Tashkent, Uzbekistan — S&P Global Ratings affirmed its ‘BB-’ long-term and ‘B’ short-term foreign and local currency sovereign credit ratings on Uzbekistan. The outlook is stable.

The stable outlook reflects our expectation that, over the next year, Uzbekistan’s fiscal and external positions will remain strong but decline slightly, because of current account deficits and government borrowing.

Although unlikely over the next year, we could raise the ratings if Uzbekistan’s increased integration with the global economy and government reforms of state-owned enterprises (SOEs) result in increased growth potential and resiliency for the economy. Further diversification of the government’s revenue base or the composition of exports would also be supportive of the ratings.

We could lower the ratings over the next year if Uzbekistan’s integration with the global economy were to result in a significant deterioration in the fiscal and external balance sheets. This could happen if imports remain elevated and current account deficits continue to be funded by debt-creating flows and asset drawdowns. We could also lower the ratings if we observed increasing weakness in key SOEs, leading to growing contingent liabilities for the government.

Uzbekistan has embarked on a rapid process of economic modernization and integration with the rest of the world, utilizing its strong external and fiscal positions in the process. We expect both positions to weaken over our forecast horizon through 2022, but to remain relatively strong in a global context.

Our ratings on Uzbekistan are supported by the economy’s external creditor position and the government’s low debt burden. These strengths predominately arise from the government’s asset position, which stems from the policy of transferring some revenue from commodity sales to the Uzbekistan Fund for Reconstruction and Development (UFRD).

Our ratings are constrained by Uzbekistan’s low economic wealth, as measured by GDP per capita. In our view, future 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: Broad-based policy reforms have improved institutions and opened up the economy, although from a low base.

Banking sector reform is the next major agenda item after authorities began a process of economic reforms in 2017 aimed at modernizing the economy, but challenges–such as SOE sector reforms and increasing foreign direct investment–remain.

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 US$1,700 in 2019; however, we expect real GDP growth will remain relatively strong, averaging just over 5% during our forecast period to 2022.

The government initiated comprehensive banking sector reforms in October 2019, with the signing of a presidential decree. The reforms aim to help banks operate in a more commercially focused manner. Over US$4 billion in loans originally granted by UFRD to be lent to SOEs, are to be returned to the UFRD. In addition, about US$1.5 billion in loans, also originally lent by the UFRD, are expected to be granted to banks to convert into equity to improve capitalization in the system. Along with these balance sheet changes, the government plans to introduce regulations to reduce subsidized lending and encourage lending in the local currency.

In addition, we expect credit growth to slow as the investment needs of the economy are met. In 2018, credit to the economy expanded by about 50%, well above nominal GDP growth. Although we still expect elevated credit growth because of the large investment needs of the economy, we do not expect levels similar to those seen in 2018.

Reforms to the banking sector come after a series of broad-based policy reforms, including attempts to increase the independence of the judiciary, 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. Reforms in the SOE sector are ongoing, with 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 future policy responses more difficult to predict. We believe that checks and balances between institutions remain weak. In addition, uncertainty over any future succession remains, despite the relatively smooth transfer of power to President Mirziyoyev.

Over our forecast period through 2022, we expect real GDP growth to average just over 5%, supported by growth in the services, manufacturing, and natural resources sectors. The construction sector is a small but growing part of GDP. The economy has been government led for many years, and is still dependent on SOEs, which contribute a large share of GDP.

Nevertheless, successful reforms of the SOE sectors, including modernizing their operations and bringing them to cost recovery levels, could lead to increased growth potential for Uzbekistan. The country has a significant endowment of 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 (FDI) is a priority for the government. Currently, FDI inflows are low and concentrated in the extractive industries, particularly natural gas. We note that FDI increased in the first half of 2019 to about US$1.9 billion from about US$1 billion in the first half of 2018. If government reforms attract more FDI, this would reduce the debt-financing of the current account balance and help to preserve the government’s large external asset position.

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. Despite steady growth, GDP per capita remains low, at about US$1,700 at year-end 2019.

Flexibility and performance profile: Banking sector reform should reduce dollarization in the economy.

We expect dollarization to decrease below 50% by year-end 2019 and gradually decline, improving monetary policy effectiveness, as price stability and confidence in the currency increases.

We expect the current account to remain in deficit averaging about 5.5% of GDP over the forecast period to meet the consumption and investment demands of the more outward-facing economy.

The government’s net debt burden will remain low despite ongoing fiscal deficits, averaging about 5% of GDP over the forecast period.

We now expect dollarization of loans in the banking system to fall below 50% because of banking sector reforms. Besides the removal of US$4 billion in dollar-denominated loans, the conversion of US$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 to 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 to remain above 10% over our forecast period and to average 15% over 2019. 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. We note that in September 2018, in response to these inflationary pressures, the central bank raised its refinancing rate to 16%.

One of the most significant economic reforms that Uzbekistan has made was the liberalization of the exchange rate regime in September 2017 to a managed float, from a crawling peg, which was over-valued 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.

The current account deficit opened up in 2018, with a deficit of about 7% of GDP. This was the result of increased capital goods imports and wider statistical coverage of previously informal sectors of the economy. We expect the current account balance to average a deficit of about 5.5% of GDP over our forecast period to fulfill the economy’s need for the capital goods and high technology goods it requires to modernize. Additionally, consumer goods imports should remain elevated, given the increased ease of trade.

Better trade relations with neighbors should boost Uzbekistan’s exports, especially of agricultural goods. Tourism is a growing component of exports, as well. However, exports remain heavily dependent on commodities, with gold, other metals, and natural gas making up approximately 50%. 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.

Current account deficits will mostly be financed with debt, but we expect FDI to grow over our forecast period. In our view, the economy’s external balance sheet will remain strong. Uzbekistan is in a net external asset position, even 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) to be relatively strong at 87%, because of the long-dated nature of the economy’s external debt and the high level of reserves.

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 the government’s fiscal balance to remain in a deficit of about 2% of GDP over the forecast period. We anticipate the government will increase social spending on areas such as education and health care, but we also expect an increase in capital expenditure, given the economy’s infrastructure needs. Currently, wages make up the largest component of expenditure, at over 50%. The government implemented tax reforms in 2019. The reforms simplified the tax code and lowered some tax rates. These changes should help expand the tax base and increase collection rates.

We estimate the general government sector will be in a net debt position by year-end 2020. Government assets, used for both domestic fiscal and external purposes, declined over 2019. We estimate government assets will average about 21% of GDP over our forecast period. The government’s assets are mostly kept in 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 cut-off 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.

The government issued a US$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 US$14 billion (25% 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. Besides the Eurobond, 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 closeness of the government to the SOEs and the ongoing support to the SOEs from the government. General government debt service is low, due to the concessional nature. We estimate interest payments at 2% of revenue on average over our forecast period.

In addition to the SOE’s external debt that we include in our data of general government debt, the government also guarantees about US$4.5 billion (11.5% of GDP) of foreign currency-denominated but domestically-held debt of SOEs. These loans are from the UFRD and we consider this government expenditure. As reforms on SOEs begin, if it becomes apparent that sizable government financial support will be necessary, we could reconsider our assessment of contingent liabilities.