Uzbekistan assigned ‘BB-’ long-term and ‘B’ short-term ratings; outlook stable

Tashkent, Uzbekistan ( -- On 21 December 2018, S&P Global Ratings assigned its ‘BB-/B’ long- and short-term foreign and local currency sovereign credit ratings to Uzbekistan. The outlook is stable. The transfer and convertibility (T&C) assessment is ‘BB-’.

The stable outlook reflects the agency’s expectation that, over the next year, Uzbekistan’s fiscal and external net asset positions will remain strong, albeit decline slightly, due to expected future current account deficits and government borrowing.

“We could raise the ratings if monetary policy effectiveness were to improve, for example through a decline in dollarization of the economy. Further diversification of the government’s revenue base or the composition of the economy’s exports would also be supportive of the ratings,” the agency said.

“We could lower the ratings if the fiscal or external positions deteriorated, for example if fiscal deficits increased beyond our base-case scenario or if higher-than-expected current account deficits led to an increase in external financing needs. We could also lower the ratings if we observed increasing weakness in key state-owned enterprises (SOEs), leading to growing contingent liabilities for the government,” S&P Global Ratings said.

“Our ratings on Uzbekistan are supported by the government’s strong fiscal and external positions. These strengths predominately arise from the government’s large asset position, which stems partly from the policy of transferring part of the revenues from commodity sales to the Uzbekistan Fund for Reconstruction and Development (UFRD),” the statement of S&P Global Ratings said.

“Our ratings are constrained by Uzbekistan’s low economic wealth, as measured by GDP per capita. In our view, future policy responses may be difficult to predict, given the highly centralized decision-making process and that accountability and checks and balances between institutions are relatively underdeveloped. Our ratings are also constrained by low monetary policy flexibility,” the agency noted.

S&P Global Ratings said institutional And Economic Profile: Reforms have begun to open up the economy but challenges remain Broad-based policy reforms have improved institutions, albeit from a low base, and opened up the economy.

“We expect decision-making to remain centralized. GDP per capita remains low, at an estimated $1,200 in 2018. We expect real GDP growth to remain relatively strong, averaging 5% over our forecast period to 2021,” the agency said.

S&P Global Ratings underlined that President Mirziyoyev, wh came to power after the death of longstanding President Karimov in 2016, has initiated a series of broad-based policy reforms, including attempts to increase the independence of the judiciary, remove some restrictions on free expression, and increase the government’s accountability to its citizens. Changes have also included the implementation of an anti-corruption law, an increase in transparency regarding economic data, and the liberalization of trade and the foreign exchange regimes.

The agency said that relationships with neighbors have also greatly improved, evidenced by increased co-operation in border demarcation with Kyrgyzstan and improvements in transportation links with Kazakhstan and Tajikistan. Further reforms earmarked for implementation beginning in 2019 are a new tax system, reforms in the banking system, and early stage development of domestic financial markets. "

“Notwithstanding the positive trend in strengthening institutions, in our view, Uzbekistan is starting from a low base. We believe that decision-making will remain highly centralized in the hands of the president, making future policy responses more difficult to predict. We observe that checks and balances between institutions remain weak. Additionally, uncertainty over any future succession remains, despite the relatively smooth transfer of power to President Mirziyoyev,” the agency noted.

“Over our forecast period through 2021, we expect real GDP growth to average 5%, supported by growth in the services, manufacturing, and natural resources sectors. The construction sector is a small but growing part of GDP. The economy has been government led for many years, and is dependent on SOEs, which contribute an estimated 60% of GDP. Nevertheless, Uzbekistan has a significant endowment of natural resources, including large reserves of diverse commodities, the export of which have supported past current account surpluses. Globally, the country is one of the top 20 producers of natural gas, gold, copper, and uranium. Uzbekistan’s population is young: almost 90% is at or below working age, presenting an opportunity for labor supply-led growth. However, it will remain a challenge for job growth to match demand,” S&P Global Ratings said.

“Despite steady growth, GDP per capita remains low, at about $1,200 at year-end 2018. We expect current account deficits over the coming years as imports increase to meet the consumption and investment demands of the more outward-facing economy,” the agency noted.

“We project that the government will remain in a net asset position, despite fiscal deficits and our expectation of increased borrowing. We expect the central bank will work to lower inflation, though we do not expect single-digit inflation within our forecast horizon through 2021,” the S&P Global Ratings’ statement reads.

S&P Global Ratings expects the government’s fiscal balance to remain in deficit, averaging about -1.4% of GDP over the forecast period. The agency also expects the government to increase social spending on areas such as education and healthcare, but S&P Global Ratings also expect an increase in capital expenditure, given the economy’s infrastructure needs. Currently, wages make up the largest component of expenditure, at over 50%.

The government is also working on a tax reform bill to be implemented in 2019. The reforms will simplify the tax code and lower some tax rates. Although this may help expand the tax base and increase collection rates, we believe initially it could lead to weaker revenues. In our view, the government’s revenue base is potentially volatile because of a high reliance on income from extractive industries. However, the government’s large liquid assets, estimated at 37% of 2018 GDP, could have a mitigating effect if needed, S&P Global Ratings said.

“The government’s assets are mostly kept in the UFRD. Founded in 2006, and initially funded with capital injections from the government, the UFRD has received revenues from gold, copper, and gas sales above certain cut-off prices. We include only the external portion of UFRD assets in our estimate of the government’s net asset position because we view the domestic portion--which consists of loans to SOEs and capital injections to banks--as largely illiquid,” the S&P Global Ratings said.

S&P Global Ratings estimates the general government sector to be in a net asset position of 15% of GDP at year-end 2018. “The government’s net asset position will moderate somewhat over the period, as we expect it to post small deficits, issue commercial debt, and transfer less money into the UFRD. Currently the government has no commercial debt, though we expect it will access the capital markets soon. We include in our forecasts an expectation of $1 billion issuance a year until 2021, though the amount could be lower subject to the government’s policy decisions and market conditions. Also included in our forecasts is the issuance of local currency debt. The government plans to issue local currency debt in the coming quarters to build depth in the local market. It has not issued local currency debt since 2012,” the agency said.

“We estimate general government debt at US$8.5 billion (22% of GDP) at year-end 2018. General government debt is almost all external and denominated in foreign currency, making it susceptible to exchange rate movements. Most debt is from official creditors, of which about half is from bilateral creditors, with the two main creditors being China and Japan. Multilateral lenders, predominantly the Asian Development Bank and the World Bank, provide the other half. We include in our estimate of general government debt the US$2.5 billion (6.5% of GDP) in external debt of SOEs guaranteed by the government, due to the closeness of the government to the SOEs and the ongoing support for the SOEs from the government. General government debt service is low, due to its concessional nature. We estimate interest payments at 1.6% of revenues on average over our forecast period,” the rating company added.

S&P Global Ratings: “We view contingent liabilities to the government from the banking sector and other nonfinancial public enterprises as limited. We estimate total banking sector assets at 67% of GDP in 2018. We note, however, that in 2017 the government injected capital of approximately US$670 million (1.7% of GDP) from the UFRD into state-owned banks. The reform agenda of the government also emphasizes improving operations at noncompetitive SOEs.”

“In addition to the SOE’s external debt that we include in our definition of general government debt, the government also guarantees about US$4.5 billion (11.5% of GDP) of foreign currency-denominated but domestically-held debt of SOEs. These loans are from the UFRD and we consider this as government expenditure. However, as reforms on SOEs begin, if any weaknesses appear or it becomes apparent that further outlays from the government are necessary, we could reconsider our assessment of contingent liabilities,” the agency said.

Uzbekistan’s banking system remains relatively stable, despite the government’s large devaluation of the Uzbekistani sum in 2017, largely because of capital support the government provided to state-owned banks, S&P Global Ratings stated.

“Government-controlled banks dominate the country’s banking system, with a market share of close to 84% of systemwide total assets. In our view, predominance of state-owned banks and a high share of directed lending in the economy distort competition and the commercial nature of banking business in Uzbekistan. Reported asset quality remains good in 2018 with reported nonperforming loans of about 1.3% because of the high share of SOEs, which benefit from ongoing government support, in the loan book. However, we think that problem loans (including restructured loans) could be closer to 10%, reflecting the large restructuring of foreign-currency denominated loans that occurred after the devaluation. Loans denominated in foreign currency represent around 57% of the systemwide loan book, and, together with very high single-name loan concentrations, represent a risk to asset quality soundness, in our view,” S&P Global Ratings said.

The Central Bank of Uzbekistan’s initiatives to strengthen banking sector capitalization and adopt some Basel III guidelines have been moderately successful. However, significant government involvement in decision-making at state-owned banks remains a substantial drag on the effectiveness of banking supervision, the agency said.

“Customer deposits and funds from the UFRD remain the key funding sources for banks, representing close to 70% of systemwide liabilities. Gross external funding represents close to 13% of systemwide liabilities and mainly includes bilateral loans from international financial institutions to fund preauthorized projects. We believe that the funding structure will remain relatively stable over the next two to three years. We think that the government is supportive toward the banking sector, reflecting periodic capital injections in state-owned banks in the previous years and the large amount of SOE debt owed to banks guaranteed by the government,” S&P Global Ratings said.

“Uzbekistan is in a strong net external asset position that is largely the result of current account surpluses and the closed nature of the economy in the recent past. We estimate that liquid external assets will exceed external debt by 34% of current account payments at year-end 2018. As the economy opens up, we expect a small deterioration of this position as the current account balance moves to a deficit. We estimate our measure of external liquidity (gross external financing needs to current account receipts plus usable reserves) at 90%,” the agency noted.

“We include in our estimate of the central bank’s reserve assets its significant holdings of monetary gold, which accounts for the majority of reserves. The central bank is the sole purchaser of gold mined in Uzbekistan,” S&P Global Ratings said.

“It purchases the gold with local currency then sells dollars in the local market to offset the increase in reserves from the gold. We do not include UFRD assets in the central bank’s reserve assets but instead as government external assets because we view them as fiscal reserves. Foreign direct investment inflows are low and concentrated in the extractive industries, particularly natural gas. Our external analysis is complicated by a lack of historical international investment position data,” the company said.

“We expect Uzbekistan’s current account balance to turn to a deficit from 2019, averaging about -1.9% of GDP over 2019-2021. We expect the reduced trade barriers to lead to an increase in imports, especially capital goods and high technology goods required to update and modernize the economy. Additionally, consumer goods imports are likely to rise, given the increased ease of trade,” the agency said.

“Better trade relations with neighbors should boost Uzbekistan’s exports as well, especially agricultural goods. Exports remain heavily dependent on commodities, however, with gold, other metals, and natural gas making up approximately 70% of exports. In our view, this dependency could lead to volatility in their terms of trade. Another important component of Uzbekistan’s current account are remittances from Uzbek workers, particularly the large number of Uzbeks in Russia,” the company said.

S&P Global Ratings said that one of the most significant economic reforms that Uzbekistan has made is the liberalization of the exchange rate regime in September 2017 from a crawling peg over-valued in comparison with the black market rate, to a managed float.

“Though we believe the central bank initially intervened heavily in the foreign exchange market, it now only intervenes intermittently to smooth volatility. he relatively short track record of the float constrains our assessment of monetary flexibility, as does our perception of the potential for political interference in the central bank’s decision-making. Our assessment of monetary policy is also constrained by high inflation and the high dollarization of the economy, which limits the effectiveness of the monetary policy transmission mechanism. Positively, the central bank is moving toward inflation targeting, hough we expect this transition will take a few years,” S&P Global Ratings said.

“We expect inflation to remain above 10% for our forecast period and to average 17% over 2018. Average inflation reached 14% in 2017 and year-end inflation was 19%, mostly because of the currency devaluation in September 2017. In addition to the effects of the devaluation, more open trade policies have allowed domestic prices to move toward regional and international prices, putting inflationary pressure on domestic goods. Growth in public sector wages, the liberalization of regulated prices, and energy prices could also add to inflationary pressure over the forecast period. We note that, in response to these inflationary pressures, the central bank raised its refinancing rate to 16% in September 2018,” S&P Global Ratings concluded.

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