Aidarkhan Kusainov: Prognoses for Kazakhstan’s Banking and Real Estate Sectors

From ThinkTank.kz

Kazakhstan’s external debt is very high — about 95 percent of the country’s GDP. Was this the cause of the financial crisis in Kazakhstan or is the global liquidity crisis to blame?

Kazakhstan’s external debt is certainly high, and it does to some extent reflect the instability of the financial system in Kazakhstan — but only to a certain extent.

The main problem is the pace of the growth [of Kazakhstan’s economy] and the efficiency of the utilization [of this growth] — or in the quality of the loan portfolio. The increasing growth of bank debt has been linked mainly to rapid growth in retail lending — mortgage and consumer lending — as well as in residential construction lending (which has been virtually equivalent to mortgage lending, especially recently). At the same time, the lending practices have become increasingly risky — low standards for issuance of mortgages, absence of developed credit bureaus and credit histories, etc. This way, instability has been embedded into the system and it only grew together with the expansion of credit.

Therefore, the problems in Kazakhstan’s financial sector are home-brewed. The mortgage crisis in the United States was not the cause for the strained state of our financial system; it simply acted as an accelerator and became a kind of a stimulus which revealed the problem… And at the same time, it presented an excellent opportunity to blame existing problems on outside forces.

Mortgage - a pyramid scheme for financial speculators…

A mortgage is simply a tool for long-term borrowing — and a quite effective tool in that. But the tool calls for correct, reasonable and cautious use. It is a good tool for those who want to buy a property, have enough money to meet the payments, and are reasonably sure of their long-term source of income.

But when our banks issue a mortgage to a young couple without any confirmation of income to purchase a third, fourth or fifth apartment, it is pure speculation where the mortgage is being used as leverage — this is always a risky proposition.

In the case of real estate, mortgage lending itself was not the critical factor — but its misuse and misregulation were. I am opposed to shifting the blame the mortgage lending programs and make this instrument a scapegoat for the crisis.

You mentioned mortgage lending as one of the causes of the crisis. Could you talk a bit more about the role and impact of mortgage lending and real estate in general on the financial sector? You yourself wrote that real estate is an important factor in the financial well-being for the people in Kazakhstan.

First, I would like to deviate slightly and talk about the the nature of such rapid increase in real estate prices.

Within all markets, there are always assets that are undervalued for some reason — they may not be “fashionable”, may be in distress, etc. And when it becomes clear that the asset is underestimated, some investors begin to actively buy it and its price begins to grow much faster than of all other assets. Then everyone notices the rapid growth, people try to jump on the bandwagon, and the price grows even faster until it reaches its “intrinsic value”. However, the inertia causes the movement to continue irrationally, pointlessly, until it reaches a top [well beyond this intrinsic value] and then falls down.

This is a normal cycle, this is how the stock market works, and indeed all markets for freely traded goods. This is how it was and this is how it always will be. The question is only about what asset we are talking. If it’s equities and there are many professional players who participate in the market, they know and understand these mechanisms. If it is residential real estate, however, it involves large segments of population, from students to retirees, who do not fully understand these mechanisms.

This is what has happened to Almaty real estate, in my opinion. By my estimates, property was undervalued by 50 percent in 2000-2002. That is, according to different estimates of income, macroeconomic parameters and comparative international indices, the cost of one square meter was twice as low as people could feasibly spend when buying property.

This undervaluation was the result of completely understandable factors. The collapse of the Soviet Union, the financial crisis in Southeast Asia, Russia’s default in 1998, the correction of tenge against the dollar in 1999, low oil prices and so on resulted in that few people thought about buying new or renovating old properties. An apartment was a purchase for 10-15 years - that was the way of thinking and something for which people had to mentally prepare.

When somewhere around 2002-2003 the incomes started to rise, people began to buy apartments, move around and be more mobile — at the same time, the prices of real estate began to climb as well. And they started to climb quickly because people inherently understood that they could spread themselves out and the dream of purchasing an apartment became something tangible.

And we entered into an exciting time when the prices began to rise by 60-100% a year. And buying and selling real estate became a real business — buy today, tomorrow the price will go up.

Here we reached the point when real estate began to significantly influence financial activity — due to a strong multiplier effect. And that happened sometime in 2004.

And what effect did this multiplier effect have, other than well-known positive effects like employment growth, improvement of housing conditions, wider availability of residential property?

First — the spread of mortgage lending. As I said before, in itself it is an excellent tool, but it can be a dangerous tool if used as financial leverage, as an instrument for speculative transactions. This product flourished because suddenly it became possible and advantageous to buy real estate without any capital (or for just 15 percent of the initial deposit) and sell the next day — the gain would be more than enough to cover any interest payments. Unlike in Russia, here [in Kazakhstan] you can borrow to buy even an unfinished apartment.

This way, you could sell one apartment for $100,000, then take a mortgage loan to buy a new apartment and a couple others in an early stage of construction (in order to sell them and repay the whole loan within a year), and the balance of the money can be used as down- payment to purchase consumer goods like a refrigerator, a TV, a car. And there are no credit bureaus, no standardized system that would monitor the levels of debt of individual borrowers.

Second — the rapid explosion in consumer credit. One case I already outlined above. The rest is simply borrowing against residential property and spending money. Have fun!

Third — new construction. With those real estate prices and new “purchasing power” backed by the banks, everyone was more than happy to lend to new construction projects. And massive construction began. And the real estate companies and speculators began to purchase land for unreasonable prices, fueling the demand for land and old homes.

Fourth — massive lending to small- and medium-sized businesses and lowering of risk management standards. Roughly speaking, if you just put in your property as collateral [to raise money to start a new business], your actual field experience, skills, management prowess and business plan are no longer so important. The consequence of this has been the declining quality of the loan portfolio.

All these factors led to a sharp rise in the need for various types of loans. It is unambiguous that incomes and the economy in general rose, but I want to stress this again: the fast or rather explosive growth in the willingness to borrow was triggered by rising real estate market, to which we reacted too late and too mildly.

Well, the demand for credit has grown, but how is it possible that the external debt became so high?

Here we come to another important aspect.

From 2000 to 2005, Kazakhstan’s economy has been in an extremely advantageous position in terms of growth. Virtually all of this time, the prices for almost all major export commodities rose significantly: oil, metals; at the same time the production grew in volume as well. And when the volume and price simultaneously increase by 10-20 percent a year, then an export growth of 20-40 percent is guaranteed. Thus, the economic situation in Kazakhstan — the growth of its gold reserves and the National Fund, increased income of the population, the improvement of Kazakhstan’s sovereign rating — makes it a very attractive market for investment, and naturally, the banks have been very successful in attracting many foreign investors. Additionally, the service and other associated sectors have been developing as well, i.e. the economy and the income grew — to lend to such an economy was clearly favorable and desirable.

At the same time, our banks remain the sole source of capital for businesses and individuals in Kazakhstan. Let me explain, the often talked about “business-to-business” loans — which are also part of external debt — are just credits of parent companies to their subsidiaries, and are mainly concentrated in the mining and oil sectors. Few Kazakh companies have been able to attract money from abroad independently, and those few that could are already companies of international standing.

Thus, the banks got an opportunity to borrow and borrow significantly, and they were helped greatly by the economic performance of the country as a whole.

This is how it came to [the high level of] external debt.

Returning to the first question, do you believe that the crisis is of our own making?

Yes, I think so and, in fact, I would suggest that we are having two crises.

First — the financial liquidity crisis, and second — it’s what I would call an overall currency crisis. And I think that our banks are the source of both.

The first one is generally well understood and obvious to all. The bubble in the real estate market burst — huge amounts of money stayed trapped in houses which cannot be sold - at least for the prices at which they are listed, unfinished houses, barely laid foundations, and purchased land. The consumer lending sector has come to a virtual halt - employees are being dismissed, sent on unpaid leave, etc.; this development could lead to default on mortgage payments for apartments bought for investment [or rather speculation]. This is certainly no secret, this matter has been discussed at the government and parliament level - the state is currently buying up commercial housing for government needs. In fact, public money of the money of national companies is being thrown together with private money.

The second one is the currency crisis. Currently, the real exchange rate of the tenge to the dollar stands at around 160, and for about a year now, it has found itself in the region of 140-160 (data can be easily found on the website of National Bank of RK) — this means that the dollar should cost around 190-200 tenge. Last time when the disbalance between the real and actual exchange rate was so high was just before the sharp devaluation of the tenge in February 1999 when it appreciated from 75 to 140 tenge to the dollar.

The exchange rate has been supported (and the strengthening of tenge was really difficult to contain), because prior to 2005, our exports grew rapidly both in absolute terms and in terms of generated revenues; in 2006, the growth in volume (at least with regard to oil) has slowed significantly, but here the record prices helped. Moreover, major share offerings took place (large to the extent that the magazine “Economist” listed Russia and Kazakhstan as the potential risk factors of world economy), major bank borrowing took place as well.

So, this is what we have for foreign exchange payables in 2007:

o A significant increase in dividend payments and other compensation due to foreign investors thanks to record prices of hydrocarbons and metals last year, an increased number of shares in a foreign ownership (from new share offerings in 2006), and the doubling of external debt.

o A significant increase in imports (to be around 60 percent judging by the first two quarters)

o A significantly negative balance sheet as a consequence of foreign lending and refinancing of short-term debt.

As for the receivables situation:

o Growth in exports, but not so much as the growth in imports (to be around 20 percent judging by the first two quarters).

o Large placements of shares are not anticipated

o It is unlikely that significant external financing will be attracted.

Therefore, I anticipate that, in order to preserve this course, it will be necessary to use foreign exchange reserves. As a matter of fact, they are already being used - only in August and early September, they declined, if I am not mistaken, by about 10 percent. It just happened sooner than anticipated because of the global liquidity crisis. The prospects for 2008 are also not encouraging.

Even if we successfully resolve the issue of domestic liquidity, minimize the casualties in the banking system and manage to avoid a substantial correction or crisis on the real estate market, our foreign trade statistics and balance of payments are not likely to change.

Imports will rise because of a strong tenge. The growth in exports will not significantly exceed the growth in imports (unless the price of oil pass the 100 dollar mark) since the current state of industry will not allow any increase in local production. Planned domestic industrial will not be operational before 2010, and again, in order to build the factories a lot of imported equipment, services, and specialists will be needed. Dividends will remain high (though prices are lower than last year but still comparatively high), as will the interest and refinancing payments.

So, going from one crisis we will fall into another one, unfortunately. Unless we adjust the exchange rate, which, again, complicates the credit situation… Most of the credit was issued in tenge but the financing was brought into the country in foreign currencies (and the proportion [of foreign financing] was very, very significant).

Somehow, everything looks quite hopeless.

That’s how it turned out. I think that such scenario has been considered because I saw and read the “Report on Financial Stability” which was prepared by the National Bank and the Financial Supervision Agency last year. Many figures in my analysis are from this report. Last year, the AFC [Financial Supervision Authority] has attempted to tighten the requirements for issuing loans and introduce stricter reserve requirements, and it even fulfilled the first part of the plan. The introduction of the second phase as planned would certainly have cooled the growth, and could, perhaps, lead to lower economic growth indicators. But it would help make the whole system more stable, and would bring much needed stability to further development. But you remember the fierce resistance of the bankers and the business lobby who almost accused the AFC of sabotage, and, unfortunately, the second phase has been postponed, as far as I know, until September this year, and now until October. Overall, I think that a year ago, the long-term sustainability has been sacrificed for short-term profit.

However, as a result of this crisis, I think that stable banks with long-term view that did not jump on the bandwagon of short-term gains will ultimately benefit.

What are your predictions regarding all the above? What will happen to the real estate market? What will be the price of one square meter? What can we expect next?

I considered several scenarios. Let’s talk about two of those.

The crisis in the real estate market, in case it’s not obvious to someone, has arrived and the process took place as follows:

In mid-2006, the cost of one square meter (index “Roof”) went through the top range of what could have been considered a fair price and went into a phase of irrational escalation. At that time, I predicted the following:

o About 6-9 months (from mid-2006) would be needed to understand that the prices were already too high, so by the summer of 2007 a “summer slowdown” would materialize. I would like to note that for the previous three years the prices were rising in the winter and in the summer.

o In September a small rush to the market will start - as a result of the fact that all “investors” will finally completely satisfy themselves that the prices are no longer rising, and will offer their “investment” properties up for sale, of course at inflated prices.

o During the next 2-4 months a smooth decline will set in, and it will finally become obvious to everyone that real estate does not sell. This will start a wave of selling, defaults on mortgage payments etc.

o Accordingly in the winter of 2007-2008, a liquidity crisis will set in with a series of bankruptcies, calls on loans, and a withdrawal of capital. This will lead to a correction of the exchange rate.

The second scenario looks as follows: tightening of state regulation, introduction of the new reserve requirements, tightening of issuance of mortgage and consumer loans, gradual correction of the exchange rate, drop in the real estate market, etc. This entire scenario that I suggested in the early summer of 2007 has not materialized.

I anticipate that in any scenario, the price for one square meter will be in the region of 1000-2000 dollars (at the current exchange rate - with a downward correction of the exchange rate it may be even lower).

As you can see, the principle difference lies in who begins the process. It will either be the market and we will have to live with the possible consequences; or it will be the government that will be able to choose the time and mechanism to minimize the possible negative consequences. I still think that it would be correct for the government to spearhead the process in order to give it a clear frame and manageability.

The American mortgage crisis came right into this situation. As you can see, in our analysis, this crisis jumpstarted certain processes, but it is not the principle element. With its arrival, though, an opportunity arose to either conduct some necessary corrective actions; or to use it to shift the blame for the current situation on this “external factor.”

You mentioned the possible bankruptcy of Kazakh banks — how massive will this process be?

Well, some banks are going to go bankrupt, in that I am almost sure, but which ones and how many I cannot say. I can only assume that those banks will survive that have an extensive depository base - the size of this base should be large relative to assets, good risk management and a relatively low level of external borrowing. It seems to me that in these matters it will not be the absolute size that will be essential for survival; small banks with a loyal customer base, both creditors and depositors may be able to weather the crisis well or even gain some benefits from the whole process. That means that the banks that remained banks in their activities will continue to exist. Important are reliability, risk management and customers - the size is not as important.

What can we expect next?

This fall and winter will be very difficult for many, but by the end of the year, I think, everything will more or less stabilize. At the same time, I think that this crisis or correction will prove to be quite useful for the overall economic health.

What will disappear will be the school of thought that you can do anything and you will always make money. Normal business will begin to develop, with risk assessment, normal business principles, good governance; businesses will be restructured, small business will begin to develop - something it can no longer do in current conditions because of the cost of real estate and related rents.

This way, many opportunities and prospects will open for our business on the global stage. Indeed, the competition in the world is competition of technologies and talent. And with the current attitude (of the type that no matter what you do, you are still going to get paid), who will invest in them? Why build management system, develop technology, strategies and plans if the economy is based on the idea to buy cheap property and resell it at higher price, or borrow cheap money in the West and a resell it here. Commodity exporters do not care about the exchange rate but producers do. And for the period from January 2006 the appreciation of the exchange rate was about 6 percent. If your operating margin is 20 percent, then you will lose 30 percent of profits, and this without taking into account the growth in wages because your good specialists are being poached by trading companies since the same 6 percent go to them.

Had all this happened earlier, it would be a correction - today we can discuss whether it is “a crisis or substantial correction” - in six months, it will definitely be a crisis.

News Roundup - October 29, 2007

Reuters: EU Urges Fair Treatment for Kazakhstan Investors

The European Commission said on Thursday that energy-rich Kazakhstan should treat foreign firms fairly, a day after the Asian country’s president signed a controversial law that could affect investments by energy firms…

Global Voices Online: Kazakhstan Blocks Opposition Websites

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International Herald Tribune: Kazakhstan Shuts Opposition Websites amid Family Feud

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Neweurasia.net: Four Billion Dollars

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Neweurasia.net: Keep Talking

The continuous trouble over the delay in the Kashagan development has seen a few new developments over the last week. The 22 October deadline after which talks between the consortium and the Kazakh government about the stalemate should have originally been resolved got extended…

TREND: Kazakhstan Will Strengthen Its Influence on Kashagan Project: Expert of Argus Media

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Radio Free Europe / Radio Liberty: Kazakh President Accused Of Ordering Opposition Leader’s Murder

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Harper’s Magazine: Mea Culpa: Haste Makes Mistake

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Hemscott: Max Petroleum Posts FY Loss; Abandons East Alibek Well

Max Petroleum PLC reported a pretax loss of 24.75 mln usd for the year to end-March 2007, and said its shares are expected to resume trading on Oct 29. The company, whose shares have been suspended pending the publication of its annual report for the year to end-March, had posted a pretax loss of 23.66 mln usd in the period from April 8 2005 to end-March 2006…