Chapter 3. Mobilising financing to transform Kazakhstan’s economy

Kazakhstan’s financial sector is unusually shallow. No comparable country achieves income levels higher than Kazakhstan with a pool of deposits and credit of such little depth. Kazakhstan’s entrepreneurs cite access to finance among their major obstacles to investment, especially newer or smaller firms, while larger firms circumvent the domestic financial system by tapping international sources. Domestic securities markets are anaemic, but this is unlikely to significantly slow economic transformation. This chapter describes how the availability of domestic finance is constrained by the limited pool of domestic investable funds, which can be attributed to both transitory and structural factors that encourage capital outflows. The government’s various financing programmes provided some support during the financial crisis, but without generating lasting gains in the availability of credit, either for the sectors targeted or more generally, and weaker oil revenues make them difficult to sustain. A more sustainable response would support banks’ access to loanable funds, from international sources and by strengthening the institutional infrastructural surrounding the financial sector to encourage domestic savings. The shift to an inflation-targeting monetary policy regime in 2015 and the development of the Astana International Financial Centre will help achieve these objectives if domestic institutions governing the financial sector are also strengthened.

The Kazakhstani financial sector needs to expand and deepen if it is to fulfil its role of essential enabler of the country’s economic transformation. Kazakhstani investors have told researchers that access to finance was an important constraint on investing and doing business, especially for smaller and newer firms (World Bank, 2013). These surveys are corroborated by various macroeconomic indicators of financial sector development and depth, and by supporting anecdotal reports. Yet the Kazakhstan state has made significant efforts to remedy this situation. The government and institutions closely connected with it have embarked on large programmes to support firms’ ability to finance their investments. Meanwhile an overhang of bad loans lingering from stresses associated with the 2005-10 global financial boom and subsequent crisis was cleared from the banking system by 2016, and the central bank took important steps to strengthen and clarify the monetary policy regime in 2015. However, cyclical factors have slowed revenue growth for most firms, but these factors are likely to be temporary as Kazakhstan’s terms of trade and the value of the tenge stabilise at lower equilibria. This will create new opportunities and challenges across the economy. This chapter assesses why the financial sector is holding back entrepreneurs’ ability to access the financing needed to realise these opportunities, and how policy could improve the situation.

A dynamic and deepening financial sector enables economic transformation

A deepening and dynamic financial sector enables faster growth and economic transformation, generates employment and government revenues, and is especially important in countries around Kazakhstan’s stage of development. The important role of a deepening financial sector in enabling growth has been consistently found across nearly a quarter-century of research. Constrained access to finance slows output growth, and the effect is stronger than other frequently-cited constraints to investment, according to cross-country firm-level evidence (Pas¸alı, 2013). Access to finance is associated with innovation and job creation (World Bank, 2014). These effects appear to be particularly strong in lower and middle-income countries, for smaller firms that face greater constraints in accessing finance, and as an unusually undersized financial sector grows towards typical sizes. These overall macroeconomic effects of a deepening financial sector can be even stronger at the microeconomic level. For example, the entry of banks that are adapted to the needs of a specific sector or group of firms, such as agriculture firms or businesses operating informally, can significantly support the development of those firms, and hence of their employees and the larger sector. These microeconomic effects can be significant but are often not recorded by macroeconomic indicators.

A dynamic financial sector provides services that raise households’ well-being. Access to savings and payments facilities improves welfare, especially for poorer households (World Bank, 2014). It allows households to maintain consumption through income shocks, such as an illness or a loss of business. It also provides products that help households manage short-term spending pressures to realise long-term investments. Social insurance and retirement savings facilities can improve the responsiveness of the labour market to evolving opportunities and its ability to absorb shocks. Having a form of guaranteed income reduces the risk for workers of shifting to new employers in expanding sectors, for example from unemployment if a start-up fails. While compulsory social insurance schemes may serve this purpose, they are often supplemented by private schemes, especially where the formal social protection system is weak or incomplete. These savings products can better mobilise households’ savings for investment by firms, generating a virtuous circle. Indeed, some work suggests that financial sector development disproportionately benefits poorer households, who suffer more from information asymmetries limiting access to financing for specific projects and are less able to raise the lack the collateral required by banks, restricting the exploitation of investment opportunities (Zhuang et al., 2009).

A well-functioning financial sector is also essential to realise evolving opportunities across the economy, and can also help mitigate “Dutch disease” effects. The global commodity cycle means that countries such as Kazakhstan experience large shifts in relative returns between sectors over time. The scale and speed of these swings make it essential that the sectors offering the greatest potential returns at a given time are able to access nimble financing, while that financing offers a term structure that will outlast weaker periods. More sophisticated and better managed financial sectors can help this process, while smoothing fluctuations in the overall economy over the commodity cycle (IMF, 2015b). For example, large commodity production facilities are often self-financing (through credit secured by export contracts) or financed through foreign direct investment (FDI). These investments often surge during periods of rising commodity prices, and then come to a halt as commodity prices weaken. By contrast, the domestic non-tradeable and non-resource sectors are generally more reliant on domestic banks and financial institutions to finance investments and operations. If the domestic financial sector is not robust and operating effectively, these investments will not occur and opportunities will be lost, both to exploit high returns while resource prices are high or new-founded competitiveness in non-resource sectors when commodity prices retreat.

Conversely, a thin and poorly functioning financial sector can amplify the variations in external conditions, as Kazakhstan’s has done over the past two decades. A poorly regulated and thin financial sector tends to be more sensitive to swings in commodity prices and other external factors, and amplifies their effects on the larger economy. Their operations are less efficient at transforming domestic savings into assets (loans), and are more reliant on wholesale funding that tends to be highly pro-cyclical, expanding strongly while conditions are supportive then coming to a sudden stop when conditions and perceptions deteriorate. At the same time, weaker internal management means that poorer assessments are made of the quality of loans, with the result that while credit is readily available during strong periods, much of it is allocated less efficiently, with a lower share converted to investment and that investment less efficiently generating additional production. When conditions deteriorate these loans are more likely to become distressed, generating greater losses of capital and sharper retrenchments in lending activity, including for assets (Kinda et al, 2016).

Box 3.1. An alternative scenario – how a stronger financial sector might have helped protect Kazakhstan’s entrepreneurs from the shocks of the 2000s

During the 2000s bank lending in Kazakhstan accelerated and loan quality declined. Much of the additional lending was for construction and property investments, and many projects proved to be unsustainable when economic conditions and banks’ access to international wholesale funds deteriorated with the global financial crisis. Growth in the stock of outstanding credit far outpaced new investment, and the efficiency of that investment appears to have declined, as indicated by the increase in total production relative to the volume of investment.* As the quality of their loan books and access to funding fell, banks cut their lending to private businesses in real terms over the following years. Weaker bank lending translated into more sluggish investment in the non-resource sector, slowing overall growth and diversification of the Kazakhstan economy, as compared with a scenario in which banks were able to manage a more consistent growth in lending.

An alternative scenario makes it possible to assess how the overall economy might have evolved if growth in credit to the private sector had been more consistent through the early 2000s to the mid-2010s. A plausible scenario would see the ratio of credit to the private sector grow at a constant rate sufficient to reduce the gap between Kazakhstan and the average of countries near its income level. At the same time, the ratio of the stock of outstanding credit to investment, and the transformation of investment into production, would both be expected to have declined by less than they in fact did over this period. The result would be somewhat weaker investment and activity during the boom years before the global financial crisis, but stronger lending, investment and activity during the years after, such that gross domestic product (GDP) growth would be less volatile and by 2015 GDP could be higher and more diversified than was realised.

While this scenario is highly speculative, it helps illustrates the long-term cost of a more volatile and less well-managed financial sector. Once balance sheets were stabilised after the 2008-10 crisis, Kazakhstan’s commercial banks generally focused on strengthening their internal systems and capacity, through mergers and investments. Prudential regulatory capacity also strengthened.

← * This is the “incremental capital-output ratio” or ICOR.

The quality of the financial sector’s performance is shown by whether Kazakhstan’s real economy can effectively access financial services, rather than whether the financial sector is converging towards a preferred structure. There are common trends in how the structure of the financial sector evolves as economies become more sophisticated. These trends, and where Kazakhstan fits among then, can identify where improving access to finance may bring the greatest gains and highlight the obstacles to achieving these. These trends are described below. However there are also significant variations between economies around those trends. These variations reflect differences in the structure of the economy, as well as each country’s history and institutions. Thus, the key indicator is how well firms across the real economy can efficiently and sustainably access credit, risk management and liquidity services from the financial sector built on healthy and robust institutions, rather than the extent to which the financial sector resembles a particular model.1

After strong but short-lived expansion, Kazakhstan’s financial sector remains undersized and lacks resources

Banks are central to providing finance for development in Kazakhstan, as they are in other countries near and above Kazakhstan’s level of economic development. Banks are the dominant source of finance for private sector enterprises, and this financing is increasingly provided in tenge. Investments in businesses dominate banks’ loan portfolios. Loans to private non-financial corporations made up three-quarters of banks’ assets in 2015, although this had declined from 82% at the end of 2009. Deposits in banks, in both tenge and foreign currencies, are most households’ dominant liquid financial asset.

Shortages of lendable funds are the main constraint on Kazakhstan’s increasingly efficient financial sector

Kazakhstan’s banking sector is shallow for a country at its income levels, across a range of measures. In absolute terms, the size of Kazakhstan’s financial sector is ranked mid-range at about 50^th globally. But it is undersized relative to the size of Kazakhstan’s economy or income levels. The broadest indicator of financial depth is liquid liabilities as a percentage of GDP, given that the measure includes the balance sheets of banks and non-bank financial institutions (NBFIs) and is scaled by the size of the economy. At 30% of GDP in 2014, only two countries have achieved higher incomes with a financial system shallower than that of Kazakhstan, and both have important oil extraction sectors (namely, Gabon and Mexico; Venezuela has a slightly larger financial sector).2 The path of Kazakhstan’s financial sector has been highly pro-cyclical, with a period of rapid and unsustained growth supported by external economic conditions being followed by a contraction that coincided with less supportive external conditions (discussed in detailed below).

Credit to the private sector from banks is limited. Credit to the private sector in Kazakhstan was 36% of GDP at the end of 2014, compared with a peak immediately before Kazakhstan’s banking crisis of 57% of GDP. The current rate is one of the lowest rates among middle and higher-income countries, and reflects a range of factors, including less supportive external conditions. Again, all countries that had achieved higher incomes than Kazakhstan with smaller provision of credit had important commodity extraction sectors, with the exception of Romania. This variable is the standard indicator in analyses of the relationship between finance and growth – countries with higher levels of private credit have been shown to grow faster and experience faster rates of poverty reduction.

Other indicators confirm the undersupply of credit in Kazakhstan, despite efforts by the regulator, rather than low credit growth reflecting limited demand. The number of Kazakhstani firms reporting the need for a loan is typical (nearly half in 2013, which is at the average across countries accounting for income levels). However, fewer than 20% of firms were able to access bank loans (2013 data) for investment or working capital, although they may be better able to access other forms of credit. The only middle and high-income countries where businesses were less likely to have a bank loan were Latvia and Hungary.

Bank credit is largely directed at domestically focused sectors. Loans orientated towards consumer sectors (loans to households, and to trade and selected services sectors) constituted almost three-quarters of loans outstanding in late 2015. Energy and extractives rely primarily on foreign financing, while construction and real estate sectors relied on wholesale foreign funding until it became scarce as the global financial crisis started in late 2007.

The domestic financial system suffers from limited resources. Deposits in the financial system are low relative to Kazakhstan’s GDP and income levels, indicating that there are unusually limited domestic resources available for lending by banks. Sources of these deposits appear to be unusually concentrated: one-third of corporate deposits in banks are attributed to the national wealth fund, Samruk Kazyna Operations, reflecting its oversized role in the economy (IMF, 2013), while businesses hold about 60% of total deposits. Economic agents’ reluctance to hold deposits in the domestic banking system may reflect negative real interest rates and expectations of a depreciation of the tenge. They occur despite moderate levels of deposit guarantees and despite the fact that depositors did not suffer losses from the 2009-10 crisis.

Banks seem to be stretching deposits as far as they can. Bank credit was 127% of bank deposits in 2013, higher than in most other countries especially among those near Kazakhstan’s level of development. This ratio indicates the extent to which banks are effectively intermediating between savers and investors, and is generally positively correlated with other indicators of financial sector development. An indicator significantly above 1 suggests that resources other than deposits are funding a significant share of bank lending. These other sources can generate instability in banks’ operations if they become unreliable, as banks from Kazakhstan and many other countries experienced during the global financial crisis. For Kazakhstan, this risk particularly relates to the use of offshore securities markets to finance domestic lending.

Adding to banks’ challenges are cyclical pressures of currency mismatching, but these are likely to abate as conditions stabilise and depositors become more willing to hold tenge. The fundamental determinants of the tenge’s value weakened substantially between 2014 and 2016. These include the price of Kazakhstan’s oil and other commodity exports and the inflow of foreign investment. In response, the NBK is allowing the tenge to depreciate, and is focusing instead on inflation control and economic stability (see Box 3.3). Anticipating future weakening of the tenge, depositors have sought to shift deposits from tenge into foreign currency, especially USD.3 This currency mismatch represents an additional challenge for banks, as the foreign currency deposits represent a growing liability relative to the static value of the tenge asset. Banks approximately balanced tenge and foreign currency loans and deposits up to 2014, but as uncertainty grew around the exchange rate’s peg, banks found that the balance of their deposits was in foreign currency and of their loans was in tenge. The central bank has helped banks manage this currency mismatch and risks by selling foreign currency repurchase (repo) agreements, as well as using its foreign reserves to ensure foreign currency remains liquid in the domestic market. As the tenge reaches a new equilibrium, the currency speculation advantage for depositors should abate and banks should have less difficulty in attracting and retaining tenge deposits.

Banks appear to be allocating scarce credit by rationing rather than adjusting the cost of funds

Lending interest rates are modest and do not appear to reflect a shortage of loanable funds, with short-term rates driven largely by exchange rate management goals. The cost of borrowing for Kazakhstani firms fell following the financial crisis and has since been modest after accounting for domestic inflation. Interest rates paid by a firm on a five-year tenge loan averaged 10.6% between 2011 and 2015, compared with average inflation of 8.1% over those years. If the firm had instead borrowed the funds in Kazakhstan but in foreign currency, it would have saved little interest, with interest rates averaging around 9.5% on convertible currency loans. This rate contrasts with exceptionally low global interest rates during this period, for example at 0.77% on one-year USD London Interbank Offered Rate (LIBOR). Short-term tenge loan rates rose when pressure for the exchange rate to depreciate was building, then retreated as the exchange rate was allowed to move towards a new equilibrium. Longer-term rates appear less responsive to these short-term pressures. Deposit and lending rates appear to be remarkably disconnected. This may reflect factors including the reliance on foreign funding to finance additional lending. Between 2009 and 2011, following the financial crisis and reduced access to international sources of funds, rates paid by banks on longer-term deposits rose while those paid by borrowers declined. Rates on demand deposits gradually declined in the years to late 2012, before moving around two percentage points higher, to between 3% and 3.5%, although this remained strongly negative in real terms.

Movements in interest rates appear to be at most of secondary importance for deposit and lending flows. Interest returns appear to not be a driving factor in determining deposit decisions, especially given that tenge deposit interest rates have consistently been well below inflation rates. However, NBK’s statistical analysis does suggest that movements in deposit interest rates do statistically lead growth in deposits, despite real deposit rates being negative. Further, temporary outflows of deposits from the banking system can induce liquidity pressures for banks, leading to spikes in short-term interest rates in the inter-bank market. Nonetheless, negative long-term real yields on deposits are likely to be an ongoing constraint on attracting funds into the domestic financial system.

Collateral requirements are not atypical, also suggesting that banks are rationing credit rather than pricing it beyond firms’ capacity to pay. Another means of increasing the cost of borrowing is very high collateral requirements, which requires firms to have more capital guaranteeing the loan, and reducing the cost of non-payment for the bank. However in Kazakhstan both the share of loans requiring collateral, and the value of that collateral relative to the amount lent, are only modestly higher than global averages. Nonetheless firms’ limited asset bases makes even these modest collateral requirements a challenge to meet, particularly for SMEs (OECD, 2013).

The banking system’s poor performance appears not to be attributable to its structure or efficiency

The structure and reach of the banking sector appear to be typical. The apparent competition structure of Kazakhstan’s banking sector is not markedly unusual. Over 30 banks operated in Kazakhstan at the end of 2015, and the sector was relatively unconcentrated. For example, in 2012 the three largest banks held less than half of the banking system’s total assets – only 14 out of 124 countries had less concentrated banking systems by this metric. Other indicators also suggest that banks have a wide reach – there are more automated teller machines (ATMs) per 100 000 population than in any of the benchmark countries, while debit and credit card penetration rates were only a little below average given income levels in 2011. The NBK, as banking regulator, has sought to ensure that individual sectors of the economy do not become dominated by one or a few banks. Its main instrument for dong this has been its policy on mergers, through which it encourages banks concentrated in a particular sector to merge with banks operating in other sectors. This is intended to make the overall sector more robust by limiting the effects of a sector-specific downturn on any individual bank. However, the efficiency of this strategy is questioned by research suggesting that access to finance improves when banks have deeper knowledge of the needs and characteristics of firms operating in specific sectors, while ensuring that the market is contestable and other banks are able to enter. For example, in many countries a small number of banks specialise in agricultural lending.

The regulator adopted a counter-cyclical approach to capital requirements towards both strengthening banks’ balance sheet and supporting ongoing credit availability. After raising minimum capital requirements for banks, in December 2015 the regulator responded to the economic slowdown by abolishing the earlier requirement of an increase in capital, and by including a decrease in the risk-weights on mortgage loans and loans to SMEs.4 These amendments raised the number of banks with existing capital, so reducing pressure on banks to merge and reducing barriers to entry for new banks. Reducing pressure to merge may also allow banks’ management to focus on their ongoing operations.

Banks overall do not appear to be suffering from outstanding inefficiencies, even while they undertake restructuring programmes to improve their operations. Overhead costs and interest margins tend to be correlated with economic and financial sector development. Larger and more dynamic financial sectors operate more competitively with tighter margins and lower costs. Kazakhstan’s banks could operate more efficiently if their deposit and lending books were larger. For example, bank interest margins are wider and overhead costs (relative to total assets) are slightly above average for countries near Kazakhstan’s income levels. But these indicators have improved over the past 15 years, with most efficiency measures moving towards typical levels. For example, overhead costs fell from over 8% of asset values in 2000 to around 3.3% in 2013, interest margins narrowed, non-interest income fell to a typical share of total income, while bank costs relative to total income fell from above to well below the average of other countries.

Rapid early growth of bank lending was unsustainable, delaying the sector’s development

Once Kazakhstan’s economy stabilised in the late 1990s, the banking sector grew quickly, but unsustainably. Kazakhstan’s banks rapidly increased lending through the 2000s. Outstanding private credit rose 30-fold from 2000 to its peak ahead of Kazakhstan’s banking crisis in 2009, from KZT 280 billon, or 8.4% of GDP, to KZT 8 142 billion, or over 50% of GDP. But this growth in credit far outpaced other aspects of financial deepening. For example, total deposits in the financial system grew strongly, but not as strongly as loans, from 8.7% of GDP in 2000 to peak at 32.1% of GDP in 2009, while growth in the financial system’s overall liquid liabilities was more moderate still. Other measures of the presence of the banking system grew more slowly, if at all. For example, there was some increase in the number of adults with a bank account, but the number of bank branches fell. The banking system became somewhat less concentrated over this period.

Easy access to international finance enabled the growth in credit. For example, Kazakhstani financial institutions’ exposure to Bank for International Settlements (BIS)-domiciled banks rose from USD 3 billion (KZT 381 billion) at the start of 2005 to a peak of USD 25 billion (KZT 3 015 billion) by the end of 2007. At the same time, other international sources became more willing to lend to Kazakhstani non-financial entities as well as the banking system. Loans from non-resident banks rose from 2.7% of GDP in 2000 to 16.3% of GDP by 2006. In 2007 alone, Kazakhstan’s banks absorbed almost USD 10 billion of net additional capital, more than 9% of GDP. These sources of finance were increasingly costly to service. Annual private debt service costs rose 11-fold from just over USD 3 billion in 2002 to almost USD 33 billion in 2008, equivalent to about 25% of GDP.

The assets underlying the banks’ offshore-sourced credit became impaired during the global financial crisis, leading to a system-wide banking crisis, although depositors were spared losses. Significant proportions of banks’ international borrowing were used to finance credit to highly cyclical sectors, notably property and construction and sectors reliant on oil export revenues. These sectors suffered from the slump in incomes and activity and depreciation in the tenge associated with the 2009 global financial crisis. At the same time as these loans started becoming stressed, banks had difficulty rolling over their international debt, as the surge of international financing to developing countries during previous years came to a sudden stop. The result was a banking crisis that started in 2008 and became systematic by 2010 (Laeven and Valencia, 2012). Non-performing loans rose to 20.9% of the value of outstanding loans in 2010, from 7.1% in 2007, generating total net losses of USD 19.1 billion, and three banks defaulted on their debt. An expanded public guarantee of deposits in mid-2008 stabilised deposits, and the government purchased equity or nationalised a number of banks. Depositors in two banks that collapsed before the global financial crisis did suffer losses, which were partially covered by the Kazakhstan Deposit Insurance Fund, but the fund was not tapped during the 2008-10 banking crisis.

The lingering effects of the banking crisis undermined new lending and development of the financial sector. Banks were less able and less willing to lend, as deposit growth slowed, international sources of funds were more difficult to access, and regulators and bankers became more cautious. Credit outstanding contracted after 2009, falling by as much as KZT 700 billion in nominal terms (or by KZT 4 000 billion in constant 2015 prices) and at the end of 2015 remained below its pre-crisis levels, after accounting for inflation. There was also a rebalancing of lending from construction and trade sectors towards “other” (mostly household or consumer borrowing), agriculture and industry. Liquidity in most other market-based components of the financial sector also plumbed new lows.

Banks’ access to international finance was limited. By late 2015 foreign banks’ exposure to the Kazakhstani financial system was between one-fifth and one-third of the pre-crisis peaks, depending on the measure. For example, BIS-reporting banks’ ultimate exposure to Kazakhstani domestic banks declined from a peak of USD 25 billion in November 2007 to USD 5 billion in August 2015. Meanwhile growth in financing for banks from domestic sources slowed after the crisis. Growth in total deposits held by individuals stalled in the second half of 2008. By 2010 some confidence had been restored in the management of the banking system and growth in deposits resumed but at less than half of its pre-crisis pace (Tumenbayeva, 2013). This boom-bust path has created volatile returns on assets and equity of Kazakhstani banks. While these measures improved after the 2009 crisis, by 2013 Kazakhstan was still among the weaker fifth of countries.5

In the mid-2010s the banking system remained vulnerable to a deterioration in conditions. Changes in the tax treatment of non-performing loans (NPLs) impeded their clearance from banks’ balance sheets until the tax arrangements were adjusted again in 2014. By late 2015 the legacy bad loans were on a path to resolution, by merging the bad loans into one financial entity and revoking its banking licence. This advanced the Kazakhstani banking system towards the Basel III prudential standards for risk-weighted capital and liquidity. However the banks remained highly exposed to a worsening in their operating environment, particularly linked to oil prices (IMF, 2015a). Dollarisation of deposits and the impact of the depreciation of the tenge on the cash flow of borrowers would generate risks of new pressures on banks’ cash flows and increases in non-performing loans. The weakening of oil prices in 2014 reduced the assets of a number of banks below the regulatory minimum, and 2015 testing of the effects of plausibly lower-than-expected oil prices and growth of emerging markets, plus a significant depreciation of the exchange rate suggested that banks responsible for half of the banking system’s assets would be short of minimum capital requirements, by the equivalent of 2.5% of GDP.

The securities markets are also underdeveloped

Kazakhstan’s securities markets are illiquid and inactive, but on balance this has limited implications for medium-term economic development objectives. The securities markets are similarly characterised by inactivity, because of the consolidation of pension assets in the single accumulative pension fund and withdrawal from the market of large institutional investors managing the private accumulative pension funds. The connection between the size and turnover of the stock market and economic development is looser and more contested than that with banking credit to the private sector. Various empirical analyses suggest that inactive securities markets may not hold back broader economic development in countries near Kazakhstan’s stage of development and economic structure (Demirguc-Kunt et al, 2012). Generally, it appears that stock and securities markets do little to support broader economic development in middle-income countries and those with economies smaller than around USD 500 billion (Demirguc-Kunt et al, 2012; Pas¸alı, 2013). As economies become larger and richer, the size of securities markets becomes a more important determinant of ongoing economic transformation. They become important financiers of development once an economy has reached the scale and complexity where further growth is enabled by more novel, longer-term investments that employ more intangible inputs, which banks tend to be less effective at financing than securities markets.

Kazakhstan’s securities markets are trapped in a low-liquidity, low-activity equilibrium. The domestic stock and bond markets are undermined on both supply and demand sides: by the lack of institutional and retail investors, and by larger Kazakhstani firms’ easier access to financing in international exchanges. The few investors prefer to buy and hold assets, rather than trade actively. The lack of institutional investors reduces demand for large issuances. All these factors limit liquidity, further reducing the attractiveness of the markets for new issuances or for purchases, and increase the cost of funds. The bond market receives some support from time to time through issuance by public entities. However, the position of the pension fund as the principal purchaser of securities and its current management by the central bank, which is also seeking to establish a conventional monetary policy framework, generates tensions that may limit the market’s effectiveness. The planned shift in the pension fund’s management to independent bodies, and the creation of competing fund managers, are likely to improve the functioning of the bond market.

Kazakhstan’s securities markets have not been able effectively to mobilise capital for investment. Kazakhstan’s stock market was established very early in the country’s reform process after independence, and the number of companies listed and the value of their market capitalisation (15% of GDP in 2013) is only a little lower than would be expected for an economy the size of Kazakhstan’s. Similarly to the banking system, over the past 15 years the development of Kazakhstan’s capital markets has essentially followed an inverted U. Market capitalisation and turnover rose strongly in the early 2000s, peaking around 2007-08, and then declined sharply, and by more than in other countries including other middle-income countries. Today trading in the markets is minimal apart from foreign exchange. Primary issuances are few, while turnover in the secondary market is extremely low – during the first nine months of 2015, each day on average USD 25.6 million was traded across 156 deals.

The domestic bond market is also modestly sized and is just as illiquid as the stock market. During the first nine months of 2015, on average each day USD 23.4 million of bonds were traded and USD 11.8 million of government securities, through seven and one transactions respectively. The development of the domestic private bond market does appear to be weakly positively correlated with economic development, at least from higher middle-income levels. Meanwhile, the strong asset net financial position of the Kazakhstan state means that it has little need to access domestic or international securities markets – in contrast to most among countries around Kazakhstan’s income levels. The Kazakhstan state readily tapped international markets for USD 6.5 billion of ten and 30-year bonds in late 2014 and mid-2015.

The insurance sector, often an important pool of investable funds, is also unusually small, although it is growing rapidly (Box 3.2). The assets of both life and other insurances are small (relative to GDP), although there are a large number of insurers operating in Kazakhstan. These insurers have limited access to reinsurance, making the sector highly exposed to events such as an earthquake near Almaty, which could exhaust the sector’s resources. As is the case with other components of the finance sector, the only countries with smaller insurance sectors and with income levels near or above Kazakhstan’s have large oil sectors (i.e Libya, Saudi Arabia and Kuwait). The importance of both life and risk insurance tends to increase with economic development. Insurance is a service that helps purchasers to manage risks better and make more productive use of their resources. Accumulated insurance premiums are also a pool of patient savings that can finance long-term investments, especially when the insurance risks are diversified through international reinsurance.

Pension savings do not play their typical long-term investment role

Kazakhstan’s sole pension fund is the one significant pool of resources, but its management arrangements have affected the ability of this financing to support economic transformation. Kazakhstan’s pension fund assets approached 12% of GDP by mid-2015. In 2014 the government merged the assets of 11 second-tier funds into one nationalised fund managed by a special unit of the NBK. The goal of this merger was to strengthen the management of the savings, so raising their returns. The management arrangement is not conducive to the implementation of monetary policies as the NBK controls both the supply and the vast number of means of acquiring long-term domestic securities. In addition, there is a risk of conflict of interest between the government and the NBK, because of pressure to apply the pension fund assets to finance the state budget or activities, rather than to obtain the maximum long-term investment income. Since December 2015, under the President’s instructions, the government with the NBK are working to transfer the pension fund assets into the management of private Kazakhstani or foreign entities, and to remove the single accumulative pension fund from the control of the NBK.

Box 3.2. The potential of Kazakhstan’s insurance sector as a new pool of investable funds

Kazakhstan’s insurance sector has consolidated with growing assets over recent years. At the end of 2015, 33 insurers (26 general insurers, seven in life insurance) and 15 insurance brokers operated in Kazakhstan, compared with 35 general insurers, five life insurers and 12 insurance brokers operating a decade earlier. Assets under management have increased sevenfold and capital quadrupled over the same period. However the sector remains small relative to GDP, at around 2%.

Compulsory insurance requirements should support the deepening of the insurance sector. In Kazakhstan nine types of insurance are mandatory, and regulated by specific laws. Civil liability for vehicle owners is the most common type of compulsory insurance. At the end of 2015 compulsory insurance made up 25% of total insurance premiums, voluntary property insurance made up 46%, and voluntary personal insurance made up 29%. Insurance is largely sold through second-tier banks and agency networks.

Life insurance also generates long-term savings and can support social development by providing self-funded protection from income loss, but is a particularly underdeveloped part of Kazakhstan’s insurance market. Life insurance made up 8% of insurance premiums in 2015, despite its potential role in offsetting weaknesses in the social protection system. Explanations for the limited development of life insurance include the limited demand from the population, lack of confidence in the integrity of long-term savings, the lack of investment instruments, and the lack of tax incentives for insuring.

The development of the insurance market is constrained by undercapitalisation and by limited scale. Low capitalisation of the Kazakhstan insurers limits their ability to retain premiums and develop their asset base. To manage this, insurers transfer premiums and risk to reinsurers outside Kazakhstan. A total of 31% of insurance contracts were transferred to reinsurers in 2015, 84% of which were held by non-residents, with the reinsurers retaining 9% of the original premiums. Development is also slowed by the relatively high cost of insurance, as a result of the lack of data for actuarial calculations, or weak demand and the small scale of individual insurance companies, as well as limited appreciation of the value of insurance.

Kazakhstan’s development and rising incomes, and its deeper integration into the global economy, generate evolving objectives and opportunities for the national insurance sector. To support the insurance market’s development, and so expand financial markets in Kazakhstan, the NBK is planning to:

Introduce in phases an assessment of the adequacy of standards of equity of insurance and reinsurance companies, in accordance with Solvency II. This will increase the capitalisation of the insurance companies and the adequacy of insurance reserves.
Introduce the electronic sale of insurance policies, which will require the transformation of business models and the development of the system of electronic insurance services.
Improve the regulatory framework for reinsurance in order to ensure capitalisation and capacity of the insurance market, and to enhance the competitiveness of insurance companies.
Revise the existing scheme of interaction among insurance intermediaries;
Introduce tax incentives for life insurance products.
Expand investment opportunities for insurance companies.

Sources: NBK and authors.

The fund’s management structure means that the pension fund’s resources are readily directed to investments other than those likely to generate the maximum returns or that offer agreed minimum levels of security. For example, the pension fund provides financing for the “Business Roadmap 2020” prioritised sectors, as well as purchasing short-term public financing instruments. The management structure means that the pension fund’s resources are readily directed to investments in the state programme for accelerated industrial innovative development (SPAIID) prioritised sectors, including in some cases into assets that are conventionally assessed as being below “investment” grade, rather than the investments likely to generate the maximum returns or that offer agreed minimum levels of security.

A pension fund structure focused on long-term investments could contribute significantly to deepening Kazakhstan’s financial sector and mobilising finance for transformational investments. Efficient pension fund systems tend to be characterised by multiple funds, where transparent competition ensures that investment strategies are efficient, seek maximum long-term returns while offering security. These systems are subject to clear and effectively enforced prudential regulation and supervision. A number of benchmark countries have developed such systems as a pool of long-term investable funds that support national investment and economic development, while ensuring retirement incomes for ageing populations. The OECD has established a number of guidelines around the governance, regulation and management of pension funds.6

International sources of finance play an unusually large role

Kazakhstani entities make an unusually large use of international finance, with the aim of circumventing thin domestic finance, although this use has unwound following the 2009-10 crisis. As economies develop, the use of offshore banks and financial markets for deposits tends to decline and that for financing investments expands. Savers in lower-income countries, where institutions are weaker, make greater use of offshore deposit-taking banks, although in most countries this use has declined since the 1990s. Conversely, enterprises in higher-income countries make greater use of offshore borrowing. This may reflect both more demand and greater willingness by lenders to lend into those countries. Kazakhstan’s private entities raise as much finance from international sources (relative to GDP) as those in countries at several times Kazakhstan’s income level, although this too followed an inverted U-shape between the start of the 2000s and the mid-2010s. In the mid-2000s Kazakhstani entities raised significant amounts of finance from offshore banks, and external facilities remained important locations of loans and deposits in 2015. Liabilities to offshore banks relative to GDP peaked at above 25% in 2009, and then net new issuance lagged behind the expansion of the overall economy. Even so, the next country with this level of outstanding private debt securities relative to GDP had an income level over three times that of Kazakhstan. In contrast, the public sector has a large net positive international investment position, reflecting the transformation of Kazakhstan’s petroleum wealth into offshore financial holdings in its national oil fund, even as the government resumed issuing Eurobonds in 2014.

Box 3.3. Strengthening monetary and exchange rate policy to deepen tenge financing

After the 2008-10 crisis, Kazakhstan’s monetary policy tool was a stable exchange rate to achieve the objective of price stability, but this approach proved to be sustainable only while external conditions were supportive. After the 2008-10 financial crisis the NBK’s monetary policy regime focused on stabilising prices and the economy by maintaining a stable exchange rate relative to the USD. This was sustainable while external shocks were positive and while the domestic financial system was rebuilding its balance sheets and so credit growth was slow. The strong real exchange rate and moderate growth in domestic demand reduced inflationary pressures. As external conditions became less supportive, efforts to maintain the tenge’s value detracted from the government’s economic stabilisation and diversification goals. Declining terms of trade as the prices of oil and Kazakhstan’s other commodity prices fell, brought lower export receipts and reduced investment inflows. At the same time, the USD appreciated against most currencies, meaning the tenge appreciated against important trading partners and competitors which had allowed their currencies to depreciate (e.g., the Russian rouble).

Economic actors switched from tenge to foreign currency for deposits and transactions, increasing demand for foreign currency and undermining the NBK’s efforts to slow and smooth the exchange rate’s depreciation. This created short-term liquidity pressures for banks, leading to spikes in short-term interest rates. The NBK attempted to maintain the tenge’s stability against the USD through both public statements and its regular auctioning of foreign exchange, as well as providing instruments such as long-term currency and interest rate swaps with banks. While these measures reduced instability, they also offered banks opportunities to make greater profits than through conventional financial intermediation. Despite these efforts, economic agents continued to move away from tenge, anticipating the exchange rate’s eventual depreciation and the pass-through into domestic inflation. These developments also undermined long-term goals of developing the financial sector and diversifying the economy, by reducing the money supply and diverting increasingly scarce loanable funds towards financial instruments, while also reducing the competitiveness of Kazakhstan’s exporters.

NBK’s shift to using a policy base rate as the policy instrument to achieve price stability breaks this dynamic, by allowing movements in the exchange rate to cushion the domestic economy from external volatility and helps domestic financial deepen. In September 2015 NBK announced its goal of achieving annual inflation of 3% to 4% by 2020, and that the exchange rate would float freely, although interventions continued to maintain liquidity and dampen overshooting. This inflation rate goal is likely to allow the economy’s structure to evolve, without the costs of higher inflation. It is likely to take some years to realise the full benefits of these policies. In the short term, credible inflation-targeting monetary policy risks working against the goals of sustained economic growth and diversification. Initially, controlling inflation during a period of substantial negative supply shocks and associated exchange rate depreciation will mean higher short-term interest rates, to slow capital outflows and the exchange rate’s depreciation, and reduce the risk of higher import prices becoming entrenched in expectations of ongoing higher inflation. In the months following the shift in its policy instrument, NBK raised its new policy base rate by five percentage points, to 17%. As conditions stabilised and inflation progressed as expected, over 2016 the NBK was able to progressively reduce its base rate, reaching 12.5% by October. Estimates suggest that a 10% depreciation of the exchange rate raises the consumer price inflation rate by two percentage points after 12 months, and that the scale and speed of this pass-through may have risen with the increased openness of Kazakhstan’s economy following the implementation of the Eurasian Economic Union. This import price inflation is likely to spike following the tenge’s 50% depreciation against the USD over 2015, adding to the challenge of building confidence in monetary authorities’ inflation-management capacity.

Reconciling competing monetary policy objectives will be a challenge in the near-term, and a simple, clear goal is likely to be the most effective approach. Monetary authorities are seeking to reduce inflation while other factors are unsupportive. The decline in the international prices of Kazakhstan’s exports effectively constitutes a negative supply shock, reducing the value of Kazakhstan’s production and national income. This can be partly absorbed by allowing the exchange rate to depreciate, with the associated pass-through into higher prices of imported items relative to domestic goods and services. At the same time, the government has longer-term goals of developing the availability of finance to support economic diversification. When it shifted the objective of monetary policy to inflation targeting, the central bank increased the costs of funds and so slowed lending. Lending slowed with the reduction in credit demand associated with the weakening in economic conditions. The availability of funds also retreated, given the decline in the availability of tenge funds in anticipation of the exchange rate’s depreciation. The NBK’s research finds a positive relationship between the growth of lending to the economy and economic activity (for example, the discussion in NBK 2013), although IMF analysis suggests that the relationship varies considerably between different economic sectors (IMF 2015a).

In the longer term, conditions are likely to stabilise if many of the challenges of the mid-2010s pass, and the benefits of a floating exchange rate and inflation targeting monetary regime are realised. Commodity prices and Kazakhstan’s terms of trade are likely to stabilise, albeit at lower levels, along with the exchange rates of Kazakhstan’s trade partners and competitors. As the real exchange rate reaches a new equilibrium, market participants will no longer expect further exchange rate depreciation or intervention by the NBK, thus reducing the incentive to shift funds out of tenge. The central bank can build its credibility by remaining committed to reducing inflation while ensuring its interventions in forex markets are directed at maintaining market liquidity rather than holding the exchange rate away from its medium-term equilibrium. Given that perceptions about exchange rate movements can be self-fulfilling in the short term, changed perceptions and stronger clarity and credibility of the central bank around its goals can help entrench stability, allowing it to rebuild its buffers of foreign reserves. In turn this stability would reduce inflationary expectations and ongoing pressures and the cost on the economy of reducing those pressures, allowing the central bank to lower its benchmark interest rate. In turn this would help rebuild tenge liquidity, supporting lending by banks, and the long-term goals of developing and diversifying the domestic economy.

Sources: Authors and Frankel, 2013.

Unlocking finance for development

The government has introduced various schemes to improve firms’ access to finance

The Kazakhstan government has offered subsidised credit through a complex array of mechanisms mostly targeted at firms investing in priority sectors (Box 3.4). In the years following the 2009-10 crisis the government developed at least 23 programmes intended to improve firms’ ability to finance investments and operations. The various programmes provided stabilisation and stimulatory functions, although there is significant heterogeneity among the programmes, with some having dominant social purposes. In addition, Kazakhstan’s development partners implemented other programmes to support access to finance. The stabilisation programmes included programmes for housing finance, programmes targeted towards female entrepreneurs and to supporting SMEs and a programme for agriculture development (Table 3.1). In 2014 this cornucopia was consolidated into a coherent programme targeted at firms operating in the national priority sectors, focused largely on industry and manufacturing (Chapter 2), although firms in other sectors may be able to access some of these programmes. Support for SMEs was combined into the “Business Road Map 2020”, and that for agro-industry was consolidated into the “Agribusiness 2020”, and individual budget programmes of the Ministry of Agriculture. However the launch of the SPAIID II programme also introduced additional government programmes to support access to finance through banks.

Box 3.4. The schemes supporting SMEs’ access to finance

The Kazakhstan State supports the provision of finance for private sector investments and business operations through a number of mechanisms. While each scheme is intended to target the needs of different groups of investors, the schemes do overlap.

Damu

Damu is the principle mechanism supporting SMEs’ access to credit. It works through a mix of developing SME businesses’ capacity, and by subsidising the cost of credit that SMEs can obtain from second-tier banks through interest subsidies or collateral guarantees. Between 2010 and 2014, Damu subsidised KZT 626 billion of credit through its 17 individual programmes – equivalent to one-third of outstanding credit to SMEs in 2014. The interest rates paid by borrowers ranged between 8.1% and 15.5%. Damu operates through the second-tier banking system. The commercial banks provide the interface with borrowers, screening loan applications, facilitating the application to Damu for the subsidy, and managing the loan provision and repayment process. The Damu programme is funded partly through transfers from the Samruk-Kazyna, with special programmes funded by Kazakhstan’s development partners such as the Asian Development Bank.

Damu focuses its subsidised credit on the government’s prioritised sectors, especially processing industries, rather than those with greatest demand for credit or where the most SMEs operate. For example, in each year from 2010 to 2014, between 27% and 31% of total subsidised credit was allocated to processing industry firms, which make up around 2% to 3% of SMEs. In contrast, between 33% and 46% of total subsidised credit was allocated to firms in trading, which is the principal activity of between 41% and 46% of SMEs. This reflects the goal of reducing the role of extractive sectors in the economy (Figure 3.13).

From the start of 2008 to late 2014, Damu supported 66 419 different loans to 13 134 borrowers, with an average loan value of KZT 63.68 million. The average loan duration was 32.74 months, and the weighted average interest rate was 11.95%, substantially lower than the typical commercial rates. Damu reported that the loans enabled the recipients to create 33 651 new jobs. While it is complicated to calculate, the subsidised interest rate and the risk guarantee overall are estimated to be worth about KZT 31 million per loan. One example of the effectiveness of the subsidy was a KZT 1.75 billion loan provided through JSC Sberbank that is likely to have made a beverage bottling plant in Arkalyk viable.

However there is little evidence that greater access to Damu credit has led to greater access to finance overall. The largest effects of the programme appear to have been in lending to industry, where greater lending benefiting from the Damu programmes appears to lead to faster growth in overall credit. But the relationship is weak and does not appear to lead to a sustained growth in credit. No relationship between Damu activity and overall lending could be found for SMEs in other sectors.

Over 2015 to 2020 Damu plans to continue its existing programmes. The Business Road Map 2020 programme projects that Damu will provide SME’s with KZT 310.4 billion of support between 2015 and 2020. The programme will be supported by the allocation additional funds from the National Fund, which will reduce to 6% the interest rate that second-tier banks charge to SME borrowers. The first tranche was totally disbursed in 2014 (most of the credit was provided to SMEs in the food production and chemistry sectors). The second tranche of KZT 50 billion was allocated and fully dispersed in 2015, with almost half dispersed into the metallurgical and engineering sectors. The third tranche of KZT 50 billion is to be dispersed in 2016. In addition, KZT 155 billion will be allocated from the Asian Development Bank (ADB), the European Bank for Reconstruction and Development (EBRD) and the World Bank for SMEs support through Damu between 2015 and 2017. Together these programmes bring Damu’s total financial support to SMEs between 2014 and 2020 at KZT 675 billion.

Development Bank of Kazakhstan (DBK)

The DBK is intended to be the lead national institution financing the modernisation and development of non-resource and infrastructure sectors of the Kazakhstan economy. These tend to be larger investment projects. It forms part of the Baiterek Holding structure, and at the end of 2013 received KZT 125 billion from the National Fund to support projects that contribute to the second five-year plan of industrialisation and the New Economic Policy, “Nurly Zhol”. The DBK prioritises projects that generate chains of technologically connected production with high added value, and projects that support Kazakhstan producers’ entry into global markets. The DBK includes a leasing arm, that provides lease financing for investment projects by medium and large-scale businesses in processing industries, production and transportation infrastructure. DBK is subject to a particular regulatory regime.

Sources: Damu (2016) and authors.

Table 3.1. Examples of programmes supporting access to finance
Stabilisation programme				Stimulus programmes
Public support programmes	Joint Action Plan of the Government, NBK, and the agency for financial sector supervision, to stabilise the economy and financial system, 2008-11	Special plan for business development in Zhanaozen, 2012-14	Programme of refinancing mortgage housing loans	Support programmes for SPAIID	Agribusiness Support Programme	SME Support Programme	Mortgage and housing programmes
Programme operators	National Welfare Fund Samruk-Kazyna; NMH “KazAgro”	JSC EDF “Damu”	JSC “Non-Performant Loans Fund”	JSC “DBK”	JSC “NMH” KazAgro”	JSC “Damu”	JSC “KMC”, JSC “Kazakhstan ZHSSBK”
Specific purpose	Strengthen business & agribusiness entities post-crisis	Financial support for entrepreneurs in Zhanaozen	Refinance mortgage-loans / mortgages	Support for projects in non-primary sectors of economy	Improve the competitiveness of agribusiness entities	Support national and regional SME projects in the priority sectors	Improve the living conditions of the population
Operational	No	Yes	Yes	Yes	Yes	Yes	Yes
Sources: Statistical Bulletin (2016) and Damu Fund (http://www.damu.kz/).

The programmes target funding new investments, ahead of providing working capital or refinancing. They use a range of methods, all implemented and managed by private second-tier banks: providing the funds themselves for lending to targeted sectors, subsidising interest rates, or providing risk guarantees on the loans provided by commercial institutions. The funds for the programmes are placed by the state programme operators with the banks for on-lending, in the form of deposits for up to 20 years, depending on the state support programme. These subsidised credit programmes are complemented by others intended to address other deficits that limit firms’ ability to raise and manage financing, for example by providing training in business management, preparing business plans, and financial reporting.

The Kazakhstan finance subsidy schemes are designed to avoid common weaknesses of such programmes, especially to limit distortions to the banking system. Importantly, second-tier commercial banks identify and assess loan applicants, and provide the finance and manage the loan. Eligibility for the subsidy is assessed by the quasi-government agency responsible for implementation (Damu). The lead involvement of the second-tier banks increases the role of commercial viability in allocating and managing credit. By contrast, many countries have relied on state-owned “development banks” to implement subsidised finance schemes. While these can provide some short-term and counter-cyclical support to lending, badly designed facilities are undermined by governance-related issues. These lead, for example, to pressure to provide non-commercial loans to select borrowers or not to pursue certain bad debts which can mean that credit is not allocated to where its returns are highest or it best supports broader economic growth, but to politically connected borrowers (World Bank, 2012). This misallocates scarce credit, and shifts the cost of the loan on to the public budget. These programmes can also suffer from a lack of additionality in generating lendable funding.

These programmes enable smaller firms to access offshore funds via the National Fund, and so help address the shortage of tenge liquidity. The programmes source their financing through various disbursement mechanisms from a mix of the National Fund, as well as the national Republican and local budgets (Figure 3.14). A total of KZT 1 trillion (USD 2.86 billion) was shifted from the National Fund’s offshore holdings to various firms via subsidised loan programmes between 2010 and 2014, and an additional KZT 750 billion is programmed to be disbursed between 2015 and 2019 for the programmes supporting access to finance. Given that the National Fund’s investments are split between liquid, low-risk government securities and higher- risk international financial assets, these programmes act as a conduit to transfer some offshore funds into physical investment programmes in Kazakhstan via credit. The sustainability of these transfers or their effectiveness at achieving the economic stabilisation and inter-generational savings objectives of the NFRK is beyond the scope of the current analysis.

Targeted lending subsidies can be effective responses to a crisis but offer limited long-term benefits

The various schemes supported access to credit during the financial crisis, but their effects became limited as conditions stabilised. An analysis of Damu-linked lending shows that the main stimulus to credit for SMEs was during the depths of the financial crisis, from mid-2008 to the end of 2009. During this period the “Damu Regions” programme and the programme supporting financing from the second tier banks were the main actors. The programmes provided as much as three-quarters of credit to SME during the peak of the crisis. However this support made a far more modest contribution to SME financing once conditions stabilised and banks resumed lending. Including the post-crisis period, the Damu-administered programmes provided only 3.6% of total credit to the economy. Further, these schemes targeted SMEs in prioritised sectors, reducing their benefits for the larger economy (Figure 3.15).

The credit provided through Damu’s programmes largely offset lower credit from banks, rather than accelerating the availability of credit overall for SMEs. An econometric analysis for the period between December 2007 and November 2014 finds that the change in new lending to SMEs is very weakly influenced by additional financing support of the type provided by the Damu programmes. Credit benefiting from the Damu programmes statistically significantly contributed to overall credit during periods when overall lending was volatile. Once credit conditions stabilised, overall lending was not significantly influenced by increased availability of funds through the Damu programmes. Across the full period, the estimates suggest that an increase of credit provided by the Damu programmes of KZT 1 million would increase growth in overall credit to SMEs by 0.0034%. Such a relation suggests that the KZT 836 billion invested through the programmes during the observed period generated KZT 224 million of additional credit. These results, plus specific analyses by periods and industries suggest that the credit support was mostly effective at offsetting banks’ unwillingness to lend during the crisis, rather than a sustained expansion in access to finance. Agriculture is the only sector where credit provided through the programme could be found econometrically to have generated additional lending.

Beyond their effectiveness in responding to the crisis, the programmes can be challenged in the control of their financing, ensuring disbursement meets targets, and generating lasting gains in credit availability or investment. The amount of subsidy relative to the amount lent or share of total lending that benefits from the programmes is uncorrelated with the growth of lending overall for a sector. This suggests that while the programmes may be subsidising individual firms’ operations and making some investments viable, but that these effects are not sufficient to affect aggregate outcomes.

Larger, highly directed programmes managed by the Development Bank of Kazakhstan (DBK) and JSC Samruk-Kazyna do reduce shortages of funding in Kazakhstan. The DBK has disbursed KZT 24.8 billion in loans to finance priority large investment projects between 2010 and 2014, of which 83.8% was provided in tenge. These funds, sourced from the NFRK, are likely to have materially contributed to reducing the demand for tenge liquidity in Kazakhstan. However the highly directed nature of the lending though sectoral programmes, largely focused on priority oil and gas projects (around 52% of flows), raises the question of whether these investments represent the most efficient use of these scarce funds (discussed further in Chapter 2).

Programmes designed to stabilise financing following banking crises need sunset clauses. Measures to ensure the ongoing availability of finance during a banking crisis can undermine the sector’s competitiveness and sustainability if they are allowed to continue operating once conditions normalise. Interventions including expanded guarantees, liquidity support and recapitalisations or nationalisations can be effective immediate responses to bank distress. But if they are allowed to continue beyond the immediate crisis they can have the effect of subsidising unsustainable components of the financial system and can push competitive pressures too far, resulting in unsustainable margins and low profitability and greater risk of instability in the face of future shocks. Most pertinent in Kazakhstan, banks rendered bankrupt by bad loans need to be able to make an expeditious and orderly exit from the banking system, rather than being allowed to continue to operate and compete with healthy banks despite their impaired balance sheets. Similarly, an effective regulatory environment is one that offers certainty to participants and over the regulatory environment requires that regulatory measures are applied consistently across different financial institutions (Kane, 2000; Beck et al, 2010).

Public interventions can help jump-start financing in particular sectors or during periods when private institutions are atypically cautious. Publicly financed lending schemes can provide an immediate fillip to the amount of financing available in a sector especially in the wake of a banking crisis, but these effects are transitory and do little to improve access to finance in the long term. These interventions can be effective at ensuring firms have ongoing access to finance while banks recover from a shock. But these effects are only transitory and last at most as long as it takes for banks to stabilise their balance sheets. The effectiveness of these interventions, and lasting gains in access to finance, rely on deeper improvements in the institutional environment. The environment needs better to ensure that private and public providers of finance are able to operate efficiently and with certainty around the regulatory environment, and that environment reduces the risk of future crises.7

Conclusion: Generating sustained gains in access to finance by expanding banks’ access to loanable funds and strengthening the institutional environment

Banks secure funds to lend from a range of sources, some of which can be expanded in the short term while others require more patient efforts. Banks lend funds from their deposits, from funds they have borrowed in wholesale markets at shorter and longer-term maturities and with and without collateralisation. Their capital base, interacting with prudential requirements, determines the amount of funds that can be lent and the risk attached to those loans, given the deposit base or the amount and type of wholesale financing raised. All of these are influenced by the quality of banks’ internal management, the supervisory regime, and the quality of broader macroeconomic management. Access to wholesale funds and the capital base can be influenced in the short-term. The other determinants take a more patient process of strengthening institutions and of building market participants’ understanding and confidence in those systems.

The immediate need of Kazakhstan’s financial sector is expanded access to wholesale funds

Helping banks gain better access to international wholesale finance may be the fastest way to improve financing for firms. The most effective immediate means of expanding the availability of finance is by reducing the constraints around accessing funds, immediately through international sources and in the longer term by improving the institutional environment for domestic savers and investors. Expanding access to longer-term international funds can be achieved through joint ventures with international financial institutions, and through greater access of wholesale funding markets. Collateralisation of wholesale funding can improve access but can also be subject to more volatility in the availability of funds. The collateralisation involves linking the funds borrowed on wholesale markets with the assets securing the final loans. Strategically, Asian wholesale financial markets may offer significant potential, especially via intermediation in Japan and via Hong Kong, given the low interest rates and availability of capital in the region – indeed the Astana International Financial Centre (AIFC) is negotiating a partnership with the Hong Kong Stock Exchange. The AIFC will help ease the availability of funds by providing an international centre for financial intermediation next to the domestic financial system, although it will take some time for the centre to become established and for these benefits to emerge. It will create various legal and regulatory institutions and a new exchange, and develop human capital in financial services and technology.

Domestically sourced funding for banks will be inadequate for the foreseeable future, and Kazakhstan is likely to remain a net importer of funds as long as domestic investment generates strong returns. The domestic savings pool is weakened on both the demand and supply side. A pool of domestic investable funds will take some years to form. The emergence of a mass retail investor market based on a sizeable middle class with significant investable assets is curtailed by modest incomes and a limited choice of savings instruments. As discussed above, the Single Accumulative Pension fund is managed by the NBK, with the policy to shift management to independent and possibly competing agencies. Its management objectives appear to be focused on ensuring that the funds maintain their value and support the government’s broader economic development and financing objectives. Meanwhile inflows of direct and portfolio investment are likely to remain available at relatively moderate costs as long as monetary policy in high income countries continues to be targeted at expanding liquidity and while Kazakhstan can offer investment opportunities with strong returns at little risk, especially in the longer term and for direct investment. At the same time, the AIFC capital market can supplement the banking system and may better mobilise financial resources within the country and the region to support the needs of the domestic national economy.

Using external finance to realise domestic investment opportunities follows the practice of several benchmark economies that are rich in resources and investment opportunities but short of capital. These economies have managed the volatility in international capital flows through flexible exchange rates supported by strong, well-managed macroeconomic, monetary and supervisory institutions and high-quality institutional environments.

Partnerships between Kazakhstani banks and international wholesale finance may also help improve access. International banks and other financial institutions have long-established and reliable means of accessing wholesale finance. Partnering with these institutions would improve Kazakhstani financial institutions’ ability to access these same sources. One model for these partnerships would be for international banks to make significant equity investments in Kazakhstani financial institutions (i.e. at least 10% shareholdings). This would increase the Kazakhstani institutions’ capital, immediately expanding their lending capacity. The equity ownership would also allow for stronger involvement by the international firm in management, which would improve the operations of the Kazakhstani entity and provide greater transparency to support its ability to tap lower-cost international funding.

Kazakhstan will need to strengthen the quality of its operating environment if it is to compete in an increasingly challenging landscape for international financial institutions. Both domestic and international developments create significant challenges for the strategy of using a greater role for international financial institutions in Kazakhstan to expand the availability of finance. Since the global financial crisis, prudential regimes have been become stricter, requiring banks to hold more capital and to take greater account of the riskiness of their investments. This has made it more difficult to invest in markets such as Kazakhstan. This is especially the case after the downgrading of Kazakhstan’s sovereign debt rating by international credit ratings agencies to just within investment grade, in the light of the deterioration in Kazakhstan’s terms of trade and the rapid draw-down of its national fund. The ratings downgrades reduce the risk-adjusted value of investments in Kazakhstan entities by international banks. To limit further ratings-driven mark-downs it will be important to ensure that Kazakhstan’s use of offshore financial resource is sustainable and does not create a growing risk of default. Meanwhile, the management of distressed banks following the 2008-10 crisis undermined confidence in the operating environment. Three foreign banks exited the Kazakhstan market in the early 2010s, amidst declining certainty around governance and the non-transparent financial transactions including the sale of the nationalised banks.

Significant pools of Kazakhstani funds are held and invested offshore, but these are unlikely to support domestic financing in the short term. Wealthier Kazakhstani investors prefer to hold their funds in foreign currency and in vehicles offshore, with varying degrees of transparency and traceability. This preference may reflect investment diversification goals, the origins of those funds, and concerns around security of property rights and the transparency and consistency of the enforcement regime. Official records suggest that Kazakhstani financial institutions held USD 18 billion in offshore investments in late 2015, while the various government and social security funds held USD 65 billion in portfolio investments. But the official statistics capture only a fraction of flows, with as much as USD 160 billion estimated to be held offshore through various vehicles by Kazakhstani entities. Some of these funds return to Kazakhstan through direct and portfolio investments; for example in international bond placements and even deposits in Kazakhstani financial institutions by offshore entities. In the medium term, the AIFC is intended to attract some of these funds, and greater security in the domestic institutional environmental may also attract additional repatriation.

In the long-term, a more proactive regulatory approach towards enabling a dynamic wealth management sector would help deepen the pool of investable funds within Kazakhstan. Kazakhstan needs to develop a competitive wealth management sector that offer robust financial products at moderate cost to a large numbers of investors with moderate investable wealth. These products would generate the pool of long-term investable funds that can finance development of smaller enterprises as well as larger, privatised SOEs and public private partnerships (PPPs). In recent years a number of countries have worked to improve the regulatory and competitive environments for the financial savings product industry, notably through the Future of Financial Advice (FOFA) review in Australia and the Financial Advisory Industry Review (FAIR) in Singapore. The sector is active in most countries that have grown beyond middle income and will become increasingly important as incomes in Kazakhstan grow. Developing the sector will also help repatriate funds held offshore or in foreign currency into the tenge market. As households’ wealth grows, international experience suggests that funds flow from basic deposit accounts into more sophisticated investment products, and if these are not available within the domestic market households will seek offshore products, highlighting the shallowness of the domestic financial system. Investor education programmes should also be developed to complement the sector’s development, to help investors self-protect and to encourage a competitive and dynamic market.

Better long-term access to finance requires a more robust institutional environment for the financial sector

As domestic banks have greater access to funding, constraints around the quality of the institutional environment for the financial sector will increasingly act as a drag on SME lending. These constraints include the quality of information about firms’ finances, and investor protection and the efficiency and transparency of bankruptcy procedures. As the economy develops into the longer term, access to more sophisticated financial services for more complex transactions will become important. Lenders report that a secondary constraint on providing finance is weaknesses and uncertainty in the enforcement of the investor protection regime and in the reliability of other aspects of the business operating environment, and that legislative changes in 2014 worsened the situation. Financers cite slow and costly mechanisms for protecting investors’ interests and amendments to those systems to favour borrowers as important constraints on their willingness to lend. International surveys also suggest that protection of investors in Kazakhstan is weaker than in many benchmark countries, although Kazakhstan’s ranking has risen significantly in recent years. All of these issues raise the cost of lending to SMEs relative to other potential uses of scarce financing, and reduce banks’ willingness to lend, especially for new businesses or clients whom they do not know well. These issues reflect weaknesses in both the law and the court system. The creation of a system of commercial courts helps address the latter. The independent judicial system and adoption of English commercial law at the AIFC may help with the former, if the domestic legal system is able to incorporate relevant principles and practices from the English system (Box 3.5).

Box 3.5. The potential of the Astana International Financial Centres (AIFC) better to finance Kazakhstan’s economic development

The Astana International Financial Centre (AIFC) is intended to act as an offshore financial centre located in, but institutionally independent from, Kazakhstan’s capital. The financial centre is expected to start full operations in 2018 after two years of development, with the goal of leapfrogging to be one of the top ten financial centres in Asia and one of the top 30 financial centres in the world by 2020. It follows the efforts to create the Almaty Regional Financial Centre which was initiated just before the global financial crisis with the intention of developing the Kazakhstan financial sector.

An independent, well-recognised legal regime is an essential element for developing a financial centre in an emerging market. The Astana Financial Centre builds on the experience of the Almaty Regional Centre by establishing an independent institutional framework, featuring an independent court system, overseen by foreign judges, operating in English and implementing English law (practical details were still being developed at the time of writing). This follows the model of other international financial centres in emerging contexts, such as the financial centres in Dubai, Qatar or Singapore. Further, the AIFC may form a “strategic partnership” with a leading stock exchange that would enable the sharing of expertise and technology, with talks being held with the management of the Hong Kong Stock Exchange. This partnership will lead to the dissemination of technology to support the full cycle for trading in securities, commodities and derivatives. The AIFC will be a platform for subsoil developers by enabling the raising of capital to finance projects.

Significant tax and other incentives are intended to make the AIFC a hub for an international financial services workforce. Participating companies and their employees will be exempt from income, property and land taxes for 50 years. There will be a 30-day visa-free regime for citizens of OECD countries, the UAE, Malaysia and Singapore, as well as a special five-year visa regime for employees of participants. Participants will be connected by direct flights to “leading international financial centres”. The NBK and the domestic stock exchange will remain in Almaty.

The AIFC is intended to have narrow linkages with the domestic financial system, to insulate the domestic real economy from volatility in international financial markets. The AIFC will not directly finance investments within Kazakhstan or in tenge. Indeed, the domestic private financial sector is to remain in Almaty, one thousand kilometres from the AIFC. In its initial form, the connections between the AIFC and the domestic financial sector and real economy will be largely limited to two mechanisms. First, as a centre for private banking and investment management it is hoped that the AIFC will attract as much as USD 80 billion of the estimated USD 160 billion of funds held offshore by Kazakhstani nationals. These funds would re-enter Kazakhstan via the securities exchanges, which would relocate to the AIFC, and via national second-tier banks selling debt securities through the AIFC. Second, and relatedly, it will be a securities market where major Kazakhstani state-owned enterprises can be listed for foreign and domestic investment. This would focus on Kazakhstan’s largest state-owned companies, such as KazMunaiGas, in oil and gas, Kazakhtelecom, the main telecoms operator, Kazakhstan Temir Zholy, the national railway, Kazatomprom, the nuclear holding company, and Samruk Energy. On a smaller scale the AIFC can help develop and diversify the economy of the Almaty region away from public administration towards other service activities, although the tax waivers provided to the centre reduce this benefit. These limited linkages reduce both the benefits and the risks to the domestic economy and financial system from the presence of the AIFC and its exposure to volatility in international financial markets and capital flows.

The measures intended to ensure the success of the AIFC mitigate its benefits for the larger Kazakhstan economy. Special economic and legal zones most benefit their host country when they encourage deepening linkages with the national economy, and when they provide sound models for institutional development that the rest of the country may adopt. They most benefit diversification of economic activity and public finances when they draw on other sectors for inputs and when they make meaningful contributions to public revenues. But significant tax concessions can encourage transfer pricing and other aggressive tax minimisation techniques that curtail both the financial centre’s direct contribution to the economy and the broader domestic revenue base. Independence from national legal institutions and national supply can be essential to achieve the international interest and scale, but can lead the financial centre to exist disconnected from the national economy, without spill-overs into larger economic capacity and productivity. Thus there is a trade-off between the various goals. As a result, maximising the success of the AIFC in the longer-term will also require developing links to Kazakhstan’s broader economy and institutions.

Sources: Authors; Bekmukhanbetova and Masters (2015).

The state and its bodies should support development of the institutional infrastructure surrounding private sector lending. The public sector can play an important role in supporting provision of credit by the private sector to SMEs by fulfilling fundamental public sector functions of providing public goods and solving collective action problems; for example, by ensuring through regulation that a system is in place efficiently to provide credit scores, the public sector can help reduce the cost of lending for private firms. Credit scores have been shown to improve the provision of credit to SMEs even in jurisdictions where SME credit is well supported by other institutions, such as the United States or in Europe through the European DataWarehouse initiative comprising mandatory loan level reporting for underlying loans of securitisation issued in Europe (Nassr and Wehinger, 2015a). This system can be developed and managed by a public or a private agency, such as a co-operative among financial institutions, and potentially in partnership with successful systems operating in other countries. Similarly, Kazakhstan’s collateral registry could be readily strengthened by allowing for easier registration of collateral, and for greater online access to details of the registered collateral. Again, these systems could be developed in partnership with agencies elsewhere.

The most effective institutions supporting lending provide readily available, reliable and transparent information about the finances of creditors. Uncertainty about the quality of credit proposals and viability of a business undermines banks’ willingness to lend, accentuating the challenges of the scarcity of funds (OECD, 2015). Collecting this information adds to the costs of lending to SMEs relative to other uses of banks’ funds. Being able to rely on firms’ financial accounts is fundamental for credit markets to function well and asymmetries of information, particularly prominent in small business financing, inhibit the provision of financing to SMEs not only through bank credit but also through capital market financing (Nassr and Wehinger, 2015b). Larger Kazakhstani firms have accounts that are prepared and audited by large international accounting firms and are assessed as being reliable. They have also developed track records with their financiers and through their use of international wholesale financial markets. Smaller, domestic enterprises lack the resources to purchase this level of advice, and are less known among financiers. They instead rely on domestic accounting and audit firms to help prepare and verify their accounts. Bankers question the reliability and authenticity of these accounts and audit opinions, which reduces their usefulness as a signal of credit quality. Some banks have worked around this by conducting their own audits of financial accounts, but this is expensive and makes borrowers dependent on the one bank, so reducing competition between banks in addition to adding to the cost of lending. This approach is not unique to Kazakhstan, with banks in many countries where financial data are of poor quality following similar practices. However, in benchmark jurisdictions dishonesty or misleadingly prepared certified accounts or audit reports bring penalties ranging from fines and loss of the accountant’s practising certificate through to liability for the damages generated by the misleading or false statements and even criminal penalties. More confidence in financial statements would reduce the cost of lending to smaller firms. It can be achieved by introducing such penalties, accompanied by efforts to raise the capacity of accountants and auditors.

Where regulators ensure providers of finance compete with each other and encourage new entrants, credit is less expensive and more readily available. Regulators and competition authorities can ensure that different actors continue to compete across the financial system, and that new actors can readily enter the financial sector. Conversely, effective regulation also ensures that failing financial institutions are allowed – or encouraged – to exit with minimum distortions and loss of funds for the larger financial system. Effective competition also requires strong consumer protection and competition institutions, which reduce the risk of market practices that are anti-competitive or that exploit information asymmetries or other market failures.

Efforts to expand the availability of financing, for SMEs in particular, should extend beyond the banking sector and allow for the provision of financing through different channels and by different actors, including long-term institutional investors. In particular, capital market financing, whether direct (small bonds, mini-bonds, public equity listing) or indirect (securitisation and covered bonds issued by banks), has the potential to fill the gap left by the banking sector, complement bank credit availability and alleviate financing constraints facing SMEs (OECD, 2015). That said, the fixed-cost nature of loan origination, as well as infrastructure requirements related to sourcing, monitoring, credit analysis and local relationship building with small companies render local banks the dominant players in SME financing (Nassr and Wehinger, 2015a).

The latest Financial System Stability Assessment (FSSA) provided a detailed roadmap of immediate tasks to strengthen Kazakhstan’s financial sector, which the authorities are progressively implementing. The 2014 IMF FSSA focused on measures to strengthen the banking supervisor and its capacity to monitor banks’ health, to improve the resolution of bad loans and insolvent institutions, and regulatory measures to improve liquidity. The assessment also made immediate recommendations to improve the robustness of the insurance sector and operations of the pension fund, which are likely to improve the sector’s operating efficiency and stability, and so help deepen its funding. However, the assessment did not develop longer-term recommendations to improve the sectors’ structures or the development of the larger funds management industry.

Investments in prudential supervision and the monetary policy regime take some time to translate into easier access to finance for firms. Priority improvements in prudential supervision include investing in the capacity of supervisory staff to assess banks’ balance sheets and the risks surrounding their assets, and to improve co-ordination with foreign supervisory counterparts where Kazakhstan banks operate. Weaknesses in the management of probity checks of banks’ clients add to their risks. These measures require investments in the regulatory regime, the structure of institutions and in the capacity of the experts who staff them. The lags between such investments and their effects on actors’ behaviour can be long. These lags make it imperative to form and consistently implement a programme for strengthening institutions. Where there is a long-term need to build trust in institutions, the confidence-building process may be accelerated by taking actions that show a re-setting of institutional practices, such as re-writing the supervisory institution’s constitution, introducing a stronger, clearer mandate, or even changing management. For such “re-setting” to be effective, it must be seen as extraordinary and it must be left in place once it occurs, otherwise the new arrangements will lack credibility and the investments in reform will not bring the intended benefits.

Box 3.6. How could the scenarios affect the context of implementation of financial development policies?

For details of the scenario storylines, please see section: Anticipating trends and preparing for future challenges: scenarios for the future of Kazakhstan in Chapter 1.

Scenario 1: “The New Commodity Super Cycle” would generate a new surge of current account surpluses and foreign direct investment for Kazakhstan. This would generate new pressures on the exchange rate and inflation control, while the appreciation of the tenge relative to other currencies would accelerate a repatriation of Kazakhstanis’ offshore savings. With such rapid progress in deepening the pool of funds within the domestic financial systems, institutional challenges would quickly become the constraint on further financial development, and progress in these efforts would become imperative. The government’s various programmes to encourage investment in priority sectors may continue to be effective in encouraging sectors that are likely to be uncompetitive in the short term relative to resource extraction, and are sustainable given the surge in revenues associated with the strength of commodity prices; however they remain a short-term fillip rather than a longer-term solution.

Scenario 2: “The Great Dissipation” presents the opposite challenge, of limited external funds investing in Kazakhstan, and ongoing weakness in Kazakhstan’s income, slowing accumulation of savings. This scenario is likely to see the ongoing shift of funds from the National Oil Fund play a greater role in Kazakhstan’s financial deepening, although weak oil prices create dangers around the sustainability of these transfers. In this scenario, given the likely difficulty in expanding the pool of loanable funds, efforts to develop the financial sector’s institutional environment should take priority, with the aim of ensuring the available funds are used with maximum efficiency. Subsidised credit programmes are not sustainable given the reduced fiscal space and do not adequately address the underlying issues to justify their continuation.

Scenario 3: “New Silk road and Central Asia Resurgence” is likely to see greater demand for finance for investment and working capital, possibly outpacing gains in the availability of funds. The scenario sees new opportunities in the non-resource tradeable and non-tradeable sectors that would be particularly reliant on bank financing. At the same time, the increased opportunities are likely to attract more direct and portfolio investment to Kazakhstan, and repatriation of savings held offshore, deepening the financial sector. As the non-extractive economy would be the lead driver of growth, fiscal space is likely to grow less rapidly and the funds available to support targeted lending programmes will be scarcer, suggesting that the government’s focus should be on strengthening the institutional environment for the financial sector and lending, rather than supporting lending to priority sectors.

Scenario 4: “New Technology Solution” presents the most challenging scenario for the development of the financial sector. It suggests a protracted period of reduced revenues for Kazakhstan from its resource wealth, reducing ready financing for Kazakhstan through oil revenues and foreign investment, given that the economy is likely to be weaker relative to those of other countries. This would make attracting foreign portfolio and other investment, and repatriation of offshore savings, more challenging, and also means that funds would be scarcer to continue the subsidised lending programmes. This would again prioritise efforts to improve the institutional framework towards longer-term financial deepening.

Source: Authors.

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Notes

← 1. The discussion in this chapter focuses on finance for firms’ investment and working capital. Other more specialised types of finance are important for firms’ ongoing operations, for example trade finance. Developments in these products generally mirror those in the mainstream types of financial products, and are further supported by specific government programmes.

← 2. Liquid liabilities are also known as broad money, or M3, and includes the sum of currency and deposits in the central bank (M0), plus transferable deposits and electronic currency (M1), plus time and savings deposits, foreign currency transferable deposits, certificates of deposit, and securities repurchase agreements (M2), plus travellers checks, foreign currency time deposits, commercial paper, and shares of mutual funds or market funds held by residents. This is presented as a ratio to nominal local currency GDP, which is deflated using the following deflation method: {(05.)*[Ft/P_et + Ft-1/P_et-1]}/[GDPt/P_at] where F is liquid liabilities, P_e is end-of period CPI, and P_a is average annual CPI. Data are taken from the electronic version of the IMF’s International Financial Statistics.

← 3. NBK data present foreign currency deposits in terms of tenge (KZT), and so by construction the reported value of foreign currency deposits will reflect movements in the exchange rate. The rise in foreign currency deposits is still apparent when controlling for the exchange rate movements, for example by converting the KZT value of foreign currency deposits to USD or EUR using current or long-term average exchange rates.

← 4. The amendment was introduced by the Resolution of the Board of National Bank of the Republic of Kazakhstan, 19 December 2015 No. 222 “On amendments and additions to some legal acts of the Republic of Kazakhstan on regulation of banking activity”.

← 5. This assessment is based on the so-called “z-score” summary indicator. It is the returns on assets plus the ratio of capital to assets, to the ratio of the standard deviation of return on assets. The z-score should show the inverse of the probability of insolvency, assuming that profitability follows a normal distribution. The z-score indicates the number of standard deviations that a bank’s return on assets has to fall below its expected value before the bank’s equity is depleted and the bank is insolvent.

← 6. The various guidelines are accessible at: www.oecd.org/daf/pensions/guidelines.

← 7. Various studies that have reached this finding and are summarised in World Bank (2012).