Turkey Country Outlook August 2008

by Edward Hugh: Barcelona


Executive Summary

Turkey’s economy grew at a 4.5 percent in 2007. The economy accelerated to an annual rate of 6.6% in the first quarter of 2008. Thus despite being faced with a series of major headwinds – the June 2006 lira crisis, the August 2007 sub-prime turmoil, the threat of having the governing party banned and a global food and energy price shock – the growth momentum of the Turkish economy has been maintained.

Headline inflation had been on a downward path, but started to pick up in the second half 2007 on the back of escalating food and energy prices, and reached an annual rate of 12.1 percent in July. Core inflation has been lower, but has followed a similar trajectory; reaching 6.8 percent in July and thus headline inflation has continued to remain above the central bank 2007 target of 7.5%. The central bank has, rather belatedly, begun a process of monetary tightening, with three 50 bp rises at three consecutive meetings before pausing in August. We do not anticipate any additional tightening in the immediate future as we feel the bank will watch and wait to observe the future course of oil and food prices.

Turkey’s current account deficit stabilized temporarily in 2007. Despite an appreciating lira, export and tourism performed tolerably well throughout the year, supported largely by earlier productivity gains. Import growth was weak in early 2007 (reflecting sluggish domestic demand and the lagged effects of the mid-2006 depreciation) but gradually regained strength as the lira once more rose and oil prices surged. The current account deficit was 5.7 percent of GDP for the full 2007 - down from 6.0 percent in 2006 - but the gap has been widening again in recent months.


Fiscal resolve in Turkey’s AKP governing party predictably weakened considerably in 2007 – an election year. Stripping out one-off factors, which buoyed fiscal performance in 2006, fiscal policy was scheduled to tighten considerably in 2007 .In the event, the envisaged discretionary tightening did not materialize: the 2007 nonfinancial public sector primary surplus was 1.5 percent of GDP less than forecast. The Turkish authorities are now targeting a primary surplus of 3.5 percent of GDP to create additional fiscal space for infrastructure investment (including major projects in poorer southeast areas), labor market reform, and higher transfers to subnational governments. The authorities view this stance as appropriately balancing macroeconomic concerns against microeconomic needs, and we by and large concur. It is also politically both wise and expedient in the view of the tensions which exist inside the country and the serious need for political stability if the desired macroeconomic reforms are to be implemented.



Country Outlook

In the midst of all the recent political debate and tension surrounding Turkey – and in particular the recent legal initiative to ban the governing party, the AKP - one feature stands out above all the rest: the extent and duration of the economic revival which Turkey has experienced since it left the deep recession experienced in 2001. It is clear that something has changed in Turkey, and in a quite remarkable way. The application of well-founded economic policies, anchored in an ongoing EU accession process and backed-up by a steady flow of International Monetary Fund reviews and arrangements, has served to provide Turkey with a greater degree of political and economic stability than was normal in the past and this, when added to the extremely favorable external conditions which characterised the global environment until August 2007, have produced in the Turkish case an impressive average annual GDP growth rate of 6.8% in the years between 2002 and 2007.

Perhaps more than the performance during the good times, what is most remarkable about the recent Turkish performance is the stability it has shown in the face of adversity. Prior to 2001 the Turkish economy had been characterized by a series of boom-bust cycles which were normally accompanied by extended periods of financial fragility. However, political consolidation post 2002 and a much more favorable demographic environment have led to both growing economic rationalization and to a considerable reduction of business-cycle volatility. The volatility of real GDP growth (or any other macro variable, for that matter) has declined to historically low levels post 2001, while total factor productivity growth has surged to around 5% a year.

Since the heady days of 2004 the Turkish economy has had three significant headwinds to contend with: the run on the Lira of June 2006, the sub-prime troubles of August 2007, and the decision by the Constitutional Court to hear the case in favour of banning the governing AKP. In each case risk aversion towards Turkey has increased. – although in each case as can be seen in the chart below with reducing intensity – and in each case the Turkish economy (whilst slowing) has stubbornly refused to be deterred from its course. The general picture can best be seen from the USD-TRY chart, which has three identifiable peaks: the June 2006 run on the Lira, the outbreak of the sub-prime turmoil and April 1, the day the Turkish Constitutional Court decided it was going to hear the case against the AKP.




Of the three the worst was undoubtedly the capital outflow hemorrhage which hit Turkey’s financial markets in June 2006 and brought about a very sharp depreciation in the value of the lira - at one point the drop was 19.0% against the dollar and 21.3% against the euro - all in the space of just four weeks. The impact of the outflow was such that the 5-year bond yield increased by 460bp from 13.4% to 18.0% over the same period, an up-jerk which naturally lead to a sudden contraction in the availability of domestic credit. Faced with the severity of the shock which hit the Turkish economy the central bank had little alternative but to move aggressively, with the central bank policy rate being raised from 13.2% to 17.25% in the space of just 20 days.

Now in each of these shocks has also been followed by some sort of slowdown in the Turkish real economy. The growth rate slowed in 2006 from a year on year 9.7% in Q2 to 6.3 in Q3 and in 2007 from an average annual rate of 5.7 percent in the first half to 3.4 percent in the second. The 2007 slowdown was the result of a variety of other factors, notably a sharp drought-related drop in agricultural production (which subtracted 0.75 percentage points from 2007 growth) and a deterioration in net exports, reflecting the generally stronger lira over 2006 (it was up 19 percent in real effective terms in 2007).




GDP growth started to accelerate again in the first quarter of 2008, but the stronger performance is not expected to be repeated in the second quarter, since alongside the political crisis and drop in confidence that this produced, Turkey has also seen, along with most other emerging economies, accelerating inflation and monetary tightening from the central bank. In general terms the strength of the expansion post June 2006 has been much weaker, and this can be largely attributed to a rapid drop in the expansion of construction activity.



Some slight recovery in construction activity can in fact be noted in the first quarter of 2008, and this to some extent coincides with a rebound in the expansion of domestic private credit which after falling back from an annual pace of expansion of around 80% in June 2006 bottomed out at around 30% June 2007, and by March 2008 was back up at a year on year growth rate of around 45%.



Recent quarters have also witnessed a steady build up in invesment in machinery and equipment, which is basically a very healthy sign since it can be read as showing confidence in future end user demand growth.



Inflation and the central bank response

At the same time supply-side energy and food shocks have also slowed Turkey’s growth at the same time as stoking up inflationary pressures. To reverse the recent surge in inflation, the central bank has halted its earlier easing cycle and moved over to a clear tightening bias.

Energy items, which represent 11½ percent of the HICP basket in Turkey - were supportive of disinflation during the first half of 2007, as lira strength and an administrative freeze on utility prices temporarily shielded consumers from rising world market prices. Since last October, however, the surge in oil prices has clearly made its presence felt on domestic inflation. In addition, food prices – which constitute 28.5 percent of the basket - have continued to exert upward pressure. As a consequence the central bank reported in their last inflation report that 6.8 percentage points of the 10.61 percent annual CPI inflation in June resulted from the direct impact of food and energy items. Of course, another way of looking at this is that 3.81 percentage points came from other factors, and this is just what the IMF staff economists pick up on in their latest report.



The central bank argues that elevated food inflation continues to be the main factor impeding the disinflation process. They suggest that even though domestic weather conditions became more favorable in the first half of 2008, the lagged effects of last year’s poor harvest and high global agricultural commodity prices have continued to keep processed food inflation at high levels. As a consequence, processed food inflation saw a cumulative increase of 14.2 percent in the first half of 2008. In July the annual rate of CPI increase excluding food, energy, tobacco and gold stood at 6.54 percent, suggesting to the central bank that “the breach of the inflation targets can be mostly attributed to factors beyond the control of the monetary policy”. The IMF economists do not agree, and have themselves computed a “virtual” inflation series by applying Turkey’s basket weights to average EU-27 inflation rates for detailed HICP components and then comparing the results. This virtual rate is an attempt to capture the impact of pan-European price trends, which in the case of Turkey are magnified by the relatively high weight of key items (especially food) in the national basket. What the IMF economists found was that while EU-wide trends explain most of Turkey’s very recent inflation dynamics, the general high level of inflation clearly remains a domestic Turkish phenomenon.

The key risk for the Turkish inflation outlook is that the recent supply-side shocks will produce lasting second-round effects. Inflation expectations had been on a steady downward path but have risen sharply again in recent weeks. Moreover, the latest monthly numbers on core inflation - 6.54% in July - do point to a problematic broadening of price pressures, also related to the lira depreciation early this year.

Turkey's central bank left its benchmark interest rate unchanged at 16.75% last week, pausing for the time being a rate hike exercise that has seen three months of consecutive 0.5 percentage point increases. The central bank now hopes that Turkey's key rate, which is now the highest among developed and emerging economies, together with the recent drop in oil prices, and the renewed rise of the lira (which is now up around 12% since it hit a 2008 low of 1.3470 against the dollar on April 1) will all help to slow the pace of consumer-price growth.




Current Account Issues

Turkey’s current account deficit stabilized temporarily in 2007. Despite an appreciating lira, export and tourism performed tolerably well throughout the year, supported largely by earlier productivity gains. Import growth was weak in early 2007 (reflecting sluggish domestic demand and the lagged effects of the mid-2006 depreciation) but gradually regained strength as the lira once more rose and oil prices surged. The current account deficit was 5.7 percent of GDP for the full 2007 - down from 6.0 percent in 2006 - but the gap has been widening again in recent months.

In general Turkey’s external position has improved considerably, and the external debt-to-GDP ratio still fell to 34 percent of GDP by end-2007 (down from 44% in 2003, with the improvement due largely to the lira’s sharp appreciation and strong nondebt-creating inflows). Foreign exchange reserves stood at $76.5 billion at the end of 2007, up from $35.2 billion at the end of 2003.

External financing was ample during 2007, but turmoil in global markets has since been exerting an influence on financing conditions. FDI inflows were buoyant in 2007, driven by mergers and acquisitions in the financial sector, and covered half of last year’s current account deficit. Equity market inflows and long-term corporate loans also were robust. This abundance of external financing allowed the central bank to increase international reserves considerably, but more recently external financing conditions have tightened in many areas - foreign investors have scaled back their portfolio holdings, securitized bank lending has all but ground to a halt, and spreads on syndicated loans have widened.


The Fiscal Dimension

Fiscal resolve in Turkey’s AKP governing party predictably weakened considerably in 2007 – an election year. Stripping out one-off factors, which buoyed fiscal performance in 2006, fiscal policy was scheduled to tighten considerably in 2007 .In the event, the envisaged discretionary tightening did not materialize: the 2007 nonfinancial public sector primary surplus was 1.5 percent of GDP less than forecast. In particular, with growth moderating, it proved difficult to enforce the envisaged spending restraint in an election year. On the revenue side, the main problem has been (and is) weakness in collections linked to consumption, reflecting slow spending for durable goods, as well to a drop in compliance and tax arrears (of around 0.25 percent of GDP) from an ailing state energy enterprise which was unable to raise tarrifs. Nonetheless debt continued to decline rapidly in 2007, helped by lira appreciation and privatization receipts. The overall fiscal balance was a deficit of 1.4% and total debt to GDP was down to 38.8% of GDP (down from 67.4% in 2003). The Turkish authorities are targeting a broadly neutral fiscal stance for 2008 and there seems to be a general consensus that the primary surplus target of the last five years (5 percent of GDP) which formed the cornerstone of earlier macroeconomic success is not necessarily appropriate in the present environment. With gross public debt down to 39 percent of GDP a primary surplus of the previous order is no longer necessary from a debt dynamics perspective, and the Turkish authorities, rightly in our view, see such a target as undesirable, given pressing needs for infrastructure investment and labor tax cuts, and given the need to take some sort of remedial counter measures in the face of a slowing global economy and tight monetary policy at the central bank.




Financial Markets


Turkish financial markets outperformed most of their peers in 2007, but then fell back significantly as the cloud of uncertainty hung threateningly over the AKP, only to rebound strongly again following the final Constitutional Court ruling. Equities rose 42 percent in local currency terms in 2007, while the benchmark bond yield fell by 460 basis points. Moreover, high interest rates and an appreciating currency made Turkey perhaps the most profitable “carry trade” destination throughout the year. The flip side has been strong exposure to global investor sentiment, as witnessed during the market turmoil in August 2007 and more recently in 2008, when Turkey was again among the hardest-hit emerging markets. Indeed, equities fell 22 percent during the January – July period, with bond yields and external spreads up 210 and 55 basis points, respectively, while the lira was down around12.5 percent against a euro-dollar basket. Since the start of July however, the stock markets have rebounded by some 18%, while the lira is up 12% against the dollar since the April 1 low.


Outlook on Key indicators

We expect GDP growth to have remained strong in the second quarter of 2008, but we now expect growth to slow further in the second half of the year. Industrial output (up 0.8% y-o-y in June) has slowed considerably and consumer confidence has been moving steadily downwards since March (suggesting much slower consumption growth in the second half of the year) although it did rebound slightly in July in anticipation of the Constitutional Court ruling. Export growth has remained reasonably strong, but this dynamic may change as Turkey sends nearly 50% of its exports to the EU, and the EU economies have now started to slow considerably.

The Turkish authorities have revised their 2008 growth forecast down from 5.5 percent to 4.5 percent, while the IMF are anticipating 3.95% growth for the year as a whole, a figure which seems to be a little nearer to the likely outcome. Economic activity in the second half is expected to benefit from recoveries in agricultural production, but be weighed down by slowing net export volume growth. At the same time, the outlook for private domestic demand seems to be looking up slightly following the rise in consumer confidence and the equity markets which have followed the Constitutional Court ruling, so we now anticipate 2008 GDP growth in the 4 – 4.5% range, with a slight acceleration in 2009 into the 5 – 5.5% range.

We see the current account deficit widening again in 2008 possibly to 6.5% of GDP. The lagged effects of 2007’s strong lira and surging oil prices are casting a shadow over net exports, and we expect this to continue as the external export environment worsens, while domestic demand continues to move forward. Uncertain prospects for growth in major trading partners pose a downside risk for exports, which is balanced to some extent by the drop in oil prices and a weakening of their impact on import values. We do not, however, anticipate any serious problems for Turkey in financing the deficit, and given that we do not anticipate any early loosening in the monetary stance of the central bank, we expect the upward drift in the value of the lira to continue.

The central bank is likely to continue to maintain the tightening bias in its interest rate policy, although further increases are unlikely in 2008 if agricultural output continues to improve and oil prices continue to fall. We do not accept the central bank view that the recent rise in inflation largely reflects adverse developments in food, energy, and administered prices. The weakening currency in a more uncertain global environment has also played a role, but internal “made-in-Turkey” components also exist – as evidenced by the sharp 18.41% increase in producer prices. So the Turkish central bank will need to keep a firm hand on the rate tiller in the immediate future, and try if it can to rival its Brazilian counterpart in competing for the reputation of being the “new bundesbank”.


The Turkish authorities are now looking for a primary surplus of 3.5 percent of GDP to create additional fiscal space for infrastructure investment (including major projects in poorer southeast areas), labor market reform, and higher transfers to sub national governments. The authorities view this stance as appropriately balancing macroeconomic concerns against microeconomic needs, and we by and large concur. We also see this approach politically both wise and expedient in the view of the tensions which exist inside the country and the serious need for political stability if the desired macroeconomic reforms are to be implemented.

Despite the significant strides forward, a number of key economic challenges are yet to be addressed. In the near term the heightened global risks remain and have even intensified. Domestic political tensions have subsided somewhat but are far from resolved, while any relief from the fall in energy prices may well be short lived. In addition Turkey faces a number of structural problems - including tax rates which are still high in comparison with competitors, a large informal economy, energy supply bottlenecks, and shallow financial intermediation, all of which need to be tackled to lift the potential growth rate.

Thailand Country Outlook August 2008

by Claus Vistesen: Copenhagen

Executive Summary

• Thailand's economy grew at 4.8 percent in 2007. Despite a number of factors affecting public sentiment - the political uncertainties, the imposition of capital controls in December 2006 (subsequently removed in March 2008), and the proposed amendments to the Foreign Business Act - net exports continued to provide the main support for growth while domestic demand has continued to remain weak. The Thai economy is expected to slow slightly in the second half of 2008, and then pick up speed again in 2009 as long as global energy prices continue to fall back somewhat from their June 2008 highs.


• Headline inflation had been on a downward path after peaking in mid-2006, but started to pick up in Q4 2007 on the back of escalating energy prices, and reached an annual rate of 9.2 percent in July. Core inflation has been lower, but has followed a similar trajectory, reaching 3.7 percent in July and thus falling just outside the Bank of Thailand's 0-3½ percent target band. The Bank of Thailand has, belatedly, begun a process of monetary tightening, but we do not anticipate they will move into truly “hawkish” mode.


• Following an appreciation of about 14 percent against the U.S. dollar in 2006, the baht appreciated by a more moderate 6.4 percent in 2007, in line with other regional currencies. The current account registered a surplus of over 6 percent of GDP, and reserves increased to US$87½ billion by end-2007 (equivalent to 6½ months of imports of goods and services). This appreciation has continued into 2008, and given the importance of exports to the Thai economy it is likely that restraining any further significant rise will be an important objective shaping policy formation both at the central bank and at the Ministry of Finance.

Country Outlook

As is to be expected, both the cyclical and the structural performance of Thailand’s economy tend to be somewhat adversly affected by the various comings and goings associated with the country’s ongoing internal political conflicts. Historically the political instability which these create has tended to manifested itself in the form of what are admitedly normally rather benign military coups. Although a strong argument could be made that these specifically Thai political theatricals have already been incorporated into market pricing and practice it is still a factor which investors need to bear in mind, as capital flows may, on occasion, be temporarily affected.






In our most recent long term analysis of the Thai economy (see Thailand’s Economy – At a Crossroads) we showed how GDP growth in 2006 was almost exclusively driven by net exports as household consumption and fixed capital formation came grinding to a halt. A key internal development to take into account here has been the military coup and ensuing economic uncertainty which lingered throughout 2006 and which naturally put a significant lid on domestic activity.

In 2007 the positive contribution from net exports remained the core component in GDP growth but there has also been a clear change in the underlying tempo. Domestic demand was on the upswing in the second half of last year with private consumption expenditure up by a moderate 1.8 percent y-o-y in each quarter, following a very lacklustre performance indeed in each of the previous two quarters. This tendency was sustained into Q1 2008, with private consumption up by a much more solid 2 pedrcent y-o-y.

Agricultural output has, as might be expected given the surge in global prices, grown considerably, and was up by 3.5 per cent year-on-year in the first quarter, accelerating slightly from 3.1 per cent in the previous quarter. Both livestock and crop production increased significantly, and particularly the production of rice and energy crops such as cassava, palm oil and soybean. High agricultural price evidently encouraged farmers to expand their production. Growth in manufacturing output remained healthy, and was up 9.7 percent year-on-year, as compared to an average growth rate of 5.7 per cent in 2007. This surge in manufacturing was driven by both export-oriented and domestic-oriented industries. Export-oriented industries which put in a strong showing included electronic products, computers and equipment, televisions and air conditioners, while domestic-oriented industries such as the production of alternative energy (E20) compatible cars and petroleum products also expanded well.


Private investment was up a healthy 6.5 percent year-on-year in Q1, largely accelerating on the back of increased machinery and equipment investment from the previous quarter’s growth rate of 3.9 percent. Previous baht appreciation helped cap import costs, while at the same time attracting the capital to replace and expand plant and equipment. Business confidence also improved in Q1, and the Business Sentiment Index rose from 45.0 in the previous quarter to 45.9. Investment in construction also began to recover, following a sharp contraction in Q4 2007.




Finally, and after a predictable slump in 2006 on the back of the political tensions and the aftermath of the Tsunami tourism, has continued to accelerate in 2008 and preliminary data for Q2 show an improving trend, partly due to a low base in the same period last year, and the number of tourists during the first 2 months of the quarter expanded on average by 16.6 per cent year-on-year.
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On the external front, net exports in Q1 contributed 0.6 per cent to GDP, down from the 2.5 per cent registered in the previous quarter. This was mainly due to a rise in imports following an expansion in domestic demand, and of course the increased cost of oil. Imports were up by 10.3 per cent year-on-year in Q1 accelerating across the board in every category from 6.2 per cent growth in the previous quarter. Meanwhile, exports of goods and services continued to expand well with a growth rate of 8.7 per cent year-on-year. Noticeably, income from foreign tourists rose sharply while exports of goods softened slightly compared to the previous quarter. This was due to a softer growth of exports in fisheries and electronic circuits, despite healthy export growth in agricultural products, jewelry, vehicles and parts, and electrical appliances.

For 2008, the central bank is forecasting GDP to be in the range of 4.8% to 5.8%, while Thailand's Finance Minister Surapong Suebwonglee is predicting 6%. Since 2007 saw growth at only 4.7% this latter view must be considered a decidedly bullish forecast, and it is more than likely that general global conditions will dictate a rather slower pace of growth in the second half of the year following a strongish showing in the first half.

As regards its external balance Thailand still seems to be laboring under a once bitten twice shy mantle. Thus, with the exception of a rough, but short, bout of capital flight in 2005 Thailand has maintained a small but clear surplus on its external books. Given Thailand’s economic development profile this may seem rather odd but the effects of the Asian currency crisis still clearly in the forefront of Thai policy makers thinking.

This surplus has been achieved through continuous attempts by the Thail authorities, not to halt capital outflows, but rather to slow down inflows and the ensuing appreciation of the Bhat. Consequently, in December 2006 the BOT put in place capital controls and demanded unremunerated reserve requirements (URR) on short term capital inflows in order to deter speculation over possible appreciation of the Bhat. Capital controls were finally lifted in November 2007 and the reserve requirements disappeared at the end of February 2008.
However, and even though Thailand has been rather cautiously dipping its toe into the water with respect to a full blown exposure to the global search for yield, the post 1998 currency crisis economy has still seen a steady flow of foreign investors moving into Thailand (see here Thailand’s Economy – At a Crossroads).

This leads us neatly to the break-up of the current external position. In light of a consistent positive financial account and thus inflow of portfolio investments Thailand’s income balance is, as might be expected, negative. This is perfectly in line with economic fundamentals as it merely means that foreigners hold more claims on Thailand than Thailand holds on foreigners.




In fact, as the GDP break down above shows, this persistent surplus on the external balance is what propelled Thai GDP growth throughout 2006 and to some extent into 2007, although domestic demand is now picking up, even though the rate of acceleration is slow.

Moving on to price developments, Thailand enjoyed something of a perfect storm in 2007 as headline inflation remained pretty subdued at 2.3% (y-o-y) with core inflation running at around 1%. This was well in line with the central bank’s, rather wide, core inflation target which lies in the 0-3.5% band.



However, a target this wide which is based on core prices does not seem an especially strong or adequate instrument in the current climate. Thus, while headline prices remained relatively low in the first three quarters of 2007, Q4-2007 and Q1-2008 have seen Thailand subjected to the full volley of the global energy and food price inflation shock.

Recent forecasts from the central bank are signalling significant upside risk to future inflation developments. The combination of rising headline inflation feeding into producer prices at one at the same time as domestic demand seems to be staging a recovery points towards further inflation in the pipeline. The quarterly PPI index rose at a significantly higher pace in Q4 2007 (7% y-o-y) and Q1 2008 (10.3% y-o-y) relative to previous quarters. Consequently, in their most recent inflation report the bank does seem to have taken on board the need to take headline inflation into account too . The main argument here is that the latter now seems to be breaking its hitherto strong trend-relationship with core prices.

In light of the increased pressure from headline prices, the central bank (chaired by Mrs.Tarisa Watanagase) opted, at the July meeting, to up interest rates by 25 basis points to 3.50%. This raise broke the 3.25% holding position the bank has maintained since Q3 2007. According to the central banks own 2008 core inflation forecasts (2.2% y-o-y) the 3.5% interest rate translates into a positive real rate of 1.3%. However, if corrected for the current headline inflation the real rate resides firmly in negative territory at -5.7%. In general, and according to the central bank’s own calculations, we can cleary affirm that Thailand’s real interest rate remains one of the lowest among any of its Asian peers.

One key variable to gauge in this context would then also be the Bhat. In light of global fundamentals one would expect a hawkish central bank to coincide with an appreciation of the currency. Given the fact that the BOT has held rates steady for the past 1 ½ year, we are still to see whether this applies in Thailand’s case. So far the appreciation against the USD has seen the Bhat rise in value to the tune of 23.5% (at its peak) since January 2006. The recent months however have seen the USD claw back some of this so that the USD/BHAT now resides in the 33-34 range.

In light of the gradual lifting of reserve requirements and capital controls the outlook on the Bhat has been decisively bullish, with sell side analysts forecasting an appreciation in the region of 15% against other major currencies. In many ways, the Bhat already has been riding an appreciation around these levels and it is unclear that it will move towards 20-25 against the USD anytime soon.

Outlook on Key indicators


GDP growth is expected to remain strong in Q2, and then slow slightly in the second half of the year. However, if we take current prices and deflate with the immediate level of inflation it is not at all unlikely that inflation may eat up a substantial amount (especially if we deflate with headline inflation) of any potential increase in living standards and purcasing power, and private consumption is likely to remain weak, and recent poor showings in consumer confidence would seem to point in this direction. Generally, the slowdown in global momentum should also be put a de-facto ceiling on the current expansion in Thailand’s economy. At the same time, should global oil prices fall back more in the second half of the year, it is our opinion that Thai growth may well accelerate again in 2009, and we are currently forecasting headline GDP growth in the 5.5 – 6 percent range for FY 2009.

In the statement following the recent 25 basis point hike the monetary policy committee (MPC) noted that it would stand ready to counter any effects from further increases in inflation. Given this investors should begin to incorporate the idea of an increasingly hawkish BOT into their thinking. However, it remains unclear whether in fact we are not at a tipping point as far as golbal inflation goes. Should this be confirmed, and should headline inflation finally begin to offer a breathing space, then the BOT may be reluctant to raise rates to any significant extent, especially if this would mean driving up the Bhat further at a time when export growth remains the principle strong point in the economy .

The future course of the Bhat is thus difficult to call at this point in time. Clearly, if the economy continues to expand from its low “post military coup” level, and if the BOT opts for a hawkish course then the scene is set for a significant further appreciation of the Bhat. However, the general outlook for Asian economies is also one of re-coupling to the rest of the world and given that Bhat already is at a fairly high level (e.g. against the USD) we will need to see the BOT’s reaction and investors’ response before making any decisive call on the trend.

India Country Outlook August 2008

by Edward Hugh: Barcelona

Executive Summary


India’s latest run of strong economic growth and continuing macroeconomic stability is a tribute the important progress made in recent years in macroeconomic management techniques as well as to an earlier generation of structural reforms. India’s economy has now expanded at an average rate of about 8½ percent for four years running, on the back of rising productivity and sustained investment. Inflation after ebbing in the second half of 2007 has now returned in full force and become one of the most pressing macro problems facing the Indian economy. In fact the record capital inflows which have followed the bout of global financial turbulance and a slowing U.S. economy, while in the long run beneficial, have only served to complicate the application of sound monetary policy. The current account deficit, which had remained modest, is now – on the back of high oil prices, heavy external energy dependence and a growing fiscal deficit – in danger of becoming a matter of concern.

India Needs:

- to bring inflation back under control and to within the central bank “comfort zone”.
- to reduce the growing fiscal deficit
- to extend and substantially upgrade infrastructure

India's Strong Points:

- solid and sustained economy growth, no likelihood a a major slowdown
- significant foreign exchange reserves
- proven human capital resources
- demographic tailwinds blowing strongly in her favour, and for several decades to come


Economic Background

India’s recent macroeconomic performance has been truly impressive, the result of sound macroeconomic policies, steady reforms which have been ongoing since the start of the since 1990s, and increasingly favourable demographic tailwinds. Growth averaged about 8½ percent in the four years through 2007/08, and while it is set to drop to the 7- 8 percent range this year, India will remain one of the world’s fastest-growing economies in 2008. The poverty rate fell from 36 percent in 1993/94 to under 28 percent in 2004/05.

India’s productivity growth has also been rapid when compared with that of other countries. The IMFs September 2006 World Economic Outlook found that India’s total factor productivity growth has averaged about 3⅓ percent in recent years, which within Asia is only exceed by China. Other recent growth accounting exercises have found TFP growth for India in the range of 3.2–3.5 percent for the recent period.

It’s the demography

At the present time some some 31 % of India’s populations are under 15 years of age. Between now and 2015 that proportion isn’t expected to change too much, but after 2015, with fertility nationwide now falling rapidly, the proportion is set to decline continually, with India moving steadily nearer the proportion which is to be found in more developed economies – Ireland, for example currently has some 21% of its population under 15, while in the United Kingdom the equivalent figure is 17%.

What this means is that India post 2015 will see a steep and sustained decline in its child dependency ratio and a steady increase in the proportion of its population who are of working age. In those Asian economies (the so called “Tigers”) who have previously passed through this demographic transition such steep declines in dependency ratios have been found to boost GDP growth incrementally, and substantially. This boost is known as the “demographic dividend”. The process is not a mechanical one, of course, and to get the increment, jobs have to be created for the new entrants into the labour force, and in India’s case these jobs will be needed at something like a rate of 15 million a year. What is really different about India is that the demographers are forecasting a continuing decline in the dependency ratio for a period of 30 years or so, as India's fertility rate - that is, the average number of children a woman expects to have in her life time – (which was standing at 3.8 in 1990) falls from the present national average of 2.9 to levels which in all probability will be well below replacement level.

There is another reason why this demographic change is important and that is that we human beings exhibit variable spending and saving activity at different moments in our life cycle. Basically we tend to save most either when we have just started working and are waiting to establish a family home, or during the latter years of our working lives. Whatsmore having children makes it harder to save wherever we are in the life cycle, and thus reducing the proportion of children in a society will tend – other things being equal – to increase the level of saving.

And, not unexpectedly, India's savings rate as a percentage of GDP has been rising steadily since 2003. It now stands in the region of 33% of GDP – a figure which is comparable to the Asian super-performers, all of whom save at above 30%, with China saving at an astonishing rate of nearly 40%.

This recent savings growth has been driven in India by improvements in the government's fiscal health and a sharp rise in corporate savings, but even if these positive factors should gradually disappear, the decline in the dependency ratio should enable India to hold its savings and investment rate above the 30% mark for the next 25 years at least.

Recent Economic Indicators

The Indian economy continued to expand strongly in the first quarter of 2008, even though growth has now dropped back somewhat from the 10.1% peak reached in Q3 2006. GDP, however, still grew at a pretty solid y-o-y rate of 8.8% in Q1, and indeed output growth was unchanged from the last quarter of 2007. So while the Indian economy is slowing, it is doing so very gradually indeed.

Private consumption continued to grow rapidly in Q1 2008 (13.5%) but gross fixed capital formation dropped back (from an average of 20% y-o-y in the previous 3 quarters to 15% in Q1). Since construction activity was still running at a strong pace (12.6%, the fastest rate since Q2 2006) it would not be unrealistic to assume that spending on machinery and equipment slowed somewhat. This would also follow from the fact that manufacturing growth (5.8%) showed the slowest expansion in many quarters (well down from the 10% average over the previous 3 quarters). Infrastructure development also lagged behind in terms of electricity, gas and water supply growth, which was only up by 5.6%. Indeed utilities output has only grown by an average of around 6% over the last 8 quarters. On the other hand government spending shot up, growing at an annual rate of 22.4%. Hence here we have two of the key themes which continue to preoccupy observers of India’s economy: the slow growth of manufacturing and infrastructure, and the rapidly increasing fiscal deficit.


Both India’s exports and imports were up quite strongly in Q1 (12.7%), and this revival in exports offers some evidence that Indian exporters have now started to benefit from the weaker rupee, which has declined by some 7 percent so far this year. India's export growth accelerated again in June and overseas shipments, which account for about 15 percent of the Indian economy, were up 23.5 percent year on year (reaching a total of $14.66 billion), following a 13 percent gain in May. Imports, however, have been increasing even more quickly, and were up 26 percent (to $24.45 billion) in June, thus widening the trade deficit (as compared to June 2007) to $9.78 billion. The deficit was however down on May's whopping $10.77 billion. India's oil imports in June rose 53.4 percent to $9.03 billion as refiners paid more for crude oil purchased overseas. India relies on imports of oil for three-quarters of its energy needs. Non-oil imports gained 14 percent to $15.4 billion.India has paid an average $8 billion a month for oil imports in the year through June, compared with $5.4 billion in 2007.

India's inflation accelerated again in late July, and hit it highest level since 1995, providing additional evidence to support last week's central bank decision to raise borrowing costs for the third time in two months. Wholesale prices were up 12.01 percent in the week to July 26, after rising 11.98 percent in the previous week.



The Reserve Bank of India raised its repurchase rate by a half-percentage point to 9 percent on 29 July, giving priority to the inflation fight over India's short term growth rate. Indeed many economists consider that the bank may well increase the benchmark rate again in the next three months. The cash reserve ratio was also raised 8.75 to 9 percent and in the statement which followed the decision the bank said it still had "headroom'' to further tighten monetary policy. The bank also increased this year's inflation forecast to 7 percent from the previous range of 5 percent to 5.5 percent.



However while the inflation process in India still has some momentum, as the global economy slows – thus reducing pressure on commodity prices - and monetary tightening reins in domestic demand, India’s inflation peak can not now be far away. Despite constant ups and downs oil prices have been generally falling since hitting the record high of US$147.27 a barrel on July 11, and by August 1st they had dropped around 15 per cent in a mere three weeks. If this trend continues then India should eventually obtain some notable relief and this is why it is so important to maintain strict monetary policy and avoid second round inflation effects at this juncture.


India's industrial production provides the most evident sign of the economic slowdown, with output growing at the slowest pace in more than six years in May as continuing price rises and tightening credit lead consumers to cut back on purchases of items like cars, fridges and other manufactured goods. Industrial output was up 3.8 percent from a year earlier after gaining 6.2 percent in April. Manufacturing, which accounts for about 80 percent of India's industrial production, was up 3.9 percent. Electricity rose 2 percent, and mining grew 5.5 percent. Consumer-goods production increased 7.2 percent.




The Ratings Agencies

One notable recent development has been the decision by ratings agency Fitch to lower India's local currency credit rating. The decision by Fitch to revise India's local currency outlook to negative from stable was based on a perception by the ratings agency of a worsening fiscal position and rising inflation. The assignment of a negative outlook suggests an increase in the sovereign default rate may follow if the problem is not corrected, and this would affect the flow of funds - and hence investment - into India. The new revised local currency rating will be 'BBB-' with negative outlook as against the earlier 'BBB-' with stable outlook.

James McCormack - Head of Asia Sovereign Ratings for Fitch - is quoted as saying the "the revision to the local currency outlook is based on a considerable deterioration in the central government's fiscal position in 2008-09, combined with a notable increase in government debt issuance to finance subsidies not captured in the budget." The rating agency has revised its economic growth forecast for 2008-09 from just under 9% to 7.7%, and this seems to be not unreasonable.

Fitch did, however, continue to affirm India's long term foreign currency Issuer Default Rating (IDR) at 'BBB-' with stable outlook, its short-term foreign currency IDR at F3 and the country ceiling at 'BBB-'. The assignment of a local currency negative outlook thus means that agency has effectively put India on watch with the implication that is the underlying causes (inflation and the underlying dynamics of the fiscal deficit) are not addressed over the next 12 to 18 months, the rating could be subject to downgrade. Obviously this is a warning shot as much as anything else, and an attempt to put pressure on the Indian government.

As regards its external balance India is rather different from many other large emerging economies since while the central bank (which has a high level of independence from government) does intervene in the spot market to try to keep a lid on the rupee’s rise and to built up a “war chest” of international reserves the bank has allowed the currency to rise substantially against the US dollar (while the rupee has fallen in 2008, it appreciated by some 12% against the dollar in 2007).



Foreign Exchange Reserves

India's foreign exchange reserves fell another $504 million - to reach $306.6 billion - in the week ended July 25. Despite the fact that India’s foreign exchange reserves, have increased by $81.3 billion in the last twelve months they have in fact now been falling since May. It could be however that the increase in interest rates and the falling price of oil could now see a reversal in this trend.




The big unknown here is the future movement in the oil price. Despite the recent price easing, India still faces an import bill for crude that may reach $120 billion this fiscal year, compared with $69 billion the year before. This extra burden is about 4% of GDP.

Add the impact of the fiscal deficit to the oil bill, and it is not hard to see that the external deficit could reach 4% of GDP this fiscal year. The IMF In April were forecasting a 3.1% for 2008. Reducing this gap is now becoming a priority, especially given the comparative strictness of the ratings agencies vis-a-vis India. Any future downgrades in credit will only make funding the gap more expensive, and as we have seen attracting the foreign capital necessary to bridge the gap has been becoming harder in recent weeks.




Money Supply and Credit

Short term cash rates have been pushing the 8.5 to 9% range in India of late as liquidity has been tighter due to the significant increase in the cash reserve ratio required by the Reserve Bank of India. Banks credit remains strong and rose by 25.8% in the 12 months through July 18. Total bank deposits rose by 21%, over the same period. At the same time, money supply in India grew 20% in the two weeks ended July 18 from a year earlier, compared with 20.5% in the prior two weeks.

While much of the recent increase in lending is likely to be associated with increased credit needs on the part of the oil companies, it also seems that bank credit to other sectors has been picking up. The Reserve Bank of India is unsurpringly rather concerned about the level of credit growth, especially considering that deposit growth slowed to 21% over the same period.

The Rupee

The rupee appreciated significantly during 2007, raising concerns about the competitiveness of Indian industry. In nominal bilateral terms vis-a-vis the dollar, the appreciation has been particularly notable, reaching successive nine-year highs as it rose about 12 percent over the year. Although the increase has been lower in nominal and real effective terms—only about 7–7½ percent—the appreciation of the effective rupee has taken it out of the historical range in which it fluctuated during most of the last decade




Growth Prospects

On the growth front a large gap has now opened up between the increasingly gloomy views about India’s prospects as seen from abroad, and the relative optimism displayed by a number of internal forecasters. The Centre for Monitoring the Indian Economy (CMIE), in Mumbai, still thinks India will grow by 9.5% this fiscal year, while JPMorgan only anticipates growth somewhere in the region of 7%.



While the CMIE estimate is undoubtedly unduly high for this (calendar) year, with growth more than likely coming in in the 7.5% to 8% range, their optimism is not totally unjustified looking forward to 2009 and 2010. Trend growth in India is surely higher than many conventional analyses tend to hold, and if inflation can be gotten under control India then India may well start to hit double digit growth come 2010, and once it breaks the 10% ceiling, it may well stay above it for some considerable time. This is simply because India has a very large untapped capacity for growth, and it is not unrealistic to anticipate that this capacity can be unleased, especially if institutional reform continues, and the fiscal deficit concerns are addressed.

But things are likely to go down before they bounce back up again, since he tightening in monetary policy will surely achieve the desired effect of slowing aggregate demand and GDP growth further. Also negative global factors are likely to continue to weigh adversely on India’s growth outlook in the short term. Consumption growth has already slowed significantly. Investments growth has also begun to moderate and it is quite probable that the slowdown in the investment cycle will accentuate over the next six months.


Everything really now depends on the outlook for inflation and capital inflows. I believe that Inflation should peak in late summer at levels which are not too far above those we are currently seeing. The rate should then start moderating and we could well be back down at 7% - 8% by the end of the financial year. In part this depends on oil prices, and year on year base effects, and oil and food prices, of course, also partly depend on growth in India and the other key emerging economies. Thus we have a kind of "inbuilt stabiliser", since as the major emerging economies slow, commodity prices ease back, and as this happens the central banks can begin once more to loosen monetary policy, providing a kind of win-win feedback effect, until, of course, commodity prices bounce back again, and they need to start tightening once more.

The key point to grasp in all this is that it is consumers in the heavy energy consumption OECD economies who are going to do the heavy lifting of bearing the pain here, as resources are effectively transferred from their wallets to those of the oil producers, and it is this process, rather than what happens in the emerging economies which is likely to keep a cap on global growth in the coming years.



Outlook on Key indicators

• Following the most recent rate hike market expectations have now solidified towards further interest rate increases in the pipeline. The driving orce here will, as ever, be inflation running above the central bank's comfort zone. Here at Emerginvest we see the Reserve Bank of India being rather more prudent at coming meetings, and we feel the current rate hike cycle may possibly peak at 9.5%. Key factors here will be the behaviour of oil prices, and wages and fiscal policy in India itself with election year approaching.

• The Rupee is likely to continue to be supported by central bank tightening and declining demand for dollars from oil producers as oil prices ease. Also should the Rupee continue to head upwards and inflation start to fall, a win-win process will again be set in motion as investors see the prospect of currency related increasing returns once more opening up. In the great global search for yield there is no better winning strategy than to back a winner. At some point however macroeconomic fundamentals will undoubtedly take over, and as the economy slows and inflation moves down towards the comfort zone (around 5%) the central bank will also move into easing mode pushing the Rupee down in the process. A violent correction however is not expected.

• Obviously, with the domestic credit induced consumer boom now fading, exports are going to become more important than ever for India's headline GDP growth. India's Trade Minister Kamal Nath recently set the target of more than tripling India's share of world trade to 5 percent by the year 2020 from the current 1.5 percent. This is a worthy target, and perfectly realiseable, but it will require India to conduct a substantial infrastructural overhaul and to intruce widespread regulatory reform. In the shorter term India is targeting exports of $200 billion in the current fiscal year, up 28 percent from the $155.5 billion achieved in the previous year. This is attainable – exports were up 23.5% y-o-y in June - but with a deteriorating external environment it will be quite hard work.
  
• GDP growth is expected to moderate in 2008 compared to the levels seen in the last three years but at this point growth projections remain solid (probably 7.5 to 8% in calendar 2008). We certainly see India’s mid term sustainable growth rate as being above the consensus 7%-8% rate once inflation is firmly under control, and expect double digit annual growth rates to be hit in either late 2009 or 2010 depending on the extent to which the global slowdown in 2009 negatively affects India’s GDP growth.

• We expect India's credit ratings to remain broadly stable even as the nation weathers higher oil prices and slowing economic growth – a view which was endorsed in a statement at the start of August by Moody's Investors Service. Moody's has a Ba2 rating on India's long-term, local currency debt, leaving it two levels below investment grade, although it rates India's foreign-currency debt Baa3, the lowest investment level. The downside risk here obviously comes from fiscal laxity, but the authorities in New Delhi are undoubtedly very aware of this.
  

Brazil Country Outlook August 2008

Claus Vistesen: Copenhagen

Brazil is a resource rich country in transition towards a much more diiversified economy where industry and high value services will begin to play an increasing role. Brazil has ample supplies of energy and agricultural products, and is currently hitting that “sweet spot” where a demographically driven growth dividend becomes available. Thus we can increasingly expect to see above trend “catch up” growth as the Brazillian economy benefits from the new wealth which accrues from the rapid global rise in commodity prices while the strong supply of young labour underpins the labour market and significant productivity improvements become available as the economy generally moves towards ever higher-value-added sectors of activity.

Perhaps the most telling sign of Brazil's rising status as a new global force to be reckoned with was the recent announcement by the National Petroleum Agency (ANP) of the discovery of a new offshore oil field (Carioca) which potentially holds as much as 33 billion barrels of oil - enough to supply every refinery in the U.S. for six years - making it the third-largest oil field ever discovered (only Saudi Arabia's Ghawar and Kuwait's Burgan fields are bigger). This, coupled with the discovery last year of the Tupi field - which has an estimated reservoir of between 5 and 8 billion barrels of oil – is now fast forwarding Brazil rapidly up through the ranks of global oil producing nations. Such new found oil prowess has even prompted president Lula da Silva to suggest that Brazil enter OPEC.

But Brazil is not only rich in energy; agriculture – that new high-value sector – is also an important contributor to Brazil’s rapidly growing GDP. Agricultural income should total 155.27 billion reais (US$ 71.4 billion) in Brazil in 2008, according to the Ministry of Agriculture. The estimate is based on crop surveys by the National Food Supply Company (Conab) and the Brazilian Institute for Geography and Statistics (IBGE).

And with global agricultural prices continually hitting record highs Brazil’s agricultural exports were up 15.22% in June over June 2007, and by 5.6% over May. The government estimate for this year’s total output includes 20 crops, some of them temporary ones such as soybean, maize, rice, wheat, sugarcane, and others permanent like coffee, cocoa, and oranges. Compared with 2007, the figure represents growth of 17.11% after inflation. The largest increases were expected to be in beans (87.78%), coffee (48.69%), wheat (40.79%), soybean (31.83%) and maize (30.65%). Brazil is now even producing grapes, and output is growing rapidly in the northeastern states of Pernambuco and Bahia.


Also Brazil's economy created a record 309,442 government-registered jobs in June as higher domestic demand coupled with revenue flows from rising commodity prices lead companies to add staff and increase output. Of these new jobs Brazil's agricultural sector accounted for the lions share, with 92,580 new jobs being created in June, the highest monthly figure recorded since the start of the current time series in 2003.

Recent Economic Indicators


The Brazilian economy continued to expand strongly in the first quarter of 2008, and turned in a respectable 5.84% increase in GDP when compared with the same period a year earlier. Looking at quarter on quarter growth on a seasonally adjusted basis (quarterly growth gives a much clearer “as things are now” snapshot of the current state of an economy at any point in time), the 0.71% reading reflected a moderate slowdown in the economy over the previous quarter. Consumption and investment both contributed to the quarterly growth rate, but it was government consumption which did the heavy lifting in Q1. The negative trade balance also acted as a drag on growth as exports declined while imports rose. Since Brazil is strong on commodity exports, and commodity prices have been very high in recent months, the underlying momentum is positive, although were inflation not to be kept in check some variant of the “dutch disease” could undoubtedly become a problem. At the present time however this danger should not be exaggerated, since underlying investment in capital goods is reasonably healthy, rising at rate of about 19% (12 month average) as compared to a rise of around 6.5% for industrial output generally.
The main driver of economic activity continues to be domestic demand. Private consumption rose in Q1 by 6.% (y-o-y) while investment held up well - rising by 15.2%. Nevertheless, the externally oriented sector has continued to weaken, largely because of the pressure on exports caused by the high Real, and exports were down 2.1% year-on-year. Imports, however, rose steeply - by 18.9%. The other aspect of growth was public consumption, which was up by 5.8%, which was the fastest rate since the middle of 2002.

One notable recent development has been the decision by ratings agency Standard & Poor’s to award Brazil investment grade, with the foreign currency debt rating being raised to BBB- from BB+. This decision has produced considerable debate as many long term Brazil watchers believe that the upgrade comes at a time when Brazil has all the cyclical winds blowing in her favour, and ask the not unreasonable question what happens when the weather shifts? It is clear however that Brazil has made tremendous improvements over the past decade in terms of central bank independence, reigning in inflation and setting public debt on a sound footing, so whatever the fine print details, Standard and Poor’s decision can surely not be considered an imprudent one.

As regards its external balance Brazil is rather different from many other large emerging economies since while the central bank (which has a high level of independence from government) does intervene in the spot market to try to keep a lid on the Real’s rise and to built up a “war chest” of international reserves the bank has allowed the currency to rise substantially against the US dollar (as of July the Real had appreciated by some 13% against the dollar in 2008) and Brazil has also recently opened a small but quite manageable deficit on its current account, which means that Brazil as it develops is becoming a net consumer of excess capacity in the global economy. A break-down of the current account position reveals that Brazil continues to retain a surplus on the goods balance due to the importance of commodities and food but that services and in particular a negative income account are now gradually pulling the overall balance into negative territory. This is really what one could reasonably expect in the context of an emerging economy at Brazil's stage of development.



On the monetary policy front the central bank is rapidly earning a reputation for itself as Latin America’s new Bundesbank, and governor Henrique Meirelles delivered a decisively hawkish message during the last monetary council meeting to accompany the decision to hoist rates by 75 basis points to the current 13% level. Brazil's interest rate is now the the second-highest inflation-adjusted one in the world after Turkey's. Brazil's real interest rate, or the benchmark 13 percent rate minus annual inflation of 6.06 percent, is 6.94 percent. Turkey currently has the world's highest so-called real interest rate at 7.55 percent.

This decision is the continuation of a hiking campaign set in motion in order to establish strong credentials for the central bank as an inflation fighter, and to prevent generalised inflation expectations from taking a hold among the population. The central bank is attempting to keep inflation within the the official target of 4.5% and with inflation forecast to be somewhat above that figure in 2009 the central bank is simply acting accordingly.



Such aggressive tightening is, however, not without its problems, and policy makers now face a serious dilemma. Predictably, given the state of the current global environment, the central bank's larger than expected interest hike was rapidly translated into an appreciation of the Real – pushing it to its strongest level since 1999. So far, the 13% rise against the USD this year puts the real in the pole position amongst emerging market currencies versus the USD. This position is reasonably comprehensible taking into account the recent decision to award Brazil investment grade status; this coupled with a nominal yield on 10 year government notes at about 15% and a benchmark stock index – the Bovespa – which is up approximately 10% from its January level, implying a 20% gain in US dollar term, basically mean that international investors are finding it hard not to put money into Brazil at this point in time.

Consequently, with a global credit crisis far from over, a hawkish central bank, and a hard currency making exports more difficult one could only reasonably expect the economy to slow in line with weaking global momentum. The key point with respect to the Real would be that a continuing rise will push the external balance further into negative territory. Moreover, in a likely scenario where global commodity prices somewhat pare-back their recent impressive upward movement Brazil’s external bookkeeping will further come under pressure.

Outlook on Key indicators

• 
  Following the most recent rate hike market expectations have now solidified towards further interest rate increases in the pipeline. The driving orce here will, as ever, be inflation running above the central bank's nominal target. Here at Emerginvest we see the Central Bank of Brazil aiming for a nominal rate of 15% which should be reached over the course of the next three meetings.
• 
  The Real is likely to continue to be supported by a hawkish central bank but as the external balance moves steadily into negative territory macro-fundamentals may take over, and as the economy slows and inflation comes into the target zone the central bank will once more move into loosening mode pushing the Real down in the process. A violent correction however is not expected.
• 
  GDP growth is expected to moderate in 2008 compared to the levels seen in 2007 but at this point growth projections remain solid, and we certainly see Brazil’s mid term sustainable growth rate as being above the consensus 3%-5% rate once inflation is firmly under control.

2007 Data

GDP (2007) - 5.4%
Inflation (2007) - 3.6%
Current Account Deficit -0.27% of GDP
Fiscal Deficit - 2.27% GDP
Debt to GDP ratio - 42.8%


Debt Ratings (local currency, long term)

Fitch - BBB-
S&P - BBB+
Moody- Ba1


2008 Central Bank Inflation Target - 4.5% (+ or – 2pp)

Population Median Age -29 years
Total Fertility Rate (2007) -1.88 child per women
Male Life Expectancy - 68.57 years

Development Indicators Rank (131 economies in total)

Global Competitiveness (World Economic Forum)
72/131 (2007-08)
Business Competitiveness (World Economic Forum)
59/131 (2007-08)


Selected Sub-components

Institutions - 104/131
Infrastructure - 78/131
Macroeconomic Stability - 126/131
Health and Primary Education -84/131

Short Term Data

Retail Sales Growth (May, y-o-y, volume index) - 10.5%
Industrial Output (May, y-o-y) - 2.4%
Inflation (July 2008) - 6.3%
Central Bank Interest Rate (SELIC Rate) - 13.0%

Kazakhstan's "Sudden Stop"

I couldn't help having my attention drawn earlier this summer by the news that the European Bank for Reconstruction and Development (EBRD) had cut its 2008 growth forecasts for a number of emerging transition economies - Ukraine, Kazakhstan, and Romania to be precise. More than the cut itself - since I was already pretty much aware of the situtaion in Romania and Ukraine - what I perhaps found more significant were the reasons given. The EBRD issued a warning that Kazakhstan was suffering from 'the impact of inflation and credit stagnation' and a as a result reduced expected gross domestic product growth for 2008 from an annual 8.5 to 5.1 per cent (the IMF forecast is something similar).

In Romania's case the growth forecast was cut from 6.5 to 5 per cent (this view is not shared by the Romanian government who have declared that they expect growth in 2008 to be a record 7%) citing the present 'rapid monetary tightening', since the central bank has been vigorously raising interest rates to try to get a grip on inflation. For Ukraine, the growth forecast was reduced from 6 to 5.5 per cent, as the EBRD warned of the impact of inflation which has been hitting an annual rate of over 30 per cent, the highest in Europe and indeed among the highest globally at this point.

So what stands out here are two factors, inflation and growing credit restrictions. Now while I cannot reasonably claim to have been that well informed about what had been happening to the Kazakhstan economy, I have been following both Ukraine and Romania quite closely. However I thought to myself that perhaps this would be a good moment to remedy that long-standing deficiency on my part, and try to find out for myself what it is that has actually been happening in Kazakhstan of late. What follows is a summary of what I found.


Kazakhstan The Country




Kazakhstan, officially known as the Republic of Kazakhstan, actually lies in both Central Asia and Europe. Ranked as the ninth largest country in the world by size, it is also the world's largest landlocked country, with a territory of some 2,727,300 km² (which is greater than the whole of Western Europe). It is bordered by Russia, Kyrgyzstan, Turkmenistan, Uzbekistan and China. On the other hand, and despite its enormous size, Kazakhstan has a comparatively small population. No one actually has an exact idea of the current size of the Kazakhstan population (not to mention the thorny issue of just how many foreign migrants live and work there), but the US Census Bureau International Database list the current population of Kazakhstan as 16.763 million, while sources drawing their data from the United Nations (like the IMF which I have relied on for the chart below) give a 2008 estimate of 15.135 million. In any event the current population level, after falling in the early 1990s as ethnic Russians left, has now stabilised, and is virtually stationary. This stagnant population is, as we will see, a major problem for a country with such a massive potential resource base as Kazakhstan has.

Substantial GDP Growth

Kazakhstan is the biggest energy producer in Central Asia and Kazakhstan's $100 billion economy has grown an average of 10 percent a year since 2000 (see chart above) as the price of oil has surged. This rapid GDP growth sparked in its wake a substantial construction boom, and it was the bursting of this boom in the autumn of 2007 - on the back of the seize-up in global wholesale money markets which followed August's financial turmoil in the USA - which was at the heart of Kazakhstan's current growth slowdown. In fact Kazakhstan's economy expanded at a 5.3 percent rate in the first quarter of 2008, half the pace in the same period a year earlier, following a dramatic curtailment in bank lending, and if Kazakhstan is able despite all the problems to maintain some sort of growth momentum at this point it is undoubtedly the result of the oil and other commodity resources, and indeed the country increased crude production by an annual 6.3 percent in the first four months of the year, according to recent government data.





Kazakhstan, however, has been struggling to curb inflation as revenue from record oil prices pushed up wages (remember, there are not THAT many people) - which hit nominal year on year rates of increase of over 30% in the autumn of last year: see chart below) and housing investment and thus sustain 5% economic growth, which is a rate which is still certainly not to be sneezed at.



So, as well as containing the property bust, the Kazakh authorities also have to continue the inflation fight (more details below) and thus far from lowering rates like the US federal Reserve has been able to do, Karakhstan's central bank was forced to raise the key interest rate to 11 percent in December, when the annual inflation rate rose to almost 19 percent, the highest in over eight years. The refinancing rate maintained at the 11% level until it was finally lowered to 10.5% at the last central bank meeting in July.



Resource Potential

Kazakhstan's industrial output growth has steadily lost momentum in 2008 as the slowdown in the building industry prompted a slump in cement production. Industrial production rose only 3.8 percent in the January-June period when compared with a year earlier, according to the most recent data from Astana-based State Statistics Agency.

Cement production was down 26 percent year on year in January , the most in five years, as growth in the construction industry stalled. Some Kazakh banks, struggling to borrow from abroad after the collapse of the U.S. subprime mortgage market, virtually stopped lending to homebuyers and builders. Copper and rolled iron output declined an annual 13 percent while output from refineries and manufacturers decreased an annual 2.9 percent.

Mining production was up 6 percent from a year earlier in the first quarter, bolstered by an increase in natural gas and coal output, which climbed 15 percent and 11 percent respectively. Kazakhstan, the biggest energy producer in the former Soviet Union after Russia, increased crude oil production by an annual 5.4 percent, the agency said.

Oil and mining - Kazakhstan's key industries - added to the slowdown, with crude oil output falling 5.6 percent month-on-month in April. Natural gas output shrank 7.3 percent and copper production fell 5.3 percent.

London-listed Kazakhmys accounts for the bulk of Kazakh copper output. The country's total copper output was down 17.5 percent year-on-year in January-April, the agency said. Industrial output in Karaganda region, home to Kazakhmys and Arcelor Mittal mines and smelters, declined 5.5 percent year-on-year in January-April.

Kazakhmys said first-quarter output fell 9.9 percent on ``severe winter weather'' and repairs at its Balkhash smelter.Production of finished copper plates, or cathodes, from the company's ore fell to 75,500 metric tons, from 83,800 tons a year earlier. These drops in output are thus in many cases not directly associated with the credit crunch, but they do give an idea of the challenging environment in which the mining and extraction industries work in Kazakhstan. Realistically speaking it seems quite likely that output in these sectors will return to more normal levels during the second-half of 2008, rebounding significantly from the low point reached in the first-quarter.


On the other hand industrial output in capital Astana and commercial hub Almaty, where most construction activities are based, was down 13.2 percent and 8.6 percent, respectively, in January-April, and this activity may well take much longer to recover.

Kazakhstan has also cut its 2008 oil production forecast to 67.6 million tonnes (1.35 million barrels per day) from a previous estimate of 70 million tonnes citing maintenance works and transport bottlenecks. This means output is likely to remain roughly stationary since the country produced 67.5 million metric tons of oil and gas condensate in 2007. Kazakhstan has 3.3 percent of the world's proven oil reserves and 1.7 percent of its gas, according to BP Plc's Statistical Review of World Energy.

Kazakhstan also has around 15 percent of world's uranium, most of which is processed at the Ulba Metallurgical Plant in Oskemen, a formerly secret city south of Siberia known in Russian as Ust Kamenogorsk. Management at the Ulba plant are currently planning to invest $850 million, 6.5 times the plant's projected annual cash flow - and offering to trade domestic mineral rights to joint-venture partners in China, Japan and Russia in return for the technology they need - in a bid to make Kazakhstan the world's biggest supplier of atomic fuel for civilian nuclear reactors. If successful, Kazatomprom would consolidate the market for its 983 million pounds of recoverable uranium deposits, second in importance only to Australia's, and become less reliant on the raw ore's spot-market price by supplying higher-value products needed to fuel the next generation of reactors.

Kazatomprom's East Mynkuduk mines, which are 1,180 kilometers (733 miles) west of Almaty, lie beneath a semi-desert, with camels grazing and temperatures which range from minus 30 degrees Celsius (minus 22 Fahrenheit) in winter to 60 degrees Celsius (140 degrees Fahrenheit) in summer. Kazakhstan is currently uranium ore's third-largest producer, behind Canada and Australia, both of which it plans to surpass by 2010.


On top of oil and uranium Kazakhstan also has 38 percent of the global supply of chromites, used to produce corrosion-resistant steel; 22 percent of all lead; and 16 percent of known silver reserves, according to Renaissance Capital, a Moscow-based investment bank. And on top of all that there is its bauxite, copper, iron and gold.


Foreign investment flooded the country after the discovery of the Kashagan oil field in 2000. At the time of discovery it was the largest new field unearthed in 30 years, containing 13 billion barrels of recoverable crude, according to Rome-based Eni, Italy's largest oil company, which is currently contracted to develop the Kashagan field along with Exxon Mobil and Royal Dutch Shell .

Buoyed by surging commodities prices, Kazakhstan's National Oil Fund is soaking up the government's share of the new petroleum revenue. As of November, it had amassed $20.1 billion, according to central bank data.

Kazakhstan is also the world's fifth-largest wheat exporter, and even though on April 15 the government placed a temporary ban on wheat exports in an attempt to control inflation, it has made clear that it will once more allow unlimited grain exports after the ban expires in September.

Apart from manpower all these resources need infrastructure, and Kazakhstan is also keeping itself busy building roads. The Kazakh government are currently out looking for investors to build or maintain 1,000 kilometers (620 miles) of roads at a projected cost of 541 billion tenge ($4.5 billion) in exchange for operating concessions. One of the roads will connect the capital Astana with the regional mining center Karaganda to the southeast. Two more roads will run from the financial capital Almaty to Kapchagai Lake and Khorgos on the Chinese border. The government also plans to build a ring road around Almaty. The state may build a fifth road from Astana to the Borovoye forest in the north and seek an investor to maintain the road in exchange for operation concessions.

The government also plans to upgrade 2,552 kilometers of roads at a cost of 900 billion tenge to create a highway that would allow freight from Chinese manufacturers to be delivered directly to European markets. The first phase of the upgrade will cost 789.3 billion tenge and is scheduled for completion by 2013. A second phase will be finished in 2016. Kazakhstan is to borrow 472 billion tenge ($3.93 billion) from banks to start the works.

The Financial Sector

Banks dominate the financial system in Kazakhstan, accounting for 80 percent of total assets. They are mostly locally and privately owned, although foreign participation has increased recently. The system is highly concentrated, with the largest five banks accounting for 78 percent of market share. Banks are very reliant on external financing, with external liabilities making up about 45 percent of the aggregate balance sheet. Easy access to external funding fueled very rapid domestic credit growth, which expanded at an annual average rate of 70 percent from end-2004 to August 2007, bringing bank credit to around 75 percent of GDP by end-2007. Lending was mainly to the household, trade, and construction sectors (the oil sector is not reliant on domestic banks for its financing).

Then came the "sudden stop" and confidence in Kazakhstan's banks plumetted, with the consequence that household deposits contracted sharply during the August–October period and nonresidents sold about $4 billion worth of tenge assets — mostly held in central bank notes — putting in the process significant downward pressure on the value of the tenge.




Inflation


Kazakh inflation accelerated in July and reach an annual 20 percent, the highest rate since March 2000. Kazakhstan is currently struggling to curb price growth as revenue from record oil prices has been pushing up wages, investment and economic growth. Food prices, which as in so many other places are one of the key drivers of the inflation, were up by a monthly 1.8 percent in June and by 8.1% since the end of December 2007.

The recent surge in inflation is all the more significant since it had been kept pretty tightly under control since the recent growth spurt started in 2000. Kazakhstan's central bank left its benchmark interest rate unchanged at 11 percent until its July meeting in a battle to keep inflation at bay following a 2% rate increase in December. The central bank raised its benchmark refinancing rate to 11 percent from 9 percent on Dec. 1.





Credit Downgrades


Kasakhstan is also suffering from the effect of a construction slump following the imposition of a credit crunch. Concern about the rate of expansion in domestic credit in the country goes back to an IMF report in October 2006 which said the pace of credit growth and external borrowing in Kazakhstan was making lenders more vulnerable to external shocks such as a reduction in the availability of financing.

But the crunch itself only came following the forecast reduction in the availability of financing following the August 2007 financial turmoil produced by the US sub-prime crisis. Some of the Central Asian nation's banks, struggling to borrow from overseas financial institutions after the collapse of the U.S. subprime mortgage market, almost completely ceased lending to homebuyers and builders in September 2007.

Essentially the banks had been financing lending by borrowing in the global wholesale money markets, and the doors to these were pretty much shut in their faces (just like they were shut in the faces of the Spanish banks) in September 2007. As a result Kazakhstan bank sales of Eurobonds and syndicated loans, which had totaled $8.63 billion during the first eight months of 2007, fell to an estimated $300 million in the following three months. Hence my reference in the title of this post to Kazakhstan's "sudden stop".


Arranging the deals for Kazakhstan's banks was a who's who of international finance. New York-based Citigroup Inc., the largest U.S. bank by assets, edged out Amsterdam-based ING Groep NV, the largest Dutch lender, as the top underwriter, according to Bloomberg data. New York-based JPMorgan Chase & Co., the third-largest U.S. bank; Frankfurt-based Deutsche Bank AG, Germany's largest lender; and Zurich-based Credit Suisse Group, Switzerland's second-biggest, round out the top five.


Kazakhstan banks also attracted international equity investors. In November 2006, JSC Kazkommertsbank, Kazakhstan's biggest bank by assets, sold $846 million of global depositary receipts in London. JSC Halyk Savings Bank, majority owned by President Nazarbayev's daughter Dinara and her husband, followed in December with a $748 million sale. JSC Alliance Bank, the country's largest consumer lender, sold $704 million of global depositary receipts in July 2007. All three are based in Almaty, the country's financial center.


The outside money helped the country's banks grow their assets 10-fold between 2002 and 2007, to $94.7 billion as of Nov. 1. It also left the banks vulnerable when investors began retrenching.

From August through October 2007, $6.8 billion in foreign currency flowed out of the country 28 percent of the central bank's total reserves. With the country's banks largely shut off from international borrowing, S&P lowered Kazakhstan's and by November the cracks were becoming visible, with the construction industry slowing rapidly.


The evolving situation lead to an ongoing series of "reappraisals" of Kazakh bank creditworthiness on the part of the ratings agencies, with Standard and Poor's downgrading the country's foreign currency-denominated debt rating one level to BBB- in October and revising its outlook on Kazakh banks to negative in December. Fitch Ratings also changed its outlook on Kazakhstan's long-term issuer default ratings to negative in December. Even Kazahstan's sovereign rating outlook was revised to negative by S&P in late April.

Moody's Investors Service reduced the credit ratings of six Kazakh banks, including TuranAlem, in November because of concerns they wouldn't be able to refinance about $40 billion of international debt. Kazkommertsbank and Bank TuranAlem were cut to Ba1, one step below investment grade. Halyk was lowered to Baa3, the lowest investment grade, while TemirBank dropped to Ba2 from Ba1.

In an attempt to stop the haemorrage the government has provided lenders with almost $11 billion of emergency cash since July last year, reducing reserves by almost a fourth. The government has also moved to limit local banks' foreign debt to a maximum of four times the lenders' capital - beginning July 1, 2009. This move is expected to cut dependence on borrowing from abroad. Kazakhstan's growth in commercial lending may slow to 13 percent this year according to central bank estimates.

On the other hand the bank said that commercial lending may rise to as much as 8.22 trillion tenge ($68.4 billion) this year, compared with 7.26 trillion tenge last year. Lending may rise further to 9.85 trillion tenge in 2009, it said. However - in a "worst-case-scenario" - the central bank warned that banks may post a 9.5 percent drop in commercial lending in the country this year, should they not have access to foreign capital markets.

At the same time the Kazakhstan government is prepared to lend $4 billion to banks to ensure liquidity. The banks also were expected to get "about 300 billion tenge ($2.48 billion) of free money" due to a decision to reduce bank reserve holdings with the central bank. The government has also said it will continue to purchase shares of Kazakh companies listed on foreign exchanges until their reach pre-August 2007 levels.

As another policy measure about $6.8 billion of assets, including $4.4 billion of cash, was legalized in the yearlong ``capital amnesty'' campaign that ended Aug. 1 last year.

The central bank has provided 1.3 trillion tenge ($10.7 billion) of emergency cash since July, reducing its reserves by more than 20 percent to $18.4 billion, S&P said.

Kazakhstan banks' foreign liabilities have risen 490 percent in dollar terms since 2004 to $13.5 billion as they used their investment-grade ratings to borrow abroad and lend to consumers and real-estate developers, according to CreditSights. The debt has become difficult to refinance because of investor wariness to all but the highest-rated debt sparked by U.S. subprime defaults. Kazakhstan's central bank holds about $20 billion of reserves and the country's oil fund has about $15 billion, which should ensure Kazakh banks have sufficient funds to meet obligations.

Credit-default swaps on the debt of Kazkommertsbank surged to 694 basis points from 225 basis points at the beginning of June, according to CMA DataVision. The contracts, used to speculate on a company or country's ability to repay debt, increase when perceptions of credit quality worsen. Contracts on the country's debt cost 148 basis points, compared with 34 basis points at the end of May. The current level is twice that of Russia's debt, which has similar ratings. Kazakhstan is rated Baa2, the second-lowest investment grade, by Moody's and an equivalent BBB at S&P.

As indicated by the chart below, the increase in EMBI spread is much higher for non-EU member states (except Bulgaria) than for the EU member countries. In addition, the increase in the spread is higher for countries running high inflation and balance of payments deficits, i.e. countries more vulnerable to external shocks. The largest increase in the EMBI spread from June 2007 to January 2008 was recorded for Kazakhstan and Bulgaria (140%), followed by Serbia (118%) and Ukraine (106%). Far lower increase was recorded for more developed Central European countries and EU member states - Poland (67%) and Hungary (49%).

Bank TuranAlem JSC, Kazakhstan's second-largest lender, sold $750 million of bonds backed by foreign currency remittances, Standard Chartered Plc said. The deal is the largest bond sale of its kind by a Kazakh bank, according to a statement distributed today by e-mail from Standard Chartered in London. The bonds were sold in four portions. Three were guaranteed by bond insurers and carry top ratings from Moody's Investors Service and Standard & Poor's. The other bond, which isn't guaranteed, is rated Baa3 by Moody's, the lowest level of investment grade, and an equivalent BBB- by S&P.

Construction Slump


After several years of rapid gains, property prices are declining, most notably in Almaty where the prices of existing homes are down by 40 percent from their peak. This decline has partly corrected previous overvaluation, although the price adjustment may have further to go, particularly if credit availability and household incomes continue to weaken.

And of course Kazakh homebuyers suddenly found themselves left out in the cold by the global credit shortage. In Almaty, the Kazakhstan's biggest city, about 30 people were to be seen on March 18 in protest at the hole in the ground which was to be found where their new apartments were supposed to have been. Work stopped on the project after builder AO Corporation Kuat declared they were unable to get further funding.

About 29,000 people had prepaid for uncompleted apartments when September arrived, and credit for Kazakh builderssuddenly dried up. More than 140 housing projects have been halted in Almaty alone, forcing the government to provide $4 billion of emergency funding to get contractors working again. Kazakh construction companies had sold 280 billion tenge ($2.32 billion) of unfinished apartments by September, including 170 billion tenge financed by mortgages, according to government statistics.


Homebuyers have been getting help from the government, which in March 13 agreed to provide $500 million to help banks finance loans to builders in Almaty. Also the governments $4 billion emergency investment program includes funds to purchase 6,000 uncompleted apartments in Astana, the capital.

Residential real estate prices are of course now falling after speculative investment and oil revenue drove property values to a record in 2007. Prices for residential property last year soared 30.2 percent, reaching a record average high of 161,300 tenge ($1,338) per square meter, up from 123,900 tenge in 2006, according to the Astana-based state statistics agency. In the financial capital, Almaty, the average price was 345,200 tenge.

Bank TuranAlem, Kazakhstan's second-biggest bank by assets, received $81.2 million last December from the state emergency investment program to finance the completion of construction projects. Western investors pumped $40.7 billion into Kazakhstan, most during the past three years, according to Moody's Investors Service. The money provided the cash for a surge in domestic lending for new homes, cars and other accoutrements of the country's improving fortunes. Now, the foreign money has almost dried up.

The Kazakh government recently announced it was going to spend 100 billion tenge ($830 million) to boost residential construction and economic growth in the former Soviet republic's two largest cities after banks curtailed lending. Fifty-nine billion tenge will be deposited in commercial banks on the condition that the money be lent in turn to builders for the completion of 131 buildings in the financial capital Almaty.

A commission chaired by Prime Minister Karim Masimov also approved spending 41 billion tenge to buy 6,000 apartments in uncompleted buildings in the capital Astana. The government will pay no more than 114,000 tenge per square meter.

The investment is part of a $4 billion investment program. London-listed AO Kazkommertsbank, the country's biggest bank by assets, is among six lenders that receive money from the program as seven-year loans and three-year deposits. Residential real estate prices in the Central Asian country are set to drop this year after speculative investment and oil revenue drove property values to a record in 2007, analysts say.

The government bailout comes two weeks before celebrations of Nazarbayev's 68th birthday and the 10th anniversary of Astana on July 6. A group representing people who purchased apartments in the unfinished buildings had planned a 5,000-strong protest march in Astana during official festivities.


The Industry and Trade Ministry have said that 939 residential buildings, with 45,130 apartments pre-paid by homebuyers, were under construction last January. Mamytbekov said that the cases of 4,558 homebuyers in 18 buildings "remain problematic'' because the builders have been "charged with crimes.'' The Kazakh Prosecutor General's Office said 123 construction companies that received 104 billion tenge ($865 million) in pre-payments from homebuyers are behind schedule or haven't even begun work on new apartment buildings.
Assets of "careless construction companies,'' including buildings and vehicles, have been seized to compensate lost investments of homebuyers and the government, according to the Prosecutor General's Office. Criminal investigations have been opened into eight companies. A total of 285 companies are building 407 residential projects in Kazakhstan and have received 231 billion tenge in pre-payments from more than 50,000 individuals and companies, prosecutors said.
Of 200 ``problem'' projects delayed by at least six months, 110 are located in the capital Astana and 42 in Almaty.

The Kazakh government has spent 51 billion tenge to complete stalled residential projects, a fraction of bailouts promised by Prime Minister Karim Masimov last year, according to data from the Ministry of Industry and Trade released on June 23. The government said on Nov. 14 that it would spend $1 billion by the end of 2007 and another $3 billion in 2008 to "provide economic stability and growth'' by supporting the real estate market and small and medium-sized businesses. Masimov said two weeks later that this emergency investment program could be expanded.

The government plans to spend 17.2 billion tenge to complete residential projects in Astana. President Nursultan Nazarbayev ordered the state to step in and finish the projects, ``which have no source of financing,'' to ``help to reduce social tension,'' according to Edil Mamytbekov, a deputy minister of industry and trade, on June 20. President Nursultan Nazarbayev ordered the state to step in and finish the projects, ``which have no source of financing,'' and to take ``tough measures against careless builders". Another 46.4 billion tenge will be spent to support residential projects in Almaty, the mayor's office said on July 26. The state has already invested 22.4 billion tenge and will spend the remaining 24 billion tenge by year's end, it said.

The government in April said that state development holding Kazyna would distribute 59 billion tenge to commercial banks this year to finish 131 buildings in Almaty. Sergei Kuyanov, a spokesman for Almaty Mayor Akhmetzhan Yesimov, when question by journalists declined to comment on the discrepancy between the level of funding announced in April and the city's lower figure.

The central bank (NBK) provided large-scale liquidity support to banks during August–October through repurchase agreements, foreign exchange swaps, early redemption of NBK notes, and the easing of reserve requirements. It also intervened heavily in the foreign exchange market, using $6 billion (25 percent) of its reserves (15 percent of total official foreign currency assets) during August–October, and has since effectively pegged the tenge to the U.S. dollar. NBK reserves have recovered this year, rising by $4 billion through early June. The government directed $1 billion to support ongoing construction and investment projects in November 2007 (another $3 billion is slated for this year, although only $130 million is additional spending). After initially spiking, interbank interest rates have eased.


Kazakhstan has large financial resources to help weather the current situation. Official foreign currency assets totaled $46 billion in early June, comprising NBK reserves of $21 billion and oil fund (NFRK) assets of $25 billion. Commercial banks also have foreign assets of which about $3.5 billion are thought to be liquid. Total foreign assets broadly match foreign liabilities when the intracompany debt of the oil sector is excluded, while liquid foreign currency assets comfortably cover potential short-term foreign currency drains.

Looking forward, growth is expected to remain relatively subdued.

Assuming limited bank access to external financing and only modest deposit growth, credit to the economy is likely to decline in real terms. Nonoil GDP growth is forecast to slow to 4.7 percent this year, from 9.2 percent in 2007, with spillovers from the oil sector partly mitigating the impact of the credit crunch. Oil output should support somewhat stronger overall growth of close to 5 percent in 2008. A strengthening in growth to 6.25 percent is projected next year assuming global financial conditions improve and pressures on bank balance sheets are reduced. The current account is projected to move into surplus in 2008, following the large deficit last year, due to higher oil and commodity prices and much slower import growth. With banks repaying debt, the external debt/GDP ratio is projected to fall sharply this year, and appears to be on a sustainable path under a range of scenarios overall budget surplus is projected to increase to 6¾ percent of GDP in 2008 due to strong oil revenue growth.

Favourable Demographics But Migrants Needed, Together With Modern Citizenship Rights


The chart you will find below is known as a “heat chart”. It depicts the ongoing changes in Kazakhstan's age structure. Each dot represents the number of people in any given age group at any given point in time. A dark red dot represents the largest concentration of people, by age, in a particular year while deep blue dots show the lowest concentrations. A single dark red dot is the equivalent of almost 406,000 people while each deep blue dot represents nearly 23,000 people.


In the upper left-hand corner of the chart the bright reds and yellow areas depicts the population boom that started in the mid 1970s and lasted until the late 1990s. The remnants of that boom extend downward from left to right across the chart. The band also narrows as this population segment ages. This feature reflects a reduction in the total number involved in the population bulge – a consequence of immigration.

Many ethnic Germans and Russians, for example, left Kazakhstan during the years following the end of the Cold War. In the lower left-hand side of the chart there is a preponderance of dark blue dots, indicating a relatively small number of people over the age of 60 years. Over time these dark blue dots are replaced by light blues and greens, a pattern reflecting a gradual but steady increase in the number of elderly people.



Kazakhstan’s population has fluctuated notably over time, rising during the 1980s and then declining during the 1990s (mainly due to outward migration). A low point occurred in 2001 but population has been rising since, with the upward trend expected to continue through 2020 when total population will probably reach an all-time high of 16.7 million – reflecting an increase of 1.8 million between 1980 and 2020.

The number of potential workers (those between 15 and 64 years of age) will fluctuate less and less – and will increasing by a total of 1.9 million over the four-decade period, while the number of those over 60 will nearly double during 1980-2020, growing by more than 1 million.

The Kazazh government, being aware of the country's enormous resource wealth and the need for a labour force to exploit it, wants to see the population rise to around 20 million by 201. Clearly given the fact that Kazakh fertility (1.89 tfr 2007) is already below replacement and heading downwards this target is only achievable via significant inward migration flows. Much of Kazakhstan is desolate and uninhabitable while many of the populated areas lack the physical and social infrastructure necessary to accommodate any large-scale increase in numbers. So the country needs both a positive migration policy and infrastructural development in order to be able to adequately accommodate the new population.

Kazakhstan’s location has meant that it has long been a transit point on the migration route of people back and forth between Asia and Europe. Its importance was only added to by the fact that historically it was used by Moscow as destination point to which colonists, dissidents, and other minority groups could be sent. Such groups included Volga Germans, Poles, Ukrainians, Crimean Tartars and Kalmyks.

Soviet-era policies were also designed to encourage the movement of ethnic Russians to the periphery of the Soviet Union. As a result, Russians were the largest nationality (exceeding even the Kazakh population) in 1980, making up slightly more than two-fifths of the total.

After the fall of the Soviet Union, Kazakhstan's German population emigrated en masse, lured by better economic prospects, ethnic ties to their original homeland and Berlin’s generous programmes for resettlement. More than a quarter of Kazakhstan's ethnic Russian population returned to Russia during the 1990s, and the departure of such a large number of Russians had a particularly dramatic impact owing to their concentration in key urban areas (particularly in the then capital Almaty) and in specific occupations. In Almaty and a few other cities, Russians significantly outnumbered ethnic Kazakhs; they had their own cultural life, spoke their language freely and never had to learn the local language. They also enjoyed a privileged occupational status, accounting for a disproportionate number of managers, scientists, professors, engineering-technical specialists, and other high-wage, high prestige professions.

In order for the population to grow, the Government of Kazakhstan has set targets that the population should increase from 15 million in 2005 to 20 million in 2015, including introducing programs for the migration of 4.5 million ethnic Kazakhs, oralmans from neighbouring countries of Central Asia, Turkey, Mongolia, and China. Although 374,000 oralmans have returned to Kazakhstan in recent years, the bulk of Kazakhstan’s population growth is currently the result of illegal migration from the rest of Central Asia.

At the present time the majority of migrant workers in Kazakhstan are Uzbeks and Kyrgyz nationals. The number of Tajik migrants working in Kazakhstan compared to Russia is small. Since the mid-1990s, Tajiks have fled their country in significant numbers and have entered Kazakhstan either as refugees or externally displaced persons. The number of Tajiks who have entered Kazakhstan in this way is estimated as around 400,000. Although Kazakhstan acceded to the UN Refugee Convention and Protocol in 1999, it has effectively continued to deny official refugee recognition to many Tajiks.

Tajik migrant workers in Kazakhstan are engaged mainly in seasonal agricultural employment. Many of them are often work irregularly. According to some sources around 12,000 Tajik citizens were residing illegally in Almaty in 2006. Many Tajiks are working as traders in markets, selling agricultural products.

Large numbers of migrants from the other Central Asian countries are drawn to Kazakhstan because it is easier to move there than to Russia; xenophobia is much less rife; and the rhythm of economic development makes it very attractive in salary terms. According to official estimates, about 500,000 migrants from other Central Asian Republics work in Kazakhstan. At the CIS summit in October 2007, the Kazakh government distinguished itself by moving to have adopted a resolution on a series of legally and socially protective measures for migrants.


More than half of Kazakhstan’s Central Asian migrants are comprised of Uzbeks, while around 200,000 are Kyrgyz and around 50,000 Tajiks. The majority of migrants are concentrated in four regions: Almaty, Astana, Atyrau and southern Kazakhstan. In the first two regions, migrants are chiefly employed in the construction industry, which is undergoing a real boom, while in Atyrau, several tens of thousands of workers (according to some sources, at least 30,000 Uzbeks) work in the oil industry. In southern Kazakhstan, predominantly Uzbek migrants are employed in the agricultural domain, especially in cotton fields. In Kazakhstan, a kilogram of cotton pays US$0.40 compared with only 0.05 in Uzbekistan. As for the Kyrgyz, a large number of them work on tobacco plantations.

The migrants are specialized in several different sectors: according to estimates, nearly a third work in the construction industry, another third in convenience services (the food service industry, small business, home repairs services), and the last third in agriculture. The highest salaries are in the construction sector (about US$200 per month), whereas those in agriculture earn a lot less (about US$80 per month). Although the overwhelming majority of migrants are male, there are an increasing number of female migrants: in 2002, women made up only 15 percent of Uzbek migrants to Kazakhstan, but by 2004 they were nearly a quarter. Kazakhstan has had labour shortages in sectors largely staffed by women, such as agriculture, the tertiary sector of the food service industry, and domestic services.

Central Asian migrations to Kazakhstan can be divided into three categories: daily, temporary, and permanent. The first takes place notably in the border regions of southern Kazakhstan, where an increasing number of Uzbeks commute to work on the Kazakh side of the border during the day, and return home at evening. Regular border closures and administrative complications at customs often trigger tensions among villagers who have become economically dependent on being able to cross the border.

The border post at Zhybek Zholy, for instance, is crossed by more than 4,000 Uzbek migrants every day. But for the majority of migrants, leaving for Kazakhstan is temporary. The length of stays thus vary largely depending on available opportunities: mostly they last between two and eight months, with construction work being seasonal, mainly in spring and summer, and work in the fields taking place in the fall. Many hope to return to their own countries after accumulating sufficient capital to construct a house or start up a small business. However, there are a growing number of migrants who decide to stay on a permanent basis. Between 1999 and 2004, more than 130,000 Uzbeks, drawn by higher living standards (an average Uzbek salary is around US$40 dollars, compared to 250 in Kazakhstan), moved to Kazakhstan permanently.

The Kazakh authorities are fully aware of the size of the migratory phenomenon and do not wish to resist it. On several occasions, the government has even stated that its citizens are not in competition for work with migrants because the latter fill a specific social niche, as they take the poor paying jobs refused by Kazakhstani citizens. The authorities nevertheless are seeking to reduce illegal immigration and to encourage legal migration, which is better controlled both judicially and socially.

Thus, in 2006, the Minister of the Interior legalized 164,000 migrants from other CIS countries, despite having initially announced a figure of only 100,000. Out of these, nearly 120,000 were from Uzbekistan, 23,000 from Kyrgyzstan, 10,000 from Russia and nearly 5,000 from Tajikistan. Astana’s open policy on migration has also led to the naturalization of many migrants: in 2005, more than 20,000 persons were granted Kazakhstani citizenship, three-quarters of these from Uzbekistan, 10 percent from Kyrgyzstan, and 5 percent from Tajikistan.

Although migratory relations between Kazakhstan and Kyrgyzstan are good, managing migratory flows between Kazakhstan and Uzbekistan has proved more difficult. Tashkent refuses to acknowledge the scale of the phenomenon. The Uzbek state has a monopoly on the legal dispatching of workers abroad, meaning each migrant is obliged to obtain official authorization from the Uzbek Agency of Work Migration. Since 2006-2007, the Uzbek government has also sought to hive off some of the financial flows of its “Gastarbeiters”. According to a government resolution “On registration of citizens seeking employment abroad”, Uzbek labor migrants have to come back to Uzbekistan, go through registration and pay customs dues before returning to work abroad. As a result, the majority of Uzbeks leave without legal permission and thereafter are unable to seek protection from their home state. This situation promotes human trafficking and the organization of mafia networks by recruiters who go from door to door asking for volunteers to work in Kazakhstan.

Working conditions for Central Asian migrants in Kazakhstan are still very poor. Legislation dealing with immigration continues to be largely insufficient, failing to penalize abusive employers and to guarantee minimum of social rights for migrants. The Kazakh police force does not seem in any hurry to denounce companies that employ migrants illegally. So, the very size of illegal migration tends to reinforce corruption in the police, the administration, and the customs services. A massive legalization is thus in the public interest, since it would enable these populations, services and money flows to become official, and therefore controllable.





Main Risk Factors

The principal risks for Kazakhstan's slow landing are threefold: a prolonged period of tight conditions in global financial markets, a substantial drop in oil prices, and/or a domestic event that triggered a loss of confidence in the banks. All or any of these could easily cause a process which was now largely under control to become much less so.


Exchange rate stability is a central policy objective of the NBK. At present, exchange rate stability is viewed as essential for maintaining depositor confidence, limiting the risks from the large foreign currency exposure of the corporate sector, and helping reduce inflation. The central bank noted that downward pressures on the exchange rate had abated since the turn of the year, and its foreign currency reserves have been rising, in part due to the decision to delay the automatic conversion of oil fund revenues into foreign currency assets.5 The country’s official foreign assets (NBK reserves and NFRK assets) are now well above the level reached prior to the onset of market volatility in August 2007. Intervention in the foreign exchange market has been substantially scaled back (as a share of total transactions) in recent months, although the NBK stands ready to intervene in the market if downward pressures on the exchange rate re-emerge. The authorities continue to view the exchange rate regime as a "managed float with no predetermined path for the exchange rate."

The central bank raised its policy rate from 9 to 11 percent last December to help contain inflationary pressures, but has recently cut the reserve requirement on foreign liabilities (to 6 percent from 8 percent) to help bank liquidity. The current policy stance is seen as appropriate to balance a number of policy goals—preserving financial stability, cushioning downside risks to growth, and ensuring that inflation is on a firm downward path. The authorities have also implemented a ban on wheat and vegetable oil exports until September and October, respectively, in an effort to contain food prices and ensure sufficient reserves for domestic consumption (wheat exports to the Kyrgyz Republic are exempt).


The NFRK continues to be managed prudently, and the government does not
expect to draw on the Fund beyond the amount of the guaranteed annual transfer to the
budget. The assets of NFRK consist of a stabilization portfolio of about $5 billion(investedin short-term debt securities) and an investment portfolio (invested in longer-term debt and equity securities). While the NFRK fulfils both a stabilization and savings role, at present the government has no intention to use the Fund’s assets to help cushion the downturn. Indeed, the government spent only 86 percent of the guaranteed transfer from the NFRK last year, and expects the mandated transfer to be adequate to meet spending needs this year.

The exchange rate regime in Kazakhstan has been reclassified from a managed
float to a conventional peg under the IMF’s de facto classification system. This is due to the very limited movement of the tenge against the U.S. dollar since last October. At present, the IMF take the view that there is no clear evidence of either over or undervaluation of Kazakhstan’s real exchange rate when compared to its estimated equilibrium level.

The fiscal position in Kazakhstan is very strong, with a large budget surplus and
low public debt.

External debt has been reduced from 92.8% of GDP in 2007 to an estimated 67.9% in 2008. The IMF forecast a further reduction to 59.6% in 2009.