Tashkent, Uzbekistan (UzDaily.com) -- Fitch Ratings has affirmed Uzbekistan’s Long-Term Foreign-Currency (LTFC) Issuer Default Rating (IDR) at ‘BB-’ with a Stable Outlook.

Uzbekistan’s ratings balance a robust sovereign balance sheet, low government debt and a record of high growth relative to rated 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 rated peers.

The resilience of Uzbekistan’s ratings to the global pandemic reflects the sovereign’s robust external and fiscal buffers, access to external financing and a diversified commodity export base. High gold prices have benefitted exports, public finances and international reserves. The strength of the fiscal and external balance sheets mitigates risks related to a wide current account deficit, which Fitch expects to persist, and a continued rise in the government debt ratio.

We expect Uzbekistan to be among the few sovereigns to avoid an economic contraction in 2020. After dropping to 0.2% in 1H20, we forecast growth to reach 0.5% in 2020, reflecting weaker household consumption and investment, due partly to containment measures against the COVID-19 pandemic, and lower external demand. Fiscal and monetary anti-crisis measures, a sharp increase in gold prices and lower-than-anticipated decline in remittances have supported economic activity.

Under our baseline scenario, growth will accelerate to 5% in 2021 and 5.5% in 2022. Fiscal consolidation will be gradual and the fiscal stance will continue to support investment and consumption, as key trading partners also recover. Uzbekistan’s young population, high investment rate and reforms to remove controls and distortions support a favourable growth outlook post-crisis. Risks to our 2020-2021 forecasts remain skewed to the downside given the uncertainty regarding the duration of the global pandemic and the potential for reintroduction of tighter containment measures in Uzbekistan or its trading partners.

The impact of the pandemic and a larger fiscal response than projected at the time of our last review in April will result in an overall fiscal deficit of 7.9% of GDP, in line with the projected 7.8% for the ‘BB’ median. The consolidated budget deficit (general government plus the Uzbekistan Fund for Reconstruction and Development (UFRD) operations and externally financed expenditure) will widen to 5.7% of GDP, reflecting both lower-than-budgeted tax collection (approximately -2pp of GDP of which 0.4pp are tax-relief measures) and additional expenditure through the Anti-crisis Fund (2.3% of GDP). Net (policy) lending will fall by less than anticipated to 2.2% of GDP (3.3% in 2019), reflecting a loan-for-equity swap for the state oil company (2.9% of GDP).

Fitch forecasts the overall deficit to narrow gradually to 5% of GDP (4.6% consolidated) in 2021, and 4.4% (4% consolidated) in 2022, as revenue growth will partly accommodate the government’s plans to support the recovery through social spending and investment. Although inflows into and outflows from the UFRD were budgeted to be in balance in 2020, the fund will likely provide additional financing to investment projects, reaching a balanced position only by 2022. Fitch expects that the reduced scale of policy lending and a negative output gap mitigate near-term risks to macroeconomic stability.

Fitch forecasts that government debt will reach 36% of GDP (including 11.2% of GDP in external guarantees) in 2020, up from 28.6% (including 8.7% in external guarantees) in 2019. Fitch projects Uzbekistan’s general government debt at 42% of GDP in 2022, still below the forecast 57% for the ‘BB’ median. However, the debt ratio would have doubled since 2018, highlighting the fast pace of borrowing even prior to the COVID-19 crisis. The debt burden is also exposed to exchange-rate depreciation, as it is almost entirely foreign currency-denominated, closely linking macroeconomic stability and debt sustainability.

Some mitigating factors include the structure of government debt in terms of maturity and costs and continued access to international financial institutions (IFIs), as highlighted by rapid financing extended by International Monetary Fund, Asian Development Bank and World Bank to support anti-crisis measures. Annual limits to contracting external debt and government plans to introduce a debt ceiling of 50% of GDP (for public and public-guaranteed obligations) aim to reduce the pace of debt accumulation. In addition, the government has high cash buffers (27% of GDP), including government deposits of 8% of GDP and UFRD liquid assets (USD10.9 billion).

Higher gold prices have cushioned the impact of the crisis on external finances. Fitch forecasts international reserves to reach USD33.4 billion (15.4 months of current external payments (CXP)) by end-2020. Gold currently accounts for 54% of gross international reserves, while UFRD cash holdings represent 32%. As import demand recovers, Fitch expects international reserve coverage to decline but remain more than double the forecast ‘BB’ median in 2021-2022 (average 4.8 months of CXP). Sovereign net foreign assets will reach 22.8% of GDP in 2020, still strong relative to ‘BB’ peers’, but Fitch expects this to deteriorate over 2021-2022 due to increased external borrowing.

The current account deficit will widen to 6.3% of GDP in 2020, almost double the projected 3.2% ‘BB’ median. Increased gold exports (56% of total) have only partly compensated for the decline in other exports and remittances, while imports of goods and services have fallen significantly (-19% yoy in January-August). We project the current account deficit to widen to 7.9% of GDP in 2021 and 7.3% in 2022, significantly higher than ‘BB’ peers; as the recovery in import demand will outpace that of external demand.

Uzbekistan’s net external creditor position is forecast at 36% of GDP in 2020, significantly stronger than that of peers (net debt of 24%), but external liabilities have increased rapidly not only due to government borrowing but higher external debt from the banking sector. We project net foreign direct investments (FDI) to almost halve to 2.1% of GDP in 2020 (3.9% in 2019) and average 3.1% in 2021-2022, directed to energy sectors like hydrocarbons and renewables.

Inflationary pressures have declined, reflecting weaker domestic demand and the postponement of utility tariff increases. The Central Bank of Uzbekistan (CBU) has maintained a fairly tight policy stance since cutting its policy rate by 200bp to 14% and we expect monetary policy to remain prudent, as part of its transition to inflation-targeting. Combined with moderate exchange-rate depreciation this will lead to a gradual decline in average inflation to 9.8% in 2022 from 13.4% in 2020, double the ‘BB’ median.

Monetary policy has gained some traction as the CBU rate now determines the floor for rates on preferential loans, which will be priced closer to market rates in 2021. However, monetary policy is constrained by high inflation expectations, financial dollarisation, shallow capital markets and a still material stock of loans on preferential terms at 20% of total loans (albeit down from 58% in 2019).

The banking sector has preserved stability, supported by the policy response from the CBU, including liquidity injections. Capitalisation levels (capital adequacy ratio of 19.4% at end-August) remain above regulatory requirements after significant capital increase in 2019. Although non-performing loans (NPLs) remain low (2.4% in July), asset quality will likely deteriorate due to a weaker macroeconomic outlook, and continued exposure to state-owned enterprises (SOEs) and foreign-currency risks. Fitch’s Macro-Prudential Indicator of 2*, indicates moderate vulnerability due to fast credit growth. After high growth in 2018-2019, lower demand and more disciplined policy lending will moderate overall credit growth.

Presidential elections are scheduled for 2021, and Fitch’s base case is that President Mirziyoyev will seek and obtain a new term. Fitch also considers that the government remains committed to the reform programme initiated in 2017 to improve macroeconomic stability and growth prospects, decrease the state’s role in the economy and address institutional and governance weaknesses. Authorities have outlined a banking sector reform strategy to strengthen governance, improve financial intermediation and reduce the share of the public sector in total banking assets, reducing the number of state-owned banks to three by 2025. Authorities also aim to move forward with privatisation plans in 2020-2021 for certain SOE assets, while still pushing forward with improvements in reporting and corporate governance standards in strategic sectors.

ESG - Governance: Uzbekistan has an ESG Relevance Score (RS) of ‘5’ for both Political Stability and Rights and for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption, as is the case for all sovereigns. These scores reflect the high weight that the World Bank Governance Indicators (WBGI) have in our proprietary Sovereign Rating Model (SRM). Uzbekistan has a low WBGI ranking at the 19th percentile, reflecting weak rights for participation in the political process and institutional capacity, uneven application of the rule of law and a high level of corruption.

The main factors that could, individually or collectively, lead to positive rating action/upgrade are:

- Macro: Maintaining high economic growth that reduces the gap vs. peers in GDP per capita, without the creation of macroeconomic imbalances.

- Structural: Significant improvement of governance standards including rule of law, voice and accountability, regulatory quality and control of corruption.

- External and Public Finances: Significant strengthening of the sovereign’s fiscal and external balance sheets, for example though sustained high commodity export prices and windfall revenues.

The main factors that could, individually or collectively, lead to negative rating action/downgrade:

- Public Finances: Greater deterioration in the medium-term outlook for public finances, for example, due to weak growth, a marked worsening in the government’s debt-to-GDP ratio or the erosion of the sovereign fiscal buffers that could result in the removal of the +1 QO notch on public finances.

- External Finances: Rapid weakening of external finances, for example, through a sustained widening of the current account deficit derived from rapid credit expansion, a significant decline in foreign-exchange reserves or rapid increase in external liabilities.