How Deep Is the Credit Crisis in Kazakhstan?

Kazakhstan is facing two major problems:

1) Large external short-term debt that the banks hold on their books and the upcoming refinancing of this debt (while facing an increased cost of new borrowing abroad).
2) Massive lending to construction companies and issuance of mortgages to general population (and the growing risk of default due to possible decline in the value of housing as collateral and the inability of people to pay the high rates of previously obtained loans).

To solve the first problem, the banks will be forced to (since the cost of external borrowing is not likely to decrease): (a) refinance their debt abroad at higher rates, (b) increase the cost of credit in the domestic market (raise their interest income), (c) raise tariffs on banking transactions (increase their non-interest income), (d) increase their capital (attract new shareholders' capital), (e) reduce operating costs, (f) sell non-core assets (g) buy foreign currency in large volumes on the domestic market to repay external debts (which may cause the tenge to devalue).

This will lead the banks to "tighten their belts", and people and businesses will see the bank lending becoming more expensive. That by itself would not be a crisis. There will be a crisis, however, if a second problem will not be resolved: the sharp decline in property values and the deterioration of the loan portfolio of banks. Then the scenario could be similar to the subprime crisis in the USA --- a sharp increase in defaults on mortgages, declining value of the banks' assets, and new risks to financial stability of banks that are least diversified and most exposed to mortgage and retail banking.

From what we know, it seems that Kazakh banks will be able to weather the current crisis. The government (including Kazakh president Nursultan Nazarbayev) and the Kazakh National Bank have stepped in and made it clear that they will support the banks and will provide necessary liquidity if needed. The question, however, is whether the crisis is only concentrated in the banking sector. The Kazakh government would undoubtedly be able to rescue the banks if they were the only sector of the economy affected by the crisis and if the crisis only involved a sudden cut-off of foreign credit. If the disease is spread among the entire economy, though, it can prove too much to handle even for this energy-rich petro-state. And there are growing signs that other sectors are affected as well --- the construction sector has been hit hard by the sudden draught of liquidity, the inflation has been running wild in the last few months, and the government even had to intervene to keep the prices of foods from rising. These symptoms may simply be the result of the banking crisis and overall uncertainty over what its consequences will be and may take care of themselves as soon as the government and the financial authorities bring the liquidity draught under control. However, should they be indicative of larger imbalances in the Kazakh economy, it could become much harder for the government to put together a bail-out plan not just for Kazakhstan’s banking system but also for the entire economy.

Interview with Alliance Bank Chairman Dauren Kereybayev

The price of Alliance Bank's shares traded on the London Stock Exchange has declined by more than half since its IPO in June. There is growing skepticism among international investors about how the bank will be able to refinance its foreign loans and whether it will be able to stop the continuing outflow of deposits. Talking to the chairman of Alliance Bank Dauren Kereybayev, however, it appears that the bank is trouble-free and in perfect shape to continue its fast growth in the Kazakh retail banking sector. Below is an interview with Kereybayev published in Kazakh business weekly "Business and Power". The original version in Russian can be found here.

Not long ago, you returned from a road show where you met with international investors? What can you say about their attitude towards Kazakh banks?

I think it is more correct to talk about their attitude towards the Kazakh banking system as a whole. If you noticed, the stock prices of Kazakh banks tend to move up or down together; if the prices are decreasing, then they are decreasing for all the banks; and if they are going up, it’s also the same. In principle, the investors’ mood is reflected in a wait-and-see attitude and their willingness to immediately forget past problems. The wait-and-see attitude that is found mainly among the Western investors is the result of their belief that we have not yet seen the end of the global credit crisis. Only after it is over, can we realistically assess who was affected by the crisis and how. The concern of British investors, specifically, is understandable because even an institution like Northern Rock with a two-hundred-year history suffers massively from the liquidity crisis. On the other hand, investors have short memories, and are ready to approach previously problematic markets, if they see that potential profits outweigh the inherent risks. Therefore, we can assume that in February of next year, when all banks publicly show the results of their 2007 activities, the Eurobond market will slowly start to resurrect.

Do you think that Kazakh banks will be able to refinance their current outstanding debt at more or less attractive terms?

Of course, the rates will be slightly higher than in the recent past but nevertheless they should allow the banks to refinance their debt and continue their activities. The result of this, however, will be that the growth of Kazakh banking sector will not exceed 30 percent next year.

Some analysts predict a second wave of the current crisis because of possible defaults in the American mortgage market. Are you ready for this scenario?

Even if there is a second wave, and there will be one, it should not affect us. I think that Kazakh banks are facing their most difficult period right now. Once they refinance their debt, there will no longer be such indiscriminate issuance of loans, especially mortgage loans. The first wave of the crisis was so distressing because it happened suddenly. It’s like a typhoon --- the first wave brings maximum destruction and damage, but by the time the second wave comes, people have time to prepare. Incidentally, I wish to point out that investors appreciate the actions of our regulators aimed at maintaining the stability of Kazakhstan's financial system.

Do you think that Western investors see today as an opportune time to enter the market and pick up the suddenly inexpensive shares of Kazakh banks?

Absolutely. They are observing the markets and trying to determine when the market sentiment changes not just in Kazakhstan but everywhere. This is the wait-and-see attitude that I already mentioned. At one point I even thought that the market players were attempting to escalate the crisis to cause an even greater fall in the prices of securities, so that they could buy them even cheaper. There is a whole army of professional markets participants with their own rules of the game and a plethora of financial instruments that they use to their goals.

What about the current liquidity situation at Alliance Bank?

We exceed all the liquidity rations. As far as the bonds accumulated in the National Bank as minimum reserves are concerned, we are not creditors. All this, in my view, clearly shows the status of the bank. We have openly spoken about our need to refinance $406 million in foreign loans by the end of the year. The non-critical bank liquidity stands currently at more than $2 billion, and as you know, our shareholders have placed on the accounts of Alliance $220 million from the IPO proceeds. Additionally, the bank receives monthly another $120-150 million from repayments of our outstanding consumer credit. Also, the recently altered method of calculating the minimum reserve requirements resulted in the lowering of these by another 15-17 billion tenge ($125-141 million) which provides additional liquidity for the bank. Therefore, the current state of liquidity will allow the bank to fulfill its internal and external obligations.

Will consumer lending continue to be the top priority for Alliance Bank?

Sure. Consumer lending has proven its viability in the face of the mortgage crisis. Consumer lending is based on the real income of the population which is generally not declining but rather increasing because of the encouraging macroeconomic situation in the country. This is why the current crisis has not been reflected in the retail lending market --- not in the volume of loans issued, not in the terms of repayment. We did not stop for a second, and we continue to grow in the same direction. It is necessary to understand that this is a specific product and it’s necessary to be able to work with it. Today, the approach that we chose has confirmed its viability, as opposed to concentrating the loan portfolio in mortgage and construction lending. In our bank, construction and mortgage only make up 22 percent of the loan portfolio. This, according to our estimates, is lower than for Halyk Bank, Bank CenterCredit and Kazkommertsbank. We have, incidentally, begun issuing consumer loans because we did not want to compete in the overcrowded mortgage market. The rivalry between participating banks led to seriously declining rates and low profitability.

The emergence of the savings product “Excellent” (its rates greatly exceed those of the competition) has caused talks that this could be an evidence of problems in the bank?

If you take a look at the market, you will see that we have the highest rate of return on our loan portfolio. That allows us to play with rates depending on the market situation. Also, if you added the cost of prizes, raffles and other promotional activities that other banks incur with their loans, I am sure that you would come up with the same rate that we pay our customers. A few years ago, Alliance Bank started an initiative to abolish these promotional activities but none of the other banks supported our efforts. Today, we no longer look at the other banks on this issue --- Alliance Bank is conducting an independent deposit policy, and the rejection of promotional activities like raffles or lottery is an integral part of our policy.

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.

Kazakhstan's Banks Feel the Pinch of Global "Flight to Quality"

Even Kazakhstan is not immune from the trembles that shook the credit markets worldwide following the crisis in the American market for subprime loans. Today, Reuters reported a “liquidity deficit” that Kazakh banks are facing after a rise in interest rate spreads on international credit markets. While the banks dismissed the lack of domestic liquidity as temporary, it clearly points to a systematic problem in Kazakh financial markets.

In the last few years, Kazakhstan experienced a significant boom in its banking sector that was fueled by rapid economic growth and increased investment in Kazakhstan oil and gas sector and, more recently, by availability of cheap credit on international financial markets. While initially Kazakh banks catered mainly to commercial clients and provided investment services, lately they expanded their services to include small business and retail to a much greater extent than earlier. While this shift in strategy led to some impressive growth numbers (especially with banks specializing in retail clients like Alliance Bank), it remains to be seen how much of this growth can be attributed to sound strategy and how much to temporary exploitation of abnormally cheap credit.

This development has not gone unnoticed by both credit rating agencies and, thankfully, Kazakhstan’s macroeconomic policy-makers. The National Bank and the Agency for Supervision of Financial Services (FSA) are concerned with this situation and have instituted a series of measures to curb foreign currency borrowing and local credit emission. They have planned an increase in the percentage amount of required reserves the banks are to hold (to be effective on August 27) and set limits in exposure to short-term liabilities to non-residents.

As a Moody’s report on Kazakhstan published in July states “it remains to be seen whether the aggregate effect of such new prudential norms will slow foreign currency borrowing and credit emission. Over the medium-term, these problems will abate as the rate of inflation falls and when and as local capital markets mature, providing investors with alternatives to speculative real estate transactions. Moody’s will continue to monitor the rate of foreign currency borrowing and credit expansion in Kazakhstan. In terms of Kazakhstan’s sovereign credit rating, it should be stressed that the government has ample resources to deal with any problems that arise in the banking system.”

While the liquidity issues that the banks were facing today seem to be a relatively minor and temporary problem, it clearly shows that the measures introduced by Kazakhstan’s financial authorities are necessary. Kazakhstan’s financial system, despite its rapid development over the last years, still remains quite illiquid and relatively undiversified even compared to markets like Russia and dependent on international financial markets. The latter has been a blessing until now but could turn into a curse if international investors and financial institutions continue their “flight to quality”. Thankfully, this issue is well known and the authorities have taken steps to decrease the likelihood of a serious crisis. And should a crisis really arise, the government would likely step in and contain it to prevent it from spreading to other sector of Kazakhstan’s economy.

Banks' Rapid Growth Not Sustainable

Kazakhstan's banks increased their net profits to $750 million in the period from January to May of this year which is 89.2 percent higher than the same period of last year. The impetus for this increase was the growth of their credit portfolios, including the booming retail loans. The enhanced competition between the banks, however, is causing the banks to decrease their requirements on borrowers which indirectly influences the quality of their loan portfolios.

According to Kazakhstan's financial watchdog AFN, the banks' revenues in the period from January to May grew to $4.9 billion, 92.3 percent compared to the same period of the previous year. Their loan portfolios grew 7.3 percent to $60.8 billion just in the month of May.

According to experts, the main factor behind the increase of the banks' net profits is the growth of their credit portfolios, especially consumer loans. This has been financed by the availability of cheap credit from abroad which also explains why 75 percent of the profits are concentrated among the four biggest Kazakh banks that are most active in attracting financing from abroad.

This rapid growth, however, reflects itself in the deterioration of the quality of the banks' credit portfolios. According the AFN, doubtful loans make up 52.8 percent of the total loan portfolio of the banks, while standard and bad loans make up 46 percent and 1.2 percent, respectively.

As far as the rapid growth goes, it's very likely that it will slow down. One of the reasons is the tightened regulation and supervision by the authorities concerned over the recent credit boom. A new law, effective on August 27, will increase the level of liquid reserves the banks are required to hold. Also, over the long-term, the banks will be required to diversify their portfolios and decrease their reliance on (cheap) foreign financing.

Alliance Bank's Debut on LSE

As Kazakhstan’s economy keeps on growing at a fast pace, more and more Kazakh companies turn to Western exchanges as sources of financing. Alliance Bank, Kazakhstan’s third largest bank and its largest retail lender, is the latest newcomer to join the club of British-listed companies from this former Soviet Union country. Yesterday, on July 17, its major shareholder, the Almaty-based holding company Seimar Alliance Financial, raised $704 billion in its listing on the LSE.

Alliance whose common shares have already been listed on the Kazakhstan Stock Exchange (KASE) placed 50.28 million GDR’s, each representing-one thirtieth of a share, to offer around 17.4 percent of the bank. The sale price implies a market value of around US$4.05 billion. Seimar sold the GDR’s at $14.00 each which is the bottom of the indicated range of $14.00 and $17.30. During the first day of trading the shares lost 6.7 percent and closed at $12.80.

Alliance is the third Kazakh bank that listed its GDR’s on LSE. Kazkommertsbank has listed its shares in London in November 2006 and Halyk Savings Bank followed in December 2006. Two other larger Kazakh banks are currently considering secondary offerings in London (Bank TuranAlem and Bank CenterCredit) while Unicredit, the Italian banking group, agreed to buy another Kazakh bank, ATF Bank, for $2.2 billion.

While Alliance’s GDR’s were listed at the low end of the estimated range, the share price indicates a huge premium to its peers. The issue price was a multiple of 4.8 times book value of $2.91 per GDR as of March 2007, a 78 percent premium to Kazkommertsbank which trades at just 2.7 times book value of $8.269 per GDR.

Alliance has been growing aggressively over the last several years and moved from being a tenth largest retail lender in Kazakhstan at the end of 2004 to being the leader today. To fuel this aggressive growth in the near future, the London listing was a logical step. However, the fast growth brings several risk factors that need to be considered.

First, the often discussed and highly praised growth of the banking sector in Kazakhstan is fueled mainly by retail credit and lending to construction companies and real estate developers. The product and services range of most Kazakh banks, and especially small and medium-size banks, is not wide, and the risks tend to be concentrated in certain areas. For Alliance, retail lending represents a total of 45 percent of its loan portfolio which makes it vulnerable to both systematic and unsystematic risks.

As most Kazakh banks, Alliance strongly depends on international capital markets as a source of capital, and as a result, is vulnerable to exchange rate, refinancing and interest rate risks. In addition, as the bright economic situation in Kazakhstan and the strength of the Kazakh tenge (especially compared to its neighbors) can be attributed to the high oil prices, at least as much as to President Nazerbayev’s economic policies, the banks are highly vulnerable to macroeconomic shocks like a sudden drop in the price of oil that would almost certainly take the tenge down as well.

Second, as already mentioned, Alliance’s growth was mainly thanks to the aggressive increasing of its market share in Kazakhstan’s retail lending. Today, its share represents 20 percent of the Kazakh market. However, as the volume of loans and the speed with which they are approved increase, so do the risks. Alliance uses a proprietary credit ranking system that allows it to grant or reject a retail loan in a matter of minutes. This, while allowing the processing of a large number of loans, naturally leads to a degradation of quality of the loan portfolio. As of the end of 2006, the non-performing loan of the ration was 3.6 percent. While this is an increase from the year before, it is mainly the result of Alliance’s strategy to focus on retail lending which is both more lucrative and riskier, and it is difficult to assess the effectiveness of the credit issuance system. The fact of the matter is that as the bank is fighting for market share, it cannot afford to cherry-pick worthy borrowers and the number of non-performing loans is almost certain to increase. As the retail loan portfolio makes up almost half of the entire loan portfolio of the bank, this may cause difficulties in the future. In addition, it should be noted that the growth occurred during a period of highly favorable macroeconomic conditions which may or may not last.

Kazakhstan has certainly been a success story, especially compared to its neighbors, and it attracts attention of not only oil and gas and mining companies but increasingly of portfolio managers around the world. However, it remains to be seen whether its almost double-digit growth of the past several years was thanks to the market-friendly policies of the presidential administration or merely to the high prices of oil and gas. The debut of Alliance Bank on the London stock exchange shows that investors are growing cautious of risky deals whatever the success story may be.