Tashkent, Uzbekistan (UzDaily.com) -- Fitch Ratings has affirmed Uzbekistan’s Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDR) at ‘BB-’. The Outlook is Stable.

Uzbekistan’s ratings balance a robust sovereign balance sheet, low government debt and a record of high growth relative to rating peers against high commodity dependence, high inflation and structural weaknesses in terms of low GDP per capita and weak institutional and governance levels relative to rating peers.

The government is committed to reforms targeting improved stability and growth prospects as well as addressing institutional and governance weaknesses. Policymakers also intend to address inconsistencies between monetary, fiscal and credit policy objectives in order to strengthen monetary policy, reduce risks to macroeconomic stability and prevent a rapid and sustained debt build-up.

Credit growth has maintained a vertiginous pace in 2019. Despite the government’s stated objective to slow credit growth (51% yoy in 2018), this averaged 51% in January-July due to the increased availability of financing and higher-than-expected Uzbekistan Fund of Reconstruction and Development (UFRD) investment before the August som depreciation pushed annual growth to 58% through the impact on foreign currency loans stock. Fitch’s Macro-Prudential Indicator of 2*, indicates increased, albeit still moderate vulnerability, due to some of the fastest credit expansion among Fitch-rated sovereigns.

Fitch forecasts inflation to average 14.9% in 2019 and rise to 16.0% in 2020 before declining to 13.5% by 2021, above the government forecasts of 12.6% and 9.9% in 2020-2021 and the highest in the ‘BB’ category, reflecting continued domestic demand pressures, expected utility tariff adjustments and som depreciation given the large external imbalances. A high current account deficit, increased public spending impacting domestic liquidity, strong FX demand and depreciation in key trading partners built up pressure on the som, which intensified in August, resulting in a 7.5% month on month depreciation (12% compared with end-2018) against the US dollar. The Central Bank of Uzbekistan (CBU) has eliminated the cap in daily FX fluctuation at interbank trading sessions, a significant step towards increased exchange rate flexibility after the September 2017 FX liberalisation.

The central bank intends to adopt inflation targeting with the objective of reaching 5% by 2023 with an intermediate target of below 10% by 2021. However, monetary policy remains constrained by the high level of financial dollarisation (40.4% of deposits and 55% of credit), high share of publicly-funded credit below market rates (60% of outstanding loans), underdeveloped capital markets, and the still developing consistency of the new policy framework.

Policy makers target an overall fiscal balance in the medium term by reducing policy lending and quasi-fiscal spending and improving coordination between the Ministry of Finance (MoF) and other entities involved in public investment. In addition, authorities plan to reform government direct concessional lending by increasing the interest rate on new local-currency loans to the level of the refinancing rate and move towards market rates in 2021. The MoF is also developing debt rules introducing ceilings for total public debt and annual borrowing. Fitch will assess the implementation and effectiveness of the proposed measures based on their effectiveness to cool the credit expansion, reduce macroeconomic imbalances and the pace of government debt build-up in 2020-2021.

Uzbekistan’s twin deficits will decline gradually over the forecast period. Fitch projects the current account deficit to finish 2019 at 7% of GDP (USD4 billion) and narrow to a still high 5.7% by 2021, compared with the 3.0% ‘BB’ median, as strong import growth (53% annual in August for machine and equipment) is driven strong domestic demand and public investment. Upside risks to current account deficits remain material in the event of continued policy stimulus and a sluggish response in domestic supply.

Fitch forecasts the consolidated budget (including regional governments and off-budget funds such as social security) deficit to equal 0.7% of GDP in 2019, as tax revenue and social security contributions over-performance due to the increased number of tax payers will outweigh increased budgeted capital and pension spending. However, Fitch estimates that greater-than-expected UFRD spending and policy lending will push the overall fiscal deficit to 2.9% of GDP.

Cuts to the VAT rate and social contributions could cost 2.1pp in budget revenues, but authorities expect this to be partly compensated by elimination of most of the import VAT exemptions and increases profit and excise taxes. Fitch projects the overall fiscal deficit to decline to 2.4% of GDP in 2020 and 1.8% in 2021, as authorities plan to tighten broad fiscal policy by gradually phasing out preferential policy lending, and plan to include UFRD spending in the 2020 budget to increase control over overall fiscal policy.

Uzbekistan’s sovereign fiscal and external balance sheets are key supports for the ratings by providing financing flexibility and mitigating near-term risk related to the large current account deficit. Fitch projects that sovereign net foreign assets will decline to 22.7% of GDP in 2019, down from 34% in 2018, but will remain stronger than the 0.2% ‘BB’ median. Gross international reserves will finish 2019 at USD28.6 billion, maintaining robust reserve coverage of 11.5 months of CXP, still more than double the forecast ‘BB’ median. A high share of international reserves (38.5% or USD11 billion) consist of UFRD cash holdings; the CBU’s share of international reserves’ holdings consist mostly of gold (56% of gross reserves).

Fitch forecasts government debt to increase to 28.7% of GDP (including 8.1% of GDP in guarantees) in 2019, up from 20.8% in 2018, reflecting increased external borrowing (net USD5.3 billion including guarantees) and the weaker som. While government debt remains well below the current ‘BB’ median (46% of GDP), it has increased at a rapid pace and is heavily exposed to currency risks (98% is foreign currency-denominated). Uzbekistan’s debt structure in terms of maturity and costs (89% bilateral and multilateral) mitigates refinancing risks.

Government deposits are forecast at 31% of GDP for 2019, thus resulting in net debt of -1.8% of GDP. Most of the debut Eurobond proceeds (USD889 million) are deposited in local banks and are not part of international reserves. Current official projections expect external debt disbursements to decline to USD4.8 billion in 2020 and USD1.8billion in 2021, which could bring net debt up to 5.2% of GDP by 2021, still stronger than the projected 38% ‘BB’ median.

Growth will remain stronger than peers supported by favourable demography and productivity gains resulting from the removal of macroeconomic and price distortions/controls. Fitch expects growth to reach 5.5% in 2019 and accelerate to 5.9% and 6.2% in 2020-2021 due to a still supportive fiscal policy stance through tax reductions and capital and social spending, and private consumption benefiting from real wage increases as well as retail credit availability.

SOE reform is moving ahead with support of multilateral partners focusing on improving companies’ oversight by MoF, corporate governance, restructuring of operations as well as separating regulatory and business functions. Continued utility tariff increases combined with improved corporate governance are aimed at reducing SOEs’ reliance on cheap financing, mitigating fiscal and financial risks, and privatisation targeting improved competition and efficiency in the economy. Reducing SOE dependence on public-sector funding could in turn provide space for reform in the large state-owned banking sector including the eventual privatisation of some public sector entities.

A fast-moving, complex and broad reform agenda creates some risks regarding coordination and institutional capacity of the public administration to effectively plan and execute policy measures while minimising economic distortions, in Fitch’s view. Despite the current strong commitment of the political leadership to the reform agenda, Fitch considers that reform fatigue is a risk, in the event that there are delays in the materialisation of its benefits in terms of higher growth, increased private investment and employment creation combined, or if social costs are greater than expected, although this would be unlikely to impact social stability.

Fitch’s proprietary SRM assigns Uzbekistan a score equivalent to a rating of ‘BB-’ on the Long-Term FC IDR scale.

Fitch’s sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows:

- Public Finances: +1 notch, to reflect to reflect government deposits of 10.4% of GDP (3.5% in FC) in addition to UFRD cash assets (20.2% of GDP) that result in net government debt forecast at -1.8% of GDP for 2019 in addition to low refinancing risks due to the favorable cost and profile of government debt.

-Macro: the committee introduced -1 notch in view of expansionary credit and public investment policies that create risks to macroeconomic stability by entrenching imbalances and erode the sovereign fiscal and external balance sheets. In addition, monetary policy is constrained to effectively address a record of high inflation.

Fitch’s SRM is the agency’s proprietary multiple regression rating model that employs 18 variables based on three year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch’s QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM

The following factors may, individually or collectively, result in positive rating action:

-Progress towards reducing risks to and improving macroeconomic stability driven by increased credibility and consistency of Uzbekistan’s policy framework.

- Faster than anticipated improvement in structural indicators including GDP per capita and institutional factors.

- A significant strengthening of the sovereign balance sheet.

The following factors may, individually or collectively, result in negative rating action:

- Policy slippage or inconsistencies that lead to sustained widening of macroeconomic imbalances and increase risks for macroeconomic stability.

- Rapid rise in government debt/GDP, for example due to continued policy lending and the materialisation of contingent liabilities from the large public sector.

-A sustained fall in foreign exchange reserves or a rapid increase in external liabilities.

Uzbekistan has an ESG Relevance Score of 4 for Human Rights and Freedoms as World Bank Governance Indicators have the highest weight in Fitch’s SRM and are relevant to the rating and a rating driver.

Uzbekistan has an ESG Relevance Score of 5 for Political Stability and Rights as World Bank Governance Indicators have the highest weight in Fitch’s SRM and are therefore highly relevant to the rating and a key rating driver with a high weight.

Uzbekistan has an ESG Relevance Score of 5 for Rule of Law, Institutional & Regulatory Quality and Control of Corruption as World Bank Governance Indicators have the highest weight in Fitch’s SRM; this is highly relevant to the rating and a key rating driver with high weight.

Uzbekistan has an ESG relevance Score of 4 for Creditors Rights as willingness to service and repay debt is relevant to the rating and a rating driver.

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