Tashkent, Uzbekistan (UzDaily.com) -- Moody’s Investors Service ("Moody’s") has today changed the Government of Uzbekistan’s rating outlook to positive from stable, and concurrently affirmed the B1 long-term issuer and senior unsecured ratings and the (P)B1 senior unsecured MTN program ratings.

The outlook change to positive reflects demonstrated improvements to institutional capacity and policy effectiveness that, if continued, will support a higher rating. In Moody’s baseline, gradual progress with key structural reforms including improvements to the monetary policy framework and adoption of a medium-term fiscal strategy will limit the growth of government debt. Further progress in reforms that further open the economy and financial sector to more competition and spur productivity in sectors such as textiles would point to stronger creditworthiness.

The affirmation of the rating reflects Uzbekistan’s small, low-income economy and fiscal and political risks relating to the government’s forthcoming structural reforms that will reduce the state’s substantial role in the economy and which may result in the crystallization of contingent liabilities during the transition to a market-driven economy. The rating also reflects moderate external vulnerability and government liquidity risks and a moderate public debt burden at low interest costs, albeit with an increasing share of external borrowings that are on commercial terms.

Uzbekistan’s local and foreign currency country ceilings remain unchanged at Ba2 and B1, respectively. The two-notch gap between the local currency ceiling and the sovereign rating reflects the government’s large footprint in the economy and weak policy predictability, balanced partially by moderate external vulnerability risk that reflects a moderate external debt stock that is on largely concessional terms. The two-notch gap between the foreign currency ceiling and the local currency ceiling incorporates Uzbekistan’s relatively weak monetary and fiscal policy frameworks, and a restricted capital account that may be prone to further transfer and convertibility restrictions in times of stress.

Since 2017, Uzbekistan has reformed economic policymaking while preserving central roles for major State-Owned Enterprises (SOEs) in strategic sectors including natural gas, mining, transport, power, and financial services.

A series of foundational reforms to remove price controls on key goods and liberalize foreign exchange transactions have already enhanced productivity and competitiveness -- from a low base - which Moody’s expects to bolster economic growth and reduce inflation expectations over time.

Institutional reforms have also focused on bolstering the monetary policy framework. The Central Bank of Uzbekistan (CBU) has introduced interim inflation estimates of 10% by end-2021, and 5% by 2023. The CBU intends to achieve this objective through a new set of policy tools to anchor short-term interbank rates around the CBU policy rate, including deposit auctions and central bank bills to inject and absorb liquidity. However, transmission is limited by the high share of dollarization in the banking system.

Inclusion of lending flows from the state-owned Uzbekistan Fund for Reconstruction and Development (UFRD) on the fiscal balance sheet supports the transparency of fiscal policy. Moody’s also expects fiscal policy credibility to improve with more regular reporting of fiscal data and the establishment of a debt management office within the Ministry of Finance. The authorities have sustained these reform efforts through the Covid-19 pandemic, demonstrated most recently with the passage of a budget management law that sets a public debt ceiling of 60% of GDP.

Moody’s expects GDP growth to rebound to 5.5% in 2021 and 6.3% in 2022 as government-backed construction and public investment projects accelerate following the pandemic, while domestic private consumption is likely to recover only gradually amid recent increases in coronavirus cases.

Moody’s expects favorable demographics and productivity gains in sectors such as textiles, energy, logistics, and food products to drive Uzbekistan’s improving economic strength, with potential GDP growth above 5% in the medium term.

Expanded trade linkages and improved relations with Central Asian neighbors, China, and the European Union (EU) will drive further gains from Uzbekistan’s increasingly diverse exports. Uzbekistan’s access to the EU’s Generalized System of Preferences Plus (GSP+) trade preference program, approved in 2021, will provide a significant boost to the emerging garments sector and food products. The Ministry of Investment and Foreign Trade expects the GSP+ approval to boost textile exports to the EU from EUR150 million in 2022 to EUR1 billion by 2025.

However, entrenched competitive advantages of state-owned companies, which account for 55% of GDP, will remain a hurdle to economic reforms. Regulatory and tax reforms will likely improve the business climate for small businesses and support the growth potential. More generally, wide-ranging reforms of the large public sector that gradually introduce more competition and spur productivity would strengthen the sovereign’s rating.

The vast majority of Uzbekistan’s moderate debt burden is denominated in foreign currency (90%), though low interest costs reflect the predominance of concessional external borrowings from official creditors. As a result, the debt level in local currency terms increased markedly with the devaluation of the Uzbek soum in 2017 to 31% of GDP from 13% of GDP in 2016. More recent debt issuance to finance public investment projects and Covid-19 relief, including from international bonds in both US dollars and the local currency, brought general government debt to 42% of GDP in 2020 from 33% in 2019.

Moody’s anticipates the debt burden stabilizing in the 40-45% of GDP range in the medium term, as the government balances its objective of deepening international capital market access with limiting the overall growth of public debt. Spending on social programs including housing, health, and education is likely to remain high in the lead-up to the October 2021 presidential election and result in further primary deficits in 2021 and 2022, although Moody’s expects a return to a primary surplus by 2023.

The government’s financing strategy will continue to shift from strictly concessional external financing toward an increased share of long-term capital market borrowing to nearly one third of overall financing, reflecting the government’s goal of setting an external benchmark for local corporates and financial institutions, and diversifying its pool of investors.

Risks to fiscal strength stem from the uncertain costs associated with the restructuring of SOEs. Moody’s expects the UFRD to mobilize a portion of its US$10.4 billion in liquid foreign currency assets, approximately 19% of 2020 GDP, to provide a partial financial buffer against losses during the restructuring process. Moody’s also expects the UFRD to act as a financial buffer against the crystallization of government guarantees, which are 14% of GDP, but Moody’s estimates that actual contingent liabilities from the SOE sector are likely larger.

The authorities are now embarking on more difficult structural reforms including the privatization and divestment of major state-owned enterprises. These reforms will include sales of the largest companies in the financial and energy sectors, governance reforms and introduction of globally recognized accounting standards in SOEs that the government intends to keep under majority state ownership, and raising household electricity and heat prices to market levels. Moody’s expects the authorities to attempt to execute these reforms at a pace that minimizes risks to macroeconomic and financial stability, while engaging technical assistance from international organizations such as the IMF and World Bank to sequence and design these reforms.

Nevertheless, the predictability and transparency of executive and legislative processes remain weak. The potential for political or social volatility arising from the country’s ongoing transition to a market-driven economy is likely to remain a source of event risk in Moody’s view, particularly as more contentious reforms move to the top of the government agenda.

The process of reform may entail fiscal costs not yet specified and may result in the crystallization of contingent liabilities, resulting in the drawdown of UFRD assets. Social demands may also rise in the absence of gains in private sector development or productivity that would otherwise create employment opportunities for Uzbekistan’s young and expanding labor force.

Structurally wide current account deficits of around 5% of GDP and increased market borrowings from foreign private investors are likely to increase external vulnerability risks over time, in part offset by the robust foreign reserves buffer. The reliance on external funding in part reflects relatively underdeveloped domestic capital markets and limited banking system capacity to finance the long-term funding needs of the government.

Foreign exchange reserves remain robust, at US$13.6 billion or 7 months of import cover, and are expected to provide ample cover for short-term external payment obligations in the medium term. However, as external market borrowing grows, Moody’s expects a greater share of government debt and repayment obligations to increase Uzbekistan’s exposure to shifts in foreign investor sentiment. While they are not included in the measurement of gross foreign exchange reserves, the central bank’s significant gold holdings could also provide liquidity support in times of increased demand on the bank’s hard currency assets.

In Moody’s view, Uzbekistan’s recent track record of accessing capital markets to help meet its external financing needs remains relatively untested, and may expose the economy to sudden increases in borrowing costs over time as market conditions evolve. These risks would be mitigated in the medium term by greater inflows of foreign direct investment to finance external gaps.

Uzbekistan’s ESG Credit Impact Score is highly negative (CIS-4), primarily reflecting weak governance and a relatively short track record of institutional reform, moderately negative exposure to environmental risks such as water scarcity and low natural capital, and social risks that balance positive demographics with weak provision of social services.

Uzbekistan’s exposure to environmental risks is moderately negative (E-3 issuer profile score), driven by water scarcity and pollution and high soil salinity due to the arid geography and occasionally high heat stress, which pose a risk to long-term agricultural productivity and the emerging textile sector. Though a net exporter of natural gas, Uzbekistan is relatively less exposed than Central Asian peers to carbon transition risk due to efforts to diversify the economy into other export commodities including garments, agricultural products, and gold.

Uzbekistan’s social risk exposure if moderately negative (S-3 issuer profile score), balancing favorable demographics relative to peers with moderately weaker levels of provision of services, including education, housing, and health care, that are comparable to Central Asian peers. While there appears to be a significant commitment by the authorities to open government and providing a greater role for the media and civil society in addressing social issues, the significant changes to the state-dominated economy envisaged by the authorities’ reform program combined with low household incomes may also put pressure on social stability.

The impact of governance on Uzbekistan’s credit profile is highly negative (G-4 issuer profile score), reflecting weak, albeit improving, institutions relative to peers and risks of poor execution of planned reforms to the state-dominated economy. The government seeks to address the country’s opaque, pervasive bureaucracy, ongoing issues with corruption, and the inconsistent enforcement of the law, which are largely byproducts of the command economy model. Technical assistance from a wide range of development partners is likely to improve institutional capacity over time.