/liabilities positions, of the large banks is needed. For BTA and Alliance Bank, where special audits are well-advanced, the results should be used to assess the scope for developing business plans and the associated restructuring and recapitalization efforts that would make these banks robust to the vagaries of future economic cycles. This will involve working closely and cooperatively with creditors who should be treated in a consistent and equitable manner in accordance with applicable law and international norms and best practices. At the same time, the authorities should ensure that creditor negotiations do not dictate how the government exercises its authority under the bank resolution law. A prompt resolution is important because the underlying businesses of these banks will deteriorate rapidly if uncertainties about their future linger. For the other large banks, a detailed independent assessment of their balance sheets would give the government a clearer picture of their financial situation, and whether any further action needs to be taken. As part of these overall efforts, additional government support may be needed to protect financial stability, but this should be designed to limit, to the extent possible, public costs.

4. It is important that the authorities have a full complement of tools available to them to ensure an efficient restructuring of the banking sector. In this context, we offer the following comments.

• The proposed amendments to the banking law will broaden the range of options available to the Financial Supervision Agency (FSA) for dealing with troubled banks, although the overall consistency and effectiveness of the bank resolution framework could still be improved further.

• The role envisaged for the Stressed Asset Fund should be clarified.

• It is essential that the Deposit Guarantee Fund (DGF) is in a position to respond quickly and effectively if needed. To be able to do this, it is important that its ability to tap a credit line from the NBK, as set out in the DGF law, and other procedures are clearly established.

5. Looking forward, the goal should be to develop a stable banking system that relies primarily on domestic financing, particularly tenge denominated deposits, rather than external borrowing in foreign currency. This will take time as public confidence in the banks will need to be restored and the public convinced that deposits offer an attractive savings vehicle. Government intervention in the financial sector will need to be carefully scaled back, including returning ownership to the private sector.

6. To underpin this process, it is essential that financial sector regulation and supervision are strengthened and that corporate governance at the banks is improved.

• The FSA needs the legal authority, independence, and resources to carry out its mandate and must be able and willing to intervene early and forcefully when it sees the financial condition of a bank deteriorating. To achieve this: (i) offsite supervisory capacities need to be further developed, including by conducting more rigorous stress tests; and (ii) the frequency and depth of onsite inspections increased. Adequate legal protection for the FSA and its supervisory staff also needs to be ensured.

• The steps being taken by the FSA to strengthen the system by raising bank capital requirements, limiting banks’ ability to borrow in foreign wholesale markets, and creating disincentives for lending in foreign currency through provisioning requirements to borrowers that do not have effective currency hedges are all welcome. It is important, however, that the timing of the introduction of these measures does not put undue pressures on banks in the near-term. When the time is appropriate, the FSA should consider stronger restrictions on foreign currency lending to unhedged borrowers, as is the case in many other banking systems, and clearer limits on off-balance sheet liabilities and guarantees to related parties.

• Measures to strengthen the fiduciary responsibilities of company directors are welcome. The clear identification of the full ownership structure of a bank must be a requirement for receiving and maintaining a banking license. This will lay the basis for more effective implementation of connected lending limits.

• Over time, domestic capital markets need to be developed to provide alternate funding sources for borrowers. The limited ability to raise long-term tenge financing is an impediment for banks to provide longer-term local currency loans.

• Recent steps to strengthen the regulation and supervision of pension funds are welcome. The impact (and contingent cost) of government guarantees in the pension industry should be fully assessed.

7. Inflation has been well-contained since the February devaluation, and we see the current monetary policy stance as appropriate. Given the weak demand environment, we expect that inflation will be contained to 9 percent by year-end and will then gradually decline during the course of 2010. When inflation is established on a downward path, there may be scope for some further easing of policy, although it is important to keep real interest rates at positive levels to support domestic deposits and help banks move toward a sustainable funding base.

8. Regarding exchange rate policy, we continue to view the peg to the U.S. dollar as being appropriate until the problems in the financial sector are resolved. With oil prices having risen from the lows seen earlier this year, foreign direct investment, particularly in the energy sector, remaining strong, and new bilateral financing emerging, flows in the foreign exchange market should be well balanced in the period ahead provided that confidence in the banking sector does not deteriorate further. This should enable the National Bank to keep the tenge within its announced +/- 3 percent band around the central rate of T/USD 150.

9. Over the medium-term, we see benefits to allowing greater exchange rate flexibility. While the dollar peg provides important stability, it also has limitations if the domestic business cycle is not synchronized with the U.S. A more flexible exchange rate would enhance the effectiveness of monetary policy and stem the build-up of unhedged foreign exchange exposures. It would also help the economy respond to commodity price movements, although here the primary burden of adjustment should fall on fiscal policy. To prepare for a change in the exchange rate regime, in addition to adaptations to prudential arrangements, steps are needed to strengthen balance sheets. We therefore welcome recent initiatives to facilitate the refinancing of foreign currency mortgage and SME loans into tenge. A clear communications strategy will also be important to manage expectations and avoid disruptions in the foreign exchange market during the transition period.

10. Fiscal policy is providing considerable support to the economy. With public debt low and financing readily available, allowing the automatic fiscal stabilizers to work and maintaining expenditures as the government is doing is appropriate. However, given the scale of the resources committed through the anti-crisis plan and the budget this year, the primary focus should now be on the effective implementation of this spending. In this context, regular progress reports on the implementation of the anti-crisis plan should continue and timely financial accounts for Samruk-Kazyna published.

11. If the downturn is more protracted than currently expected, we do see scope for fiscal policy to support the economy again in 2010. In our view, any additional spending should focus on strengthening the social safety net and supporting spending on development priorities such as infrastructure, health, and education. Once the current downturn has abated, however, it will be important that the non-oil fiscal deficit is put on a firm downward path and that financial resources are once again accumulated in the oil fund.

12. The government has announced that one of its top priorities is to limit the increase in unemployment. In this context, we welcome the intention to ease the burden of regulation on businesses, particularly in the SME sector, to support efforts to create employment. Initiatives to broaden job retraining programs, together with a strengthening of the social safety net, with also help ease the burden of adjustment for those laid off.

13. Lastly, we would like to highlight two other issues. First, the government’s announced intention to meet all validation indicators of the Extractive Industries Transparency Initiative (EITI) and raise participation of Kazakhstan’s oil companies in the initiative over the next three years is very welcome. Second, the latest draft of the AML/CFT legislation is still pending parliamentary approval. We urge its rapid passage.