"The revision to Kazakhstan's Outlook reflects its continuing recovery from the severe impact of the global financial crisis, which is evident in its economic growth, improved balance of payments position, some signs of stabilisation in the banking system, a reduction in the budget deficit and strengthening in the sovereign's balance sheet," says Ed Parker, Head of Emerging Europe in Fitch's Sovereigns team. "Nevertheless, problem loans in the banking system remain a material source of risk and the main constraint on the sovereign rating."

The macroeconomic backdrop is now supportive of sovereign credit. Real GDP grew by 7.5% in the first three quarters of 2010 (year-on-year), helped by an increase in oil production, the rebound in oil prices and the feed through of policy stimulus measures. Fitch forecasts real GDP growth of 5% - 6% in 2011 and 2012, supported by exposure to currently-booming commodities and China, as well as strong foreign direct investment (FDI) and infrastructure development. Oil production will rise sharply when the Kashagan Caspian Sea field begins production, which the authorities expect in 2015. Production could double by around 2020, which could make Kazakhstan the world's 5th largest oil producer.

External financing risks have diminished significantly. Fitch forecasts Kazakhstan's current account to move into a surplus of around 3.7% of GDP in 2010 and 3.2% in 2011, after a deficit of 3.1% in 2009. Net foreign direct investment (equity and inter-company debt) could be around USD10bn a year, while external borrowing by state-owned enterprises and from international financial institutions and China are boosting capital inflows, despite the external debt default by certain Kazakh banks. The National Bank's foreign exchange reserves (FXR) were USD28bn in November 2010 and total FXR and the foreign assets of the National Oil Fund (NFRK) rose to USD58bn, from USD42bn in June 2009 - giving the sovereign a substantial FX liquidity buffer and net external creditor position. Nevertheless, Fitch forecasts net external debt at 19% of GDP at end-2010, compared with the ten-year 'BBB' range median of 9%. This is primarily due to high private sector external debt - around half of which is inter-company with quasi-equity characteristics.

Kazakhstan's public finances are improving, and are a rating strength. Fitch forecasts the general government budget (on Fitch's definitions consolidating NFRK flows) to be in balance in 2011, compared with a deficit of 5.3% of GDP in 2009 (including some off-budget expenditure), helped by the boom in oil revenues, GDP growth and an easing in anti-financial crisis measures. The government's policy to limit the transfer of NFRK oil revenue to the budget to a nominal USD8bn per year (6.4% of 2010 GDP), plus a variable new oil export fee of less than 1% of GDP, should help fiscal transparency, though is subject to implementation risk. Gross government debt is low at 13% of GDP at end-2010, compared with a long-term 'BBB' range median of 35%, according to Fitch's forecasts. However, these strengths are partly qualified by substantial contingent liabilities in the form of state-owned enterprises and the weak banking system.

The main constraint on the sovereign rating is the banking sector. Three banks defaulted in 2009, including two of Kazakhstan's largest, leading to losses of some USD10.9bn (10% 2009 GDP) for creditors, following restructuring completed in 2010. These write-downs plus USD9bn in sovereign capital have bolstered the banking sector's capital adequacy ratio to 17%, but the inclusion of substantial "accrued interest" raises a question mark over its quality. The sovereign and state-owned enterprises are also providing substantial funding. However, asset quality is poor and still uncertain. On national definitions, non-performing loans were 26% of total loans, as of November 2010, up from 18% a year earlier. However, Fitch estimates total problem loans, including restructured loans, at more than 50%. Although provisions equivalent to 17% of loans as well as capital provide a loss absorption buffer capacity, some banks still appear under-capitalised. Nevertheless, Fitch does not expect further sovereign re-capitalisation, though this cannot be ruled out. Dollarisation rates, foreign currency mismatches and the loan/deposit rate are declining, and sustained economic recovery would aid the sector's rehabilitation. Credit is shrinking in real terms and the weak financial system may act as a drag on credit and GDP growth for some time. This would mainly affect consumers and SMEs, as large corporates and key development projects would have access to international funding.

Other weaknesses that weigh on Kazakhstan's ratings include poor governance and corruption; exposure to commodity prices (which tend to be associated with greater macroeconomic volatility); relatively weak business climate that constrains investment, diversification and growth; and a history of high and relatively volatile inflation and macro-financial instability.

Potential triggers for future rating actions include increasing confidence that investments in the natural resource sector and other development projects are delivering robust growth prospects and a healthy balance of payments position, which could lead to an upgrade. Firmer evidence that the banking system is returning to health, with a reduction in problem loans and avoidance of further costly sovereign support, could also lead to an upgrade. A strengthening in the sovereign's balance sheet would increase upward pressure on the ratings.

Conversely, the emergence of problems in the banking system that are worse than Fitch currently estimates, a severe and sustained drop in oil prices or a breakdown in fiscal discipline could lead to negative rating action.