International Financial Management

Kazakhstan

Group 4

Subba Chuda Kumari 4036540

Emilio Vernaza 4007329

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Table of content

1. Financial system

2. Monetary system

3. Exchange rate system

4. Financial markets

5. SWOT Analysis

6. Risk Analysis:

a. Political

b. Exchange Rate

c. Sovereign

7. China Petroleum and Chemical Corporation (Sinopec Limited)

a. Identification of exposure to the exchange rate risk

b. Recommendations

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1. Financial System

The Banking system of the Republic of Kazakhstan is a two-tier banking system. The National Bank of the Republic of Kazakhstan (“the National Bank” hereinafter) is the central bank of Kazakhstan and is the upper tier of the banking system of Kazakhstan. It is responsible for ensuring price stability in the country by maintaining inflation at low levels. All other banks are the lower tier of the banking system with the exception of the Kazakhstan Development Bank (KDB), which has a special legal status.

2. Exchange Rate System

In August 2015, the government introduced the free floating exchange rate system for the Kazakhstani tenge (domestic currency). At the beginning the floating exchange rate caused an initial sharp depreciation of the currency and an increase in inflation; as well as, eroded real wages and consumer purchasing power. As this report is being written one tenge is worth $0.0030USD. They adopted this floating regime as a response to the fall in oil prices and to increase competition in Eurasian markets.

3. Monetary System After the floating system came into place the National Bank changed its monetary policy to an inflation targeting system.

Consumer prices rose by 11.5% in October 2015. It is the lowest inflation rate since last year. (See Graph 1)

(Graph 1, November 2015-Present, Kazakhstan inflation rate, Source: World Bank)

Very recently, the national bank of Kazakhstan started gradually decreasing the interest rate from 17% to 12% in order to stimulate the economy. (See Graph 2)

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(Graph 2, November 2015 – Present, Kazakhstan interest rate, Source: World Bank)

4. Financial Markets

The Kazakhstan stock exchange (KASE) was founded in 1993 in Almaty (the capital). KASE operates on the following markets: foreign currency market, government securities, equity securities, corporate debt securities, repo transactions market and derivatives market. The transactions are conducted in US dollars, euros, Chinese yuan and the Russian Ruble and the tenge. The most active market participants are the second tier banks and the National Bank. The KASE index components are weighted by the market capitalization of the most liquid shares traded on KASE and calculated real time as trades are being executed.

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5. SWOT Analysis

Strengths 1. Kazakhstan is estimated to have 30 billion barrels of crude oil (12th in the world), 3.7

trillion cubic metres of gas (11th in the world), 34.5 billion tons of coal (in the top ten countries) and 1.5 million tons (or nearly 15% of the world). With the OBOR initiative, Kazakhstan is going to be able to export this resources to other countries with no trade barriers.

2. They have very good relations with neighboring countries and are neutral in regional political affairs. Kazakhstan participates in free trade agreements with the major economic powers (China, Russia, EU and US). For example, they have a bilateral trade agreement between the EU. They also participate in the Eurasian Customs Union which grants them easy access to trade freely with Russia and other neighboring countries. By participating in the OBOR initiative, Kazakhstan will further increase the number of free trade agreements it currently has and will be able to engage in trade more freely with other participation nations.

Weaknesses 1. The country has a high dependence on natural resources extraction. This is a cause why

Kazakhstan has not yet fully developed other industries in which it can compete with other OBOR countries.

Strengths: 1. Abundance of natural resources such as

fossil fuels reserves, uranium, copper and zinc.

2. Participation in major trade agreements with Russia, China, EU and US.

Weaknesses: 1. The economy is highly dependent on

mineral resources extraction. Economic prosperity is tied to commodities prices.

2. Largest landlocked country. No direct access to an ocean port.

Opportunities: 1. Develop the country’s infrastructure. 2. Develop logistics industry with the

creation of a logistics hub close to the Russian and Chinese border.

3. OBOR will lead to the acceleration Chinese mining investment in Kazakhstan.

4. Reestablish grain production as a national priority and export surplus to China.

Threats: 1. Unsustainable management of its water

resources. 2. The hydrocarbon economy era is coming

to its end. Newer and greener energy sources are becoming widely adopted.

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2. Kazakhstan is the largest landlocked country in the world, which means it has no access to ocean ports.

Opportunities 1. As a result of OBOR, Kazakhstan has already secured 33 cooperation agreements with

China to develop the country’s infrastructure. These projects are worth USD23 billion. 2. The country has great opportunities in the logistics industry. They already started the

construction of a logistics hub close to the borders with Russia and China. This will be a critical success factor when OBOR is implemented.

3. Kazakhstan has the opportunity to increase their agriculture production (specially grain) and export the surplus produced to other countries. This initiative is part of its strategy plan (Kazakhstan 2050). Certainly, it will be more relevant with OBOR because they will be able to export food to other countries.

4. Kazakhstan is going to be benefited with an influx of Chinese investment in the mining sector. Currently, both countries have a joint-venture in the production of nuclear energy with uranium. With these funds, Kazakhstan will be able to construct nuclear power plants and fulfill the Chinese demand for nuclear energy.

Threats 1. The country’s environmental policy has not been very effective up to this moment.

Kazakhstan has contaminated the Caspian Sea by pouring thousands of tons of oil pollutants. After OBOR, the country will experience economic development but it should also consider a more sustainable management of its water resources.

2. Hydrocarbons are less used every day and the World is demanding greener energy to protect the planet. In January of this year global leaders met in Paris and created the Paris Climate Agreement which 192 have already signed, including Kazakhstan. 6. Risk Analysis a) Political risk

Since 1991, Kazakhstan has been ruled by an authoritarian governance where the power is heavily concentrated in the ‘Nur Otan’ party led by President Nursulatan Nazarbayev. The political stability may be adversely affected by the discontent of social causes for instance corruption, rising prices, low wages, mass protests, religious extremists and fears of terrorist attack. A notable protest held in May 2016 of the opposition on a land reform project that encouraged foreigners the upper hand to on leasing of lands. However, due to the tightened security measures of after the outbreak, it is now unlikely for mass protests to happen. Moreover, there

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is a significant uncertainty of the presidential power in respect to the transition of Mr.Nazarbayev’s successor after his withdrawal from the office with consideration of the his advanced age. The government will still put social discontent as a priority to if not eliminate then reduce the damage it may cause in the long-term through providing more social expenditure. So, social discontent is not a major concern that may affect political instability in the near future. Nevertheless, Standard and Poor’s outlook in the near future is that Kazakhstan will remain stable politically.

b) Exchange rate risk Transitioning from the lower-middle-class-income to the upper-middle-class-income status and with the proven record of having the ninth largest oil reserve around the world, Kazakhstan’s economy majorly depends on commodity exports followed by manufacturing and business services. As mentioned, in 2015 the state bank of Kazakhstan has shifted to use the floating exchange rate meaning that the currency floats freely in the market so the risk of the Tenge is likely to fluctuate in terms of the rise or fall of oil prices that determines the income level. In reference

to graph 2 of the country, the interest rate of the country is relatively high as of the present date but however it is offset by a high inflation rate in respect to graph 1. The major determinant of the currency is the oil price (income level) but due to the unpredictable fluctuation, therefore the exchange rate risk is as volatile as the oil prices. (Graph 4, 2010 – 2015, Tenge’s currency, Source: Bloomberg)

c) Sovereign Risk According to the latest research update of the Standard and Poor (S&P)’s credit rating sovereign report, the long and short term credit ratings are scored at BBB- and A-3 respectively with an outlook that remains negative. A sovereign credit rating is a financial indicator that indicates the level of risk to a potential investor and apparently, India is in the lower medium-investment grade.

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Kazakhstan being rated at BBB- in the long term credit rating is an implication of the S&P’s long-term issuer credit ratings’ definition “An obligor rated 'BBB' has adequate capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitments” (S&P credit rating definition, 2016). The rating outlook assesses the which direction Kazakhstan may take over six months to two years’ time and is assessed at ‘negative’ signaling that it is likely to change its outlook with considerations for possible changes of any economic and or fundamental business conditions within the country. According to the research update on solvency report of Kazakhstan, the economic conditions and changing circumstances such states that the centralized political environment that is too concentrated in one political party (Nr), high dependency on commodity exports and low oil price, inflexibility of the monetary policy and slow level of economic development hinders the positive outlook. Moreover, the feeble global commodity environment also adds on as a factor along with the decline of the fiscal performance supported by the fall of oil price over the two years. Even so, the government has kept the debt level as low as 20% of the GDP remaining in a net creditor position. (S&P, 2016)

(Graph 5, 2004– 2015, Kazakhstan Debt to GDP, Source: Bloomberg) From the deficit of 8.6% in GDP last year, it is expected to increase is as close to zero this year moving in an upward direction from last year, which will reach positive figures by 2017. An average annual surplus of 3.5% of GDP is speculated over the next five years. The contributing factors are:

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(i) On one hand, the oil price is expected to increase over the years and on the other, ‘the Kashagan oil field is expected start its operations in the Caspian Sea that will contribute to the state bank’s revenue.

(ii) The government’s spending and expenditure was a major factor that lead to a deficit, it is strongly believed that with containing the government’s spending according to priority would reduce the deficit figures.

(iii) The performance of government revenue is also expected due to the authorities’ plans on revamping the tax administration and collection process that will optimize the tax legislation thus generating supplementary income.

Over the medium term, the GDP in early 2016 will experience deficit by 4% of GDP but the start of Kashagan’s oil field and increase in oil prices will offset the current account’s depletion of import as a result of decline in private consumption and country’s Tenge and in addition to the ineffective sovereign institutions, the outlook of Kazakhstan will remain negative.

(Graph 6, 2012– 2016, EIU Sovereign Risk Score for Kazakhstan, Source: Bloomberg)

7. China Petroleum & Chemical Corporation (Sinopec Limited) Sinopec Limited is a Chinese oil and gas company based in Beijing, China. It is currently listed in Hong Kong, Shanghai and New York. Its parent company, Sinopec Group is the largest oil refining and petrochemical company in Asia. Sinopec Limited operates in every of the oil and gas segments, every of the petrochemicals segments and the import/export of commodities. The reason we picked Sinopec Limited (“Sinopec” hereinafter) is because last year they acquired 50% ownership of Caspian Investment Resources (CIR), a Kazakhstani oil and gas company. Sinopec will now have an exposure to the exchange rate risk of Kazakhstan and the success of this acquisition might be determined on how well they deal with this risk. In the text below the transaction, economic and translation risks are going to be identified and some recommendations are going to be made on how to manage the potential exchange rate risk.

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Transaction exposure risks Sinopec acquired an interest in Caspian Investments Resources (“CIR”) in order to help satisfy China’s energy demand. In other words, Sinopec could at some point have financial obligation abroad, by importing crude oil from its subsidiary and paying in foreign currency (tenge). This will expose the company to a transaction risk. For example, Sinopec makes a contract with CIR in which they will buy crude oil the next year and pay a fixed amount in tenge. If the tenge appreciates then Sinopec will be negatively affected because importing crude oil from its subsidiary will become relatively expensive. They will require more RMB to buy the same quantity of crude oil agreed upon. Our recommendation is to use a hedging strategy to lock in an exchange rate and eliminate the transaction exposure risk. • Buy and hold the foreign currency – the company could buy the tenge needed to pay for

the crude oil at the date the contract is established. They should hold on-to the tenge until the contract settlement date.

• Forward contract – the company uses a forward contract to lock in a price for the foreign currency at the date the contract is established. They would have to pay the agreed price for the tenge. This strategy is effective if for hedging an appreciation of the tenge, but if instead the foreign currency depreciates then Sinopec will not benefit from it.

Economic exposure: Although the depreciation of the Renminbi has made a significant profit for the Sinopec translated currency exchange but it is inevitable for the company to economic exposure risk. The unanticipated changes in the exchange rates may affect the operations of the company, the Renminbi is relatively stable in comparison to the Tenge that fluctuates according to the volatility of the oil prices. For instance, the Sinopec company may import oil from the Caspian Investment Resources and if the Tenge’s currency appreciates against the Renminbi then it would increase the cash outflow of the company thus making it more expensive to purchase oil from Kazakhstan and hurting it’s operating income vice versa noting that the Company is made committed to purchase from its joint venture and subsidiaries based on market prices, no exception. The company can consider to hedge its business writing up currency risk-sharing agreements where they reach a consensus to share the risk of the unpredictable exchange rate fluctuation. Another method is implementing back-to-back loans in other words, credit swap so the company and CIR can borrow each other’s currencies for a period of time. After the repayment, each company will be able to receive collateral in a foreign currency which appears on both of their balance sheet as an asset and liability.

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Translation exposure: Sinopec Limited consolidated financial statements of all its subsidiaries outside China are translated from their home currency to Renminbi at spot exchange rates as quoted by the People’s Bank of China (PBOC rates) on the day of transaction.

In reference to the statement above, the company faced a loss in the translation difference in its foreign currency statements during the year 2014 because of the high exchange rate of the currency. However, over last year, Renminbi devaluated its currency and remained rather low against other currencies so the depreciation increased the translation earning of the Company. Therefore, Sinopec faces the risk of translation exposure while doing business in Kazakhstan due to the volatility of the Tenge’s exchange rate that is determined by the volatility of the oil prices. Sinopec can consider to buy the Tenge forward before receiving the accounts receivables from the CIR which could possibly maximize the translation differences.

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