Tashkent, Uzbekistan (UzDaily.com) -- On 5 June 2020, S&P Global Ratings revised the outlook on its long-term ratings on Uzbekistan to negative from stable. At the same time, we affirmed the ‘BB-/B’ foreign and local currency sovereign credit ratings, and the ‘BB-’ transfer and convertibility assessment.

“The negative outlook reflects our view that Uzbekistan’s external and fiscal debt could continue to increase rapidly over at least the next 12 months, potentially faster, for instance because of COVID-19-related spending, while benefits of government investment related to increased borrowing will only become apparent over the medium term. We expect current account deficits will remain elevated, and government borrowing will finance reforms and investment programs aimed at improving infrastructure and modernizing the economy,” the agency said.

“We could lower the ratings if we expect external debt accumulation over the period to 2023 will result in a further significant deterioration in Uzbekistan’s fiscal balance sheet or increased gross external financing needs. This could happen if economic growth or current account receipts do not increase to mitigate additional external borrowing,” the statement of the agency said.

“We could also lower the ratings if we observe increasing weakness in key state-owned enterprises (SOEs), leading to the realization of contingent liabilities on the government’s balance sheet, or if dollarization levels in the economy significantly increase despite recent reforms,” S&P Global Ratings added.

“We could revise the outlook to stable if the pace of external debt accumulation slows over the medium term, in line with our expectations,” it added.

Uzbekistan’s increased integration with the global economy and government SOE reforms could support the ratings if they result in increased economic growth potential and resiliency. Further diversification of the government’s revenue base or the composition of exports would also support the ratings.

Uzbekistan’s still-strong external position and the government’s low debt burden support the ratings, although both have deteriorated sharply over 2019-2020. The government has become a net debtor, with government debt surpassing government assets, which are largely with the Uzbekistan Fund for Reconstruction and Development (UFRD). At the same time, we estimate the economy’s gross external debt will increase above its liquid external assets due to further external borrowing in 2020. This will be a significant change given the economy was previously in a very strong external asset position.

We expect government debt net of liquid assets will climb to 10% of GDP by year-end 2020, from a net asset position of 9% of GDP at year-end 2018. We anticipate a slowdown in debt accumulation, with the change in net debt to GDP averaging about 3.7% over 2021-2023. This would be a sharp deceleration compared with our estimate of an average increase of about 9% of GDP in 2019-2020. In 2020, the government expects an extra $1 billion in expenditure related to COVID-19, but most of the borrowing will be to finance current government expenditure and its significant investment plans. Continuing rapid debt accumulation could, in our view, reduce the government’s fiscal flexibility. The government predominately borrows from abroad, which also increases risks to the economy’s external position. Although we note that a large portion of government debt is concessional.

Our ratings are constrained by Uzbekistan’s low economic wealth, as measured by GDP per capita. In our view, policy responses may be difficult to predict, given the highly centralized decision-making process and the relatively less developed accountability and checks and balances between institutions. Our ratings are also constrained by low monetary policy flexibility.

Institutional and economic profile: We expect the economy will expand by 1% this year, showing resilience to COVID-19 headwinds and weak global growth. Despite the COVID-19-related shutdown, large portions of the economy, including most large SOEs, are still operating.

The authorities continue to progress with institutional reforms and, although we expect improvements in governance, we think decision-making will remain centralized.

GDP per capita remains low, at an estimated $1,700 in 2020.

Over the past two years, Uzbekistan has made progress on its reform and economic modernization agenda, which should improve the economy’s productive capacity and the government’s institutional capacity. Most recently, a significant portion of foreign currency denominated loans were returned to the UFRD, reducing dollarization in the banking system. This year, loans to SOEs will be set to at least the Central Bank of Uzbekistan’s (CBU’s) policy rate, beginning reforms to reduce credit market segmentation. Both reforms should help as the CBU transitions to inflation targeting, strengthening monetary policy.

We expect growth will decelerate this year to 1% because of the fallout from COVID-19, and weakness in key trading partners due to low oil prices. The government reacted swiftly to the pandemic, closing transport links with other countries and restricting travel within the country. Large events were cancelled and schools and universities operated remotely. There were also restrictions on retail stores. The government has begun a phased lifting of restrictions as the number of new cases declines. During the restriction period, large segments of the economy continued to operate. The agricultural sector and the important industrial sector--including food processing, manufacturing, oil refining, and metals and mining--have continued to operate. Large infrastructure and investment projects have also continued, slowing only to provide for additional safety measures.

The government has introduced stimulus measures to counteract the effects of the pandemic. The government expects to spend an additional $1 billion this year from the budget, with about $100 million on health-related measures to mitigate the impact of the virus; $870 million to support entrepreneurship, employment, and infrastructure projects; and about $70 million to support low income households. The CBU will set up revolving credit facilities of about $3 billion to support private-sector business and ensure additional provision of liquidity to the banking sector and cash in ATMs, and businesses in key sectors will be eligible for zero-cost debt service deferrals.

We expect real GDP growth will average just under 5% over our forecast period through 2023, supported by growth in the services, manufacturing, and natural resources sectors. The construction sector’s contribution to GDP is small but increasing. The economy has been government-led for many years, and still depends on SOEs, which contribute a large share of GDP. Nevertheless, successful SOE sector reforms, including the modernization of operations to support cost recovery, could lead to increased growth potential for Uzbekistan. The country has significant natural resources, including large reserves of diverse commodities, the export of which has supported past current account surpluses. Globally, the country is one of the top-20 producers of natural gas, gold, copper, and uranium.

Attracting foreign direct investment is a priority for the government, with current inflows low and concentrated in the extractive industries, particularly natural gas. Foreign direct investment increased in 2019 to about $2.3 billion from about $0.6 billion in 2018. If government reforms attract more foreign direct investment, this would reduce the current account’s debt financing.

Uzbekistan’s population is young, with almost 90% at or below working age, which presents an opportunity for labor supply-led growth. However, it will remain a challenge for job growth to match demand, in our view. Despite steady growth, GDP per capita remains low, at a forecast $1,700 at year-end 2020.

The government initiated comprehensive banking sector reforms in October 2019. The reforms aim to help banks operate in a more commercially focused manner. Over $4 billion in UFRD loans, previously onlent through the banking sector SOEs, were returned to the UFRD balance sheet. In addition, the UFRD granted about $1.5 billion in loans to banks to convert into equity to improve capitalization in the system. Along with these balance sheet changes, the government has introduced regulations to reduce subsidized lending and encourage lending in the local currency.

Broad-based policy reforms have improved institutions and opened up the economy. Reforms to the banking sector come after a series of broad-based policy reforms, including attempts to increase the judiciary’s independence, remove restrictions on free expression, and increase the government’s accountability to its citizens. Changes have also included the implementation of an anti-corruption law, an increase in transparency regarding economic data, and the liberalization of trade and foreign exchange regimes. The government is working on a law to privatize nonagricultural land, and further reforms in the agricultural sector are expected, after the abolishment of state orders for cotton. Reforms in the SOE sector are ongoing, with the unbundling and corporatization of large SOEs in the mining and energy sectors and the notable recent creation of the Ministry of Energy, which will have regulatory purview over the oil, gas, and electricity sectors.

Notwithstanding the positive trend in strengthening institutions, in our view, Uzbekistan is starting from a low base. We believe that decision-making will remain highly centralized in the hands of the president, making policy responses more difficult to predict. We believe that checks and balances between institutions remain weak. In addition, uncertainty over any succession remains, despite the relatively smooth transfer of power to President Shavkat Mirziyoyev.

Flexibility and performance profile: The economy will move into a net liability position in the coming years.

We expect the current account deficit will average about 7% of GDP over the forecast period to support consumption and investment demands of a more outward-facing economy, increasing external indebtedness.

The government’s net debt burden will remain low despite ongoing fiscal deficits, with the expected change in net debt averaging about 4.8% of GDP over the forecast period.

We expect dollarization will remain below 50% and will gradually decline over the forecast period, improving monetary policy effectiveness while price stability and confidence in the currency increases.

In 2020, we expect a government deficit of 3.6% of GDP as the government increases spending in response to COVID-19, and revenue weakens from slower economic activity and revenue-reducing stimulus measures. At the same time, the government’s debt burden will increase faster, to about 9% of GDP, primarily due to government borrowing to finance investment and modernization plans, as well as exchange rate depreciation given most government debt is in foreign currency. After 2020, we anticipate the government will continue increasing social spending on areas such as education and health care, and that capital expenditure (capex) will remain elevated given the economy’s infrastructure needs. Currently, wages make up over 50% of capex. The government implemented tax reforms in 2019, which saw revenue in 2019 increase by 25% compared with 2018. The reforms simplified the tax code and lowered some tax rates, helping expand the tax base and increase collection rates. Fiscal transparency has increased as the government brought extra-budgetary spending onto the budget, for instance with the UFRD.

The government issued a $1 billion Eurobond in February 2019 and issued its first local currency treasury bonds since 2012 in December 2018. We estimate general government debt at $15.8 billion (29% of GDP) at year-end 2019. General government debt is almost all external and denominated in foreign currency, making it susceptible to exchange rate movements. We note the exchange rate depreciated 14% in 2019 and expect 10% depreciation this year. Besides the Eurobond and local currency debt (about $130 million at year-end 2019), debt is split roughly equally between official bilateral and multilateral creditors. In our estimate of general government debt, we include external debt of SOEs guaranteed by the government due to the ongoing support to the SOEs from the government. As reforms on SOEs continue, if it becomes apparent that sizable government financial support will be necessary, we could reconsider our assessment of contingent liabilities. A large portion of general government debt is concessional, resulting in low debt-servicing costs. We estimate interest payments at 1% of revenue on average over our forecast period.

The government crossed into a net debt position in 2019, although debt remains low relative to that of peers. We expect net general government debt will increase to 16% by 2022. The government’s assets-about 23% of GDP--are mostly kept at the UFRD. Founded in 2006, and initially funded with capital injections from the government, the UFRD has received revenue from gold, copper, and gas sales above certain cutoff prices. We include only the external portion of UFRD assets in our estimate of the government’s net asset position because we view the domestic portion--which consists of loans to SOEs and capital injections to banks--as largely illiquid.

We expect the current account deficit will increase in 2020 to about 10% of GDP, up from 6% in 2019. The increased deficit is driven by lower gas exports, weaker tourism receipts (an increasing component of services exports), and lower remittances. Remittances and income from abroad are an important component of Uzbekistan’s current account, given the large number of Uzbeks working abroad, particularly in Russia. Offsetting these declines is the increase in the price of gold. Exports remain heavily dependent on commodities and gold is the main export good. We expect the current account balance will average a deficit of about 7% of GDP over our forecast period in order to fulfill the economy’s need for the capital goods and high technology goods to modernize. Additionally, consumer goods imports should remain elevated, given the increased ease of trade.

Current account deficits will mostly be financed with debt over the forecast period. This year, we forecast Uzbekistan will move to a net external debt position, when only considering liquid public and financial sector external assets. We estimate our measure of external liquidity (gross external financing needs to current account receipts, plus usable reserves) is relatively strong at 91%, because of the long-dated nature of the economy’s external debt and the high level of reserves. We expect foreign direct investment will increase over our forecast period. The authorities’ external statistical capacity related to coverage, timeliness, and transparency, has been increasing.

We include in our estimate of the central bank’s reserve assets its significant holdings of monetary gold. The central bank is the sole purchaser of gold mined in Uzbekistan. It purchases the gold with local currency then sells dollars in the local market to offset the increase in reserves from the gold. We do not include UFRD assets in the central bank’s reserve assets; but instead consider them government external assets, because we view them as fiscal reserves.

We expect dollarization of loans in the banking system will remain below 50% because of banking sector reforms. In addition to the removal of $4 billion in dollar-denominated loans, the conversion of $1.5 billion to loans in local currency and increases in retail and commercial lending in local currency should keep dollarization on a declining trend. Deposit dollarization is already below 50%, and we expect local currency deposit growth will outpace foreign currency deposit growth. In our view, declining dollarization should help improve the effectiveness of monetary policy transmission mechanisms. However, our assessment of monetary policy is still constrained by high inflation.

Positively, the central bank is moving toward inflation targeting, but we expect this transition will take a few years. Although the effects of the September 2017 currency devaluation have mostly worked through the economy, we expect inflation will remain above 10% over our forecast period and will average 13% over 2020. More open trade policies have allowed domestic prices to move toward regional and international prices, putting inflationary pressure on domestic goods. Growth in public sector wages and the liberalization of regulated prices should also add to inflationary pressure over the forecast period. In April 2020, in response to COVID-19 and lower inflationary expectations, the central bank lowered its refinancing rate to 15% from 16%.

One of Uzbekistan’s most significant economic reforms was the liberalization of the exchange rate regime in September 2017 to a managed float from a crawling peg, which was overvalued in comparison with the black-market rate. Although we believe the central bank initially intervened heavily in the foreign exchange market, it now only intervenes intermittently to smooth volatility. The relatively short track record of the float constrains our assessment of monetary flexibility, as does our perception of the potential for political interference in the central bank’s decision-making.