Key factors behind the february 2009 devaluation of the tenge

By Jean-Christophe Lermusiaux, Managing Director - Head of Research

April 2009

On 4 February 2009, the National Bank of the Republic of Kazakhstan implemented a one-day devaluation by allowing the USDKZT rate to go up 22% to KZT150/USD. On the same day, the newly-appointed National Bank Governor, Grigory Marchenko, stated in a press conference that the National Bank and the Government had decided to move from a target range of KZT117-123/USD to a range of KZT145-155/ USD over the medium term. Having considered the reasons for KZT devaluation, we do not expect the Government and the National Bank to repeat their actions in the near term, Nevertheless, we cannot exclude the possibility that the situation may change by the second half of the year.

In our view, the one-day devaluation scenario was chosen in order to minimise currency speculations after the likelihood of the KZT weakening became evident. The National Bank cited two specific reasons for KZT devaluation in its press release on 4 February 2009:

• Preserving foreign reserves of the country
• Mitigating the negative impact of recent devaluations in neighboring countries (primarily in Russia and Ukraine) on domestic producers

While these are key issues, we believe that the National Bank and the Government may also have considered other factors before choosing the new level of USDKZT:

• Sustainability of banking system to exchange rate change
• Decreasing National Budget deficit
• Inflation at manageable levels (resulting from higher prices on imported goods)
• Reducing imports to the level where financial flows related to current account of balance of payments are
  balanced
• Repaying private sector external debts
• Keeping reserves to M3 aggregate ratio above 100%

We believe that given the country's high level of foreign reserves (US$46.2bn) and the side-effects that further devaluation may cause, the USDKZT rate is likely to remain within 145-155 interval specified by the National Bank for the first half of 2009. Based on recent trends, we expect that limited KZT liquidity in the banking sector is an important factor that could support KZT against USD. But if the Government increases financial inflows in KZT into the banking system, the pressure on KZT may be higher.

Sustainability of banking system According to stress tests referred to by officials, two large commercial banks (Alliance Bank and BTA Bank) would have had significant difficulties if the KZT had devalued by more than 15%. For the purpose of mamtaining stability in the financial system, the state fund Samruk-Kazyna acquired 78% of BTA Bank (for ca US$2.1bn, at KZT120/USD) and 76% of Alliance Bank for KZT100 (less than one dollar) just two days before the devaluation of KZT. In addition, the Fund provided KZT24bn credit to Alliance Bank. It is interesting to note that Halyk Bank and Kazkommertsbank each received KZT120bn less than a week before the devaluation.

National Budget deficit

Before the devaluation, the government planned to cover 64% of its 2009 National Budget deficit with a US$7.0-7.6bn transfer from the National Fund (KZT120/USD). The remaining US$4.3bn would have come from borrowing on the domestic market. The amount of transfer from the National Fund is fixed in USD, while the budgeting is done in KZT. At KZT150/USD rate, the budget would receive 25% more in KZT from transfers, and its remaining deficit would decrease by ca 40% to ca KZT300bn (US$2.0bn at KZT150/USD). The lower deficit in KZT makes it more feasible for the Government to borrow on the domestic market.
Fig 2 2008 imports of goods by category (US$bn)

Inflation

By year end 2008, YoY inflation in Kazakhstan decreased to 9.5% from 18.8% at year end 2007. In December 2008 and January 2009, MoM inflation (not annualized) was 0.3% - quite a low level for Kazakhstan. We believe that one of the reasons why the authorities decided to cap the USDKZT rate increase by 25% was to keep inflation at a reasonable level. The National Bank expects 11% YoY inflation by the end of 2009. We believe that inflation could be higher (12-16%) as we estimate that the share of imports in domestic private consumption is high (40% of food, 80% of cloth and other consumer goods). Inflation well above 20% in Russia and Ukraine would diminish the positive effect of lower prices from the devalued RUB and UAH. In addition, the Chinese Yuan remains strong against the dollar.

Reducing imports

Reducing imports could be another reason for devaluating KZT. While Kazakhstan's industrial production decreased 3.5% MoM in real terms in December 2008, industrial imports for the same month grew 29% to US$1.5bn/month. In our view, the changes could have reflected lower prices on industrial products in neighbouring countries. The same trend could have continued in January, as industrial production declined another 10.4% MoM. Moreover, non-industrial imports in December remained at summertime levels (ca US$950m/month).

During the second half of 2008, monthly exports from Kazakhstan declined 44% to US$4.2bn. The decline was sharp because 90% of Kazakhstan's exports are related to commodities.

As a proportion of imports are financed through FDI, at KZT150/USD and US$40/bbl the financial flows related to the current account could be balanced as imports would reduce. Nevertheless, a significant part of pressure on KZT could remain since repayments of external debt fixed in foreign currencies would not reduce if KZT devalued.

Repayment of external debt

Kazakhstan's banking sector is to repay USfll.lbn in external debt in 2009. Other sectors will pay an additional US$9.0bn. Though a part of this debt could be revolved to later periods, we believe that external debt repayments could put significant pressure on KZT. Given Kazakhstan's US$46.2bn in foreign reserves (including foreign reserves of the National Fund), the country can undoubtedly afford to repay foreign debt in the medium term. In the longer term, stability could depend on the state of the banking system and whether overseas assets of commercial banks (ca US$22bn) are able to generate revenues in foreign currency.

As total foreign reserves (National Bank foreign reserves plus National Fund foreign reserves) declined only 1.0% in January (to US$46.2bn), we believe that the Government and the National Bank acted in advance rather than retroactively.

Keeping reserves to M3 ratio above 100%

In its policy, the National Bank tries to keep foreign reserves at a level above 100% to money supply (M3) in the economy. At this level of reserves, the National Bank is able to buy all KZT cash in circulation, and in current accounts and saving deposits. We believe that this puts it in a very strong position. We also note that before devaluation that ratio had fallen below 100%.

Another measure we composed is the ratio of foreign reserves to all KZT cash and KZT-denominated accounts (Fig 4). In our view, this measure of KZT's resistance to devaluation pressures, could more appropriate in a stable financial system where there is no outflow of deposits in KZT from commercial banks.

In spring 1999, Kazakhstan devalued KZT by 50%. This action followed the 80% devaluation of the Russian ruble in summer-autumn 1998. This time round the RUB weakened by only 35% and the KZT by 19% (if measured through KZTUSD rate), so from this perspective we would not expect a higher KZT devaluation.

Conclusion

While it could make sense to allow even further KZT devaluation, the potential for negative secondary effects is high. We believe that the authorities will observe the consequences of the recent devaluation of KZT before deciding their next steps. On 24 February, the National Bank Governor, Grigory Marchenko, denied rumors of a second wave of KZT devaluation. The Governor stressed that the range of KZT145-155/USD has been chosen for the medium term, meaning "more than one year". A day later, President Nursultan Nazarbaev, also stated that there were no plans to devalue the national currency further

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