Kazakhstan’s Banking Crisis - What Went Wrong?

Kazakhstan’s financial system is currently undergoing a trying period coping with lack of liquidity caused by the subprime crisis in the United States. The banking system is the most developed among the CIS states, possibly even counting Russia, but massive lending sprees in international financial markets and overexposure to the (suddenly hurting) real estate sector seem to be stretching its limits.

The first sign that international investors grew wary of Kazakhstan’s success story was the public offering of the GDR’s of Kazakhstan third largest bank, Alliance Bank, on the London Stock Exchange. The bank tried to capitalize on global appetite for Kazakhstan’s IPO’s that enabled two other large Kazakh banks to raise record amounts of money on the LSE and made Timur Kulibaev officially a billionaire. However, by the time Alliance presented its shares for sale, it was clear that investors were going to pay closer attention to what was offered. The subprime crisis was still contained to the United States, and it seemed likely that the only victims would be a few overleveraged hedge funds whose bets went wrong. But investors suddenly became wary of inherent risks not only in exotic derivative products but also in exotic emerging markets like Kazakhstan.

At the first look, Alliance Bank was a success story and a poster child of Kazakhstan’s emerging banking sector. Within less than three years it grew from being the tenth largest retail lender in Kazakhstan to being the leader in June 2007. The bank was a trailblazer in marketing strategies (some rather controversial) to attract retail and SME clients and was the fastest growing banking institution in Kazakhstan. However, the risk factors that this fast growth brought are representative of Kazakhstan’s banking sector as a whole.

The overexposure to the retail and construction sectors (in the case of Alliance retail lending represented 45 percent of its loan portfolio) has made the banks vulnerable to macroeconomic shocks. This systemic risk has not been a factor yet as Kazakhstan’s overall economy remains relatively stable and healthy. Another important risk factor, however, exposed Alliance, and other Kazakh banks, to the current crisis - its dependence on foreign credit. More than fifty percent of Kazakh banks’ borrowing is conducted abroad, and only 2006 they managed to obtain a combined $18 billion from international creditors. As long as credit was cheap, this influx of foreign money helped fuel the rapid growth of Kazakh banking sector and significantly contributed to the real estate booms in Almaty and Astana. The downside, however, was the ever increasing dependence on the willingness of foreign lenders to finance this growth. Until this summer, credit spreads were extremely low as compared to historical averages. This was thought to be due to a better ability of investors to understand and manage risk with derivative instruments. The fallacy of this view is clear now but for several years it contributed to the willingness of international lenders to overlook the inherent risks of investing in an emerging economy which depends almost entirely on the global oil prices boom. And Kazakh banks borrowed more than willingly, profiting handsomely lending at high rates to Kazakh home-buyers and retail consumers. It was an almost perfect arbitrage opportunity — as a consequence, they experienced rapid growth and their investors reaped massive rewards from IPO’s in London.

In retrospect, it is not difficult to determine that this growth was not sustainable and its cause was mainly (temporarily) cheap credit. During the height of the Kazakhstan frenzy, however, investors, creditors and credit rating agencies largely chose to ignore the presence and possible consequences of the inherent risks. In those rare instances when the risks were brought up, they were muffled by the great showing of Kazakhstan’s overall economy and its double-digit annual growth. Kazakhstan and its banking system were held as an example of desirable and functioning banking reforms that helped distribute oil wealth among the people.

The Kazakh banks’ penetration of the retail sector is the highest among the CIS states, and Kazakh banks have been among the most active and innovative. This level of development, though, has been the reason why Kazakhstan finds itself on a verge of a banking crisis. Kazakhstan’s banks were among the few in the former Soviet states that could easily (and cheaply) raise funds on international markets. They have been the fastest in rolling out banking and mortgage products and dispersing credit among the population. But this perfect storm of the Kazakh banks’ willingness to borrow, and the eagerness of international lenders to lend to not miss out on the Kazakh miracle led to an overexposure to foreign borrowing. As mentioned above, Kazakh banks raised more than half of their funds on international markets. Russian banks, as a comparison, raised approximately 18 percent of their non-equity funding on international markets. At the point, when international lenders realized that Kazakhstan is an emerging country with a highly suspect authoritarian government and they should require an appropriate compensation for investing in such conditions, Kazakhstan’s banks were caught on the wrong end. They held $40 billion of foreign loans in foreign currencies, a significant share of which had to be refinanced at suddenly very high rates.

The continuing lending spree also led to an artificial inflation of the value of the Tenge, and the sudden drop in demand for Kazakh lending was immediately reflected in an increased volatility of the currency. This factor obviously further exacerbated the situation making the repayment of the foreign-denominated debt all the more unpredictable and difficult. The Kazakh National Bank has been pumping money into the financial markets since August and it seems that it has managed to keep the Tenge relatively stable.

Despite these systemic setbacks, it is unlikely that Kazakhstan, and its banking sector, will suffer a significant crisis. The system that first helped to jumpstart the rapid growth of the Kazakh banking sector and then was a cause of a liquidity crisis, should help the banks (at least the majority of them) to survive and thrive. The Kazakh government has already issued reassuring statements to international lenders and investors, and the consensus is that it will readily step in to bail out a major bank that would get into serious trouble. The question now may be where the line will be drawn. A run at the bank in Alliance shows that it may find itself right under the line but overall the banking sector should emerge stronger.

The credit crisis in Kazakhstan follows the predictable pattern (at least in hindsight) of boom and bust. First foreign lenders and investors did all they could to get a piece of action in the booming Kazakh market, often ignoring present warning signs. Then, when the confidence in Kazakhstan’s economic miracle finally suffered, they overreacted to warnings that should have been obvious for a long time. For Kazakhstan and its young banking system, this crisis should be an important lesson. Even before the crisis unfolded, the financial authorities were trying to pressure banks to be more conservative in their lending and borrowing policies — recent events should leave no doubt that while the Kazakh banking system is fundamentally strong, certain restraint is necessary and in long-term interest of both the Kazakh economy and the banks’ shareholders. As for Western investors, Kazakhstan just became another hot emerging market that suddenly went cold. However, the continuing commodity boom will without a doubt provide further impetus to continuing growth of Kazakh economy and strengthening of its banking sector, and today just may be a perfect time for investors to find some great bargains among the battered banks.

News Roundup - October 11, 2007

EurasiaNet: Oil Companies on the Defensive in Kazakhstan
Development of the Kashagan oil field appears close to getting back on track, as the Kazakhstani government and a consortium led by the Italian oil company Eni SpA make progress in settling grievances surrounding the project…
Reuters: Total Presses for Kashagan Deal before End-Year
Talks between Kazakhstan and a consortium led by Italian oil company Eni on the development of the giant Kashagan oil field should be wrapped up quickly, the head of French oil company Total said on Wednesday…
CNN Money: Kazakhstan’s Alliance Bank Assigned ‘B+’ Corporate Rating; Outlook Stable - S&P
Standard & Poor’s Ratings Services assigned Kazakhstan-based Alliance Bank JSC a ‘B+’ long and ‘B’ short-term counterparty credit ratings, with a stable outlook…
Kommersant: Kazakhstan’s Ratings Lowered
S&P lowered the country’s sovereign rating on October 8. At the same time, It lowered its long- and short-term rating on obligations in tenge from BBB+/A-2 to BBB/A-3 and gave its short-term obligations in hard currency an A-3 rating…
Radio Free Europe / Radio Liberty: EU Pushing Energy Cooperation With Central Asia
European Union foreign policy chief Javier Solana is in Kazakhstan today as part of a Central Asian tour to promote cooperation between the region and the EU, particularly in the field of energy resources…
Radio Free Europe / Radio Liberty: OSCE: Member States Must Stand Up To Russia’s ‘Bluster’
For the past two weeks, civil-society groups from across the former Soviet region have been meeting in Warsaw with member states of the Organization for Security and Cooperation In Europe (OSCE)…
Radio Free Europe / Radio Liberty: Making Sense Of Post-Soviet Alphabet Soup
Youth leaders from the four member states of the GUAM Organization for Democracy and Economic Development meet today in Azerbaijan’s capital, Baku…
Ferghana.ru: Blended into the United Social Democratic Party, the Opposition Learns to Live in the New Kazakhstan
The opposition is learning to live and operate in the conditions where a multiparty system coexists with a one-party parliament as peacefully as the Communist regime and free enterprise do in China. When the figures reported by the Central Electoral Commission or Statistics Agency differ so greatly from what one sees with his own eyes, it inevitably brings to mind the concept of parallel worlds…
Gazeta.KZ: EU Is Interested in Deepening the Cooperation with Kazakhstan
Kazakhstan Today. October, 10. ASTANA. The European Union is interested in deepening the cooperation with Kazakhstan, said on briefing after the meeting with the RK Minister of Foreign Affairs Marat Tazhin the EU Council Secretary General Xavier Solana, as reported by KZ-today correspondent…
Kazinform: Fitch Teleconference: Kazakhstan Sovereign Outlook
Fitch Ratings will host a teleconference call on Wednesday 10 October at 17:00 Moscow time (14:00 London time) to discuss Kazakhstan’s outlook and key sovereign rating drivers, following the agency’s sovereign rating mission to the country last week and its affirmation on Monday 8 October of Kazakhstan’s sovereign ratings, while revising the Outlook to Stable from Positive…
RIA Novosti: Moscow-Astana Space Symbiosis
Kazakhstan and Russia have few reasons for discord, but Russian rocket launches are an increasingly sore point between them. In Kazakhstan’s opinion, they often fall on its territory causing significant environmental damage…
Gazeta.KZ: The President of Kazakhstan Discussed Almaty Regional Financial Center Development
The President of Kazakhstan, Nursultan Nazarbayev, discussed with his freelance adviser, James Wulfenson, perspectives of development of Almaty Regional Financial Center, as reported by KZ-today correspondent…