Booming oil prices, good harvest, heavy FDI inflow spur growth Kazakh economy : A CIS Success Story

Kazakhstan's industrial sector rests on the extraction and processing of oil and natural gas and mineral resources. It also has a large agricultural sector featuring grain and livestock. Besides these, Kazakhstan also has a growing machine-building sector specializing in construction equipment, tractors, agricultural machinery and some defense items. Initially, the breakup of the USSR led to the collapse in demand for Kazakhstan's traditional heavy industry products, which resulted in a short-term contraction of the economy, with the steepest annual decline occurring in 1994. During the period 1995-97, the pace of the government programme of economic reforms and privatization quickened, resulting in a substantial shifting of assets into the private sector. Kazakhstan enjoyed double-digit growth in 2000-01 and 9.0 percent per year in 2002-05 - thanks largely to its booming energy sector, but also to economic reform, good harvests and foreign investment. The opening of the Caspian Consortium pipeline in 2001, from western Kazakhstan's Tengiz oilfield to the Black Sea, substantially raised its export capacity. Kazakhstan also has begun work on an ambitious cooperative construction effort with China to build an oil pipeline that will extend from the country's Caspian coast eastward to the Chinese border. The country has embarked upon an industrial policy designed to diversify the economy away from over-dependence on the oil sector by developing light industry. The policy aims to reduce the influence of foreign investment and foreign personnel. The government has engaged in several disputes with foreign oil companies over the terms of production agreements; tensions continue. Upward pressure on the local currency continued in 2005 due to massive oil-related foreign-exchange inflows.

Economy Fact-Sheet

GDP (purchasing power parity): $133.2 billion (2005 est.); GDP - real growth rate: 9.0 percent (2005 est.); GDP - per capita (PPP): $8,800 (2005 est.); GDP - composition by sector: agriculture: 7.8 percent, industry: 40.4 percent, services: 51.8 percent (2005 est.). Workforce: 7.85 million (2005 est.); by occupation: agriculture: 20 percent, industry: 30 percent, services: 50 percent (2002 est.). Inflation rate (consumer prices): 7.4 percent (2005 est.) Investment (gross fixed): 22 percent of GDP (2005 est.) Budget: revenues: $12.19 billion, expenditure: $12.44 billion; including capital expenditure of $NA (2005 est.) Agriculture - products: grain (mostly spring wheat), cotton; livestock Industries: oil, coal, iron ore, manganese, chromite, lead, zinc, copper, titanium, bauxite, gold, silver, phosphates, sulfur, iron and steel; tractors and other agricultural machinery, electric motors, construction materials Industrial production growth rate: 10.7 percent (2005 est.) Electricity - production: 60.33 billion kWh (2003), Electricity - consumption: 52.55 billion kWh (2003). Electricity - exports: 6 billion kWh (2003) Oil - production: 1.3 million bbl/day (2005 est.), Oil - consumption: 221,000 bbl/day (2003 est.), Oil - exports: 890,000 bbl/day (2003). Oil - proved reserves: 26 billion bbl (1 January 2004) Natural gas - production: 18.5 billion cu m (2004 est.), Natural gas - consumption: 15.2 billion cu m (2004 est.), Natural gas - exports: 4.1 billion cu m (2004 est.), Natural gas - proved reserves: 3 trillion cu m (1 January 2004) Current account balance: $3.343 billion (2005 est.), Exports: $30.09 billion f.o.b. (2005 est.), Exports - commodities: oil and oil products 58 percent , ferrous metals 24 percent , chemicals 5.0 percent, machinery 3.0 percent, grain, wool, meat, coal (2001) Imports: $17.51 billion f.o.b. (2005 est.), Imports - commodities: machinery and equipment 41 percent, metal products 28 percent, foodstuffs 8.0 percent (2001) Reserves of foreign exchange and gold: $11.13 billion (2005 est.), Debt - external: $32.7 billion (2005 est.), Currency (code): tenge (KZT), Exchange rates: tenge per US dollar - 132.88 (2005)

Medium-Term Economic Outlook Favourable: IMF

An IMF mission visited Kazakhstan from March 30 to April 11, 2006 to hold discussions on the country's microeconomic developments, on-going reforms and policy changes. According to the mission's report, Kazakhstan continues to record rising living standards and improvements in key social indicators. The key near-term policy challenge is to sustain the strong economic performance amid mounting risks in the banking sector and a marked pickup in inflation in recent months. The report concludes that the medium-term economic outlook is favourable. Following are excerpts of the IMF Mission report. Economic activity remained very strong in Kazakhstan with 2005 marking the sixth consecutive year of real GDP growth in excess of 9 percent. Key social indicators improved further and unemployment continued to decline. High oil prices and buoyant growth in non-oil revenues permitted a further substantial expansion in budgetary expenditures and, at the same time, a sizable increase in the overall fiscal surplus, much of which was saved in the National Fund of the Republic of Kazakhstan (NFRK) for future generations. Activity is expected to remain buoyant in 2006, although non-oil growth will likely slow from the heady pace of 2005. The Key Policy Challenge The key policy challenge to sustaining strong economic performance relates to mounting risks in the banking sector and the marked pickup in inflation in recent months. Credit growth has picked up to an annual pace of about 75 percent, financed in part by a surge in banks' external borrowing$4.5 billion in the fourth quarter of 2005 alone. As a result, banks' vulnerability to a tightening of international financing conditions and a sharp slowdown in credit expansion, which could lead to a fall in the quality of loan portfolios, has increased. In addition, inflation is projected to stay above 8.0 percent in the near-term, including on account of the further large increase in civil service wages planned for 2007 and the ongoing surge in bank lending. Tightening of Monetary Policy A marked tightening of the monetary policy stance is needed to mitigate risks and reduce inflation. While the ongoing remonetization should permit continued growth of the monetary aggregates in excess of nominal GDP growth, the National Bank of Kazakhstan (NBK) will need to move quickly to soak up liquidity to slow the pace of credit expansion and contain inflationary pressures. This can be achieved by increasing the interest rate it pays on bank deposits to at least international levels and by broadening the coverage of reserve requirements to include all liabilities, which should also help slow external borrowing. In addition, consideration should be given to a moderate and temporary increase in reserve requirements to aid in mopping up liquidity. It is expected that banks will pass on the higher policy interest rates and tighter reserve requirements to their customers in the form of higher lending interest rates, which have fallen to very low levels in real terms. That would be a welcome development which would help curb credit demand. Exchange Control At the same time, nominal appreciation of the tenge will help curb inflationary pressure. Indeed, underlying economic fundamentals and the major improvement in Kazakhstan's terms of trade on account of high oil prices suggest that significant real appreciation is inevitable over the longer term. Limiting nominal appreciation of the tenge in these circumstances will lead to higher inflationas the experience over the past year highlightsthat could be difficult to reverse and ultimately prove more disruptive to the economy. Country's Budget & Balance Sheet Tighter monetary conditions will affect the NBK's balance sheet, which will eventually need to be replenished from the budget. Higher policy interest rates will involve increased interest expenses for the NBK. In addition, exchange rate appreciation will imply sizable revaluation losses arising from the translation of official reserves, which are held in foreign currency, into tenge for accounting purposes. Legislation passed in 2005 that envisages capital replenishment in response to such losses is a welcome step. However, in current circumstances, a capital injection now into the NBK would send a convincing signal to markets that monetary policy can shoulder the burden of combating inflation squarely and will not be constrained by profit and loss considerations. Prudential Regulations A number of welcome prudential regulations have been adopted over the past year to contain risks associated with banks' loan portfolios, including on related-party lending, real estate exposures, and cross-border loans. In the light of the ongoing rapid escalation of property prices and continued surge in mortgage and construction lending, a further tightening of loan-to-value ratios and the credit scoring system for loan classification may need to be considered, especially if credit growth decelerates more slowly than desired in response to tighter monetary conditions. Moreover, consideration should also be given to tightening prudential regulations on banks' foreign lending and investment activities. Containing Liquidity Further prudential measures to contain external funding are also needed. The surge in external borrowing by banks has clearly increased their vulnerability to a sharp tightening in global financing flows. The mission strongly supports measures under consideration to tighten liquidity requirements for foreign liabilities, a further reduction in net open position limits, and the introduction of limits on short-term external borrowingincluding longer-term borrowing with an early repayment optionrelated to bank capital. These could be supported by higher reserve requirements on external liabilities than domestic liabilities on a temporary basis. In addition, the mission notes that there are significant discrepancies in the data on banks' external obligations compiled by the NBK and the Financial Supervision Agency (FSA). A high priority should be accorded to resolving these discrepancies in order to assess the true maturity profile of bank debt, and systematic monitoring of the future debt repayment profile should be developed. This will aid in assessing any upcoming lumpiness in debt repayments and the associated rollover risk for the banking system as a whole. Regulatory Measures & Vigorous Supervision The regulatory measures will have to be supported by vigorous supervision to ensure banks' compliance. Increasing the frequency and depth of on-site inspections, especially unscheduled topic-based inspections, and enhancing off-site stress testing and monitoring of banks' liquidity models and maturity gap analysis will be critical components of an intensified supervisory effort. Maintaining the FSA's independence will be critical for its credibility and effectiveness. In addition, an increase in supervisory resources at the FSA, which have not kept pace with the growth of the banking system, will likely be required and salaries will need to be kept at adequate levels to attract and retain staff with the appropriate supervisory skills. In view of the mounting risks, the FSA will need to stand ready to deal with any violations of prudential regulations expeditiously and, should difficulties emerge, to intervene and resolve the situation before any spillover effects develop. Easing of Fiscal Policy Adequate monetary tightening should facilitate the planned easing of fiscal policy to address social and infrastructure needs and help diversify the economy. With oil revenue projected to rise further and with non-oil revenue expected to remain buoyant, there is significant room to expand spending and reduce taxes without compromising fiscal sustainability. Under the spending plans currently in place, including the supplementary allocations that are expected to be approved shortly, government expenditure will continue to rise in relation to GDP in 2006 and 2007. This underscores the importance of intensified scrutiny over expenditure efficiency, especially the project approval and ex-post evaluation mechanisms. On the revenue side, the mission cautions against distortive tax incentives for specific sectors and excessive reliance on tax cuts to effect increased tax compliance, including from the shadow economy. Technical assistance from the World Bank in this areawhich is presently underwayshould help in the design of an efficient and fair tax system. Medium-term Outlook The medium-term outlook for the Kazakhstan economy remains favorable. However, if the required tightening of the macroeconomic policy stance through monetary policy and exchange rate appreciation is not undertaken in the near-term, higher inflation may become entrenched and vulnerabilities in the banking system will mount further. In such circumstances, there could be significant adverse consequences for growth and competitiveness. Investment Climate Important steps to enhance the investment climate and economic governance have been taken. The mission welcomes the authorities' decision to join the Extractive Industries Transparency Initiative (EITI). Expeditious publication of audited reports will mark an important gain in transparency. Transparency will also be enhanced by the phased implementation of the new mechanism governing the NFRK in July 2006 and January 2007. The mechanism will clearly identify the scale of oil revenue and its use, and will help in the design and implementation of the medium-term budget strategy. The new mechanism will not automatically instill budget discipline, however, and the authorities' prudent fiscal approach of the past will need to be retained. The mission also welcomes the implementation of the information system for the VAT, which has led to a marked improvement in VAT administration as evidenced by sizable revenue gains. Structural Reforms An acceleration of structural reforms in other areas is needed to sustain the non-oil sector's growth prospects and achieve the authorities' diversification objectives. Significant gains in productivity will be required to offset the impact of the inevitable trend real exchange rate appreciation on the non-oil sector's competitiveness over the medium term. Early WTO accession, customs administration reform (supported by World Bank technical assistance), and further progress in enhancing regional trade will help secure these gains. In addition, reforms to address weaknesses identified in business climate surveyssuch as telecommunications infrastructure, excessive inspections and business documentation and licensing requirements, as well as anti-competitive practiceswill boost growth prospects. Appropriate Policy Stance Better disaggregation of national accounts and balance of payments data into the oil and non-oil sectors will facilitate the assessment of macroeconomic conditions and formulation of the appropriate policy stance. The mission welcomes the authorities' intention to enhance the compilation of the related information and urges expeditious implementation of the recent IMF technical assistance mission's recommendations. Close cooperation between the Ministry of Finance (Customs Control Committee), the NBK, the Agency on Statistics, and the Ministry of Economy and Budget Planning will be needed.