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

The transfer and convertibility (T&C) assessment is ‘BB-’.

Outlook

The stable outlook reflects our expectation that Uzbekistan’s comparatively strong fiscal and external stock positions should help its economy withstand additional possible negative macroeconomic spillover effects from the Russia-Ukraine conflict and weak global growth over the next 12 months.

Downside scenario

We could lower the ratings if Uzbekistan’s fiscal and external positions weaken more than we currently expect. This could, for instance, result from more significant negative fallout from the Russia-Ukraine conflict for Uzbekistan via the trade and remittances channel beyond 2022. It could also be the case if public and financial sector external debt continues to rise at a fast pace, in contrast to our current expectation of the increase moderating.

In addition, the ratings could come under pressure if the financial performance of key state-owned enterprises (SOEs) weakens, leading to the transfer of contingent liabilities to the government’s balance sheet.

Upside scenario

Although unlikely in the next year, we could raise the ratings if Uzbekistan’s economic reforms and increased integration with the global economy result in stronger economic growth potential and broader diversification of export receipts and fiscal revenue.

Rationale

Uzbekistan’s economy has so far weathered the spillover effects from the Russia-Ukraine war better than we initially anticipated because of stronger-than-expected remittance inflows and money transfers from Russia this year. The latter partially reflects the human capital flight out of Russia, as some Russians have chosen to relocate and move part of their savings to Uzbekistan. Russia is Uzbekistan’s largest remittance source and trading partner, accounting for about 20% of Uzbekistan’s total imports and 15% of exports as of August.

At the same time, inflation has accelerated and the government had to increase social spending to support households, resulting in a wider-than-budgeted fiscal deficit in 2022. The unusually high money transfers from Russia are unlikely to be sustained, in our view. Coupled with continued negative regional effects from the ongoing war, weak global economic growth and monetary tightening could pose additional risks to growth and financing conditions for emerging markets including Uzbekistan from 2023.

Our ratings on Uzbekistan are supported by the economy’s net external creditor position and the government’s moderate net debt burden, although these metrics are on a weakening trajectory. Uzbekistan’s fiscal and external stock positions have historically benefitted from the policy of transferring some revenue from commodity sales to the sovereign wealth fund, the Uzbekistan Fund for Reconstruction and Development (UFRD). In addition, external borrowing was limited for many years under the previous regime of Islam Karimov, and only began to rise in recent years. We forecast net general government debt will amount to 18% of GDP by the end of 2022.

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

Institutional and economic profile: Downside risks to growth remain significant

We project Uzbekistan’s growth at a still-high 5.8% in 2022, down from 7.4% last year.

Economic and governance reforms will continue at a gradual pace, including plans to partially privatize several SOEs.

We also believe decision-making will remain centralized and the perception of corruption high (though on an improving trend).

Uzbekistan’s broad-based growth has been bolstered by higher remittance inflows, exports, and government spending. We have therefore revised our growth estimate for 2022 to 5.8%, from 3.5% previously.

Real GDP growth reached 5.8% during the first three quarters of this year. Instead of declining, remittances and transfers rose to US$12.6 billion as of September 2022, more than double last year’s. This is mainly explained by higher inflows from Russia due to factors that include switching to official transfer channels given higher restrictions and cost of cash transactions, favorable currency movements between the Russian ruble and Uzbek sum, and continued demand for Uzbek workers in Russia. Moreover, Uzbekistan has benefited from financial and human capital flight from Russia, which is driving higher consumption and investment into specific sectors such as information and communication technology. Trade flows with Russia improved since direct trade between Russia and several other countries has become more difficult.

That said, we expect Uzbekistan’s economic outlook to be more volatile in the context of the ongoing Russia-Ukraine war, slowing global growth, and inflationary pressures. The surge in remittances, capital, and migrant inflows are likely to be temporary and could reverse from 2023, in our view. We expect foreign direct investment (FDI) to fall due to lower investment from Russian companies. A more severe recession in Russia could also weaken trade and remittances.

Uzbekistan’s ongoing investment programs and SOE sector reforms--including the modernization of operations to support cost recovery, development of the nascent private sector, and improvements to the business environment--could help support growth, somewhat mitigating the headwinds mentioned above. We note that Uzbekistan’s growth in the past five years was heavily investment-led, with the investment-to-GDP ratio one of the highest globally at about 40%. The government has borrowed externally to support projects in the electricity, oil and gas, transportation, and agricultural sectors. FDI inflows remain relatively low and concentrated in the extractive industries, particularly natural gas.

One focus of the government’s economic reform agenda is improving the operations of SOEs and state-owned banks. The IMF estimates that half of Uzbekistan’s recorded economic output comes from SOEs. The government has an ambitious privatization schedule for 2023 with about 20 government-related entities (GREs) planned for initial or secondary public offerings, and selling up to 25% stakes. This includes Uztransgaz, Uzbekneftegaz, Xalq bank, and Agrobank. In our view, high geopolitical tensions and a weakening global economic outlook could delay privatizations. For instance, a memorandum of understanding was signed for the partial sale of Ipoteka Bank (the fifth-largest in the country) to a Hungarian bank at year-end 2021, but the sale has been delayed, although negotiations recently resumed.

Uzbekistan benefits from favorable demographics, given that its population is young. Almost 90% are at or below working age, which presents an opportunity for labor-supply-led growth. However, it will remain challenging for job growth to match demand, in our view. Weakness in the Russian economy, where most of Uzbekistan’s permanent and seasonal expatriates are employed, could further exacerbate this issue. Despite improvements in recent years, GDP per capita remains low, forecast at slightly above US$2,000 in 2022.

In our view, Uzbekistan has made strong progress on economic modernization agenda since 2017, improving the economy’s productive capacity and institutions. Reforms have included a new privatization law, an increase in transparency regarding economic data, and the liberalization of trade and foreign exchange regimes. The government has also passed laws to privatize agricultural and nonagricultural land, abolished state orders for cotton, and liberalized wheat prices. We expect that delayed electricity and gas tariff reforms will resume from next year. Fiscal transparency has increased with the government bringing most extrabudgetary spending, such as that channeled from the UFRD, onto the budget.

However, Uzbekistan’s reform momentum is starting from a low base. We also consider that reform efforts have to some extent slowed due to the COVID-19 pandemic and the Russia-Ukraine conflict. Overall, we view Uzbekistan’s checks and balances between institutions as weak, while decision-making is highly centralized under the president’s office, making policy responses difficult to predict. Recently announced constitutional amendments would allow a resetting of President Shavkat Mirziyoyev’s term, enabling him to run for a third consecutive term, and would extend the period to seven years from five. The constitutional changes had also initially proposed a reduction in the north-western region Karakalpakstan’s autonomy, which led to unrest in July. The government later announced that changes to its status would be rescinded.

Following decades of highly centralized rule by former president Islam Karimov, there was a smooth transfer of power to President Shavkat Mirziyoyev in 2016, and he won a second term in the October 2021 election. International observers noted a lack of competition in the election. In our view, significant uncertainty over future succession remains.

Flexibility and performance profile: A pronounced rise in government and total external debt in recent years, but we expect their growth rate will moderate

We expect net general government debt will reach 23% of GDP by 2025, which we still view as contained in a global comparison.

After a temporary dip in 2022, we forecast Uzbekistan’s current account deficits will average nearly 6% of GDP through 2025. These will be funded through a combination of net FDI and debt.

Despite improvements in monetary policy in recent years, we still view the central bank’s operational independence as constrained, while loan dollarization remains elevated at about 46%.

To mitigate the fallout from the Russia-Ukraine war and rising food and commodity prices, the government has increased social and infrastructure spending. Authorities introduced higher pension allowances, tax incentives for importers of food and food price controls, and financial resources for exporters. We expect the fiscal deficit will reach 4.5% of GDP in 2022, relative to the budgeted 3%. Thereafter, we expect gradual fiscal consolidation on the back of moderating capital expenditure, better targeted social spending and energy tariff reforms, along with improvements in tax collection. As the government works to reduce the gray economy and improve operations at SOEs, we expect the tax base will gradually increase.

However, risks to our fiscal projections remain, including from government revenue reliance on the sale of commodities, such as gold, the prices of which can be volatile. Social spending, including wages, makes up about 50% of government expenditure and can be difficult to adjust for political reasons.

We estimate that gross government debt will reach 37% of GDP at end-2022. Given declining fiscal deficits, we project that debt will stabilize through 2025. In our estimate of general government debt, we include external debt of SOEs guaranteed by the government, due to the ongoing support the government provides to them. The government recently began setting yearly limits on external loan agreements. The limit for 2022 is US$4.5 billion.

The government’s debt is almost all external and denominated in foreign currency, making it susceptible to exchange rate movements. Besides the outstanding Eurobonds (US$2.6 billion) and local currency debt (close to US$500 million), the remaining portion is to official creditors, split about equally between bilateral and multilateral lenders. Because of the high proportion of official lenders, the interest burden remains low. We forecast government interest payments at just under 2% of revenue on average over 2022-2025.

Uzbekistan crossed into a net debtor position in 2019, although at a level that remains contained relative to that of peers. We expect net general government debt will increase to 23% of GDP by 2025. The government’s liquid assets, estimated at 17% of GDP, are mostly kept at the UFRD. Founded in 2006, and initially funded with capital injections from the government, the UFRD receives 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 and unlikely to be available for debt-servicing if needed.

Uzbekistan’s exports remain reliant on commodities (comprising nearly half of goods exports). Higher global commodity prices and gold sales helped exports increase by 35% during the first half of 2022. However, we expect gold prices to decline over our forecast period to US$1,700 per ounce (/oz) in 2022, US$1,600/oz in 2023, and US$1,400/oz from 2024 (see "S&P Global Ratings’ Metal Price Assumptions: Lower Prices And Higher Costs Start Squeezing Profits," published Nov. 1, 2022, on RatingsDirect). Increasing copper prices, on the other hand, should support exports over the forecast period. Meanwhile, natural gas exports will decline further as the expanding economy’s domestic needs for gas and electricity increase.

Remittances are also an important component of Uzbekistan’s current account, given the large number of citizens working abroad, particularly in Russia. We expect remittance inflows will make up around one-third of current account receipts in 2022, and reduce the current account deficit to about 2% of GDP, from 7% of GDP in 2021. We forecast current account deficits of close to 6% of GDP on average over the next three years, partly fueled by imports of capital and high-tech goods. The deficits will be funded through a combination of net FDI and debt flows.

Uzbekistan remains in a net external creditor position vis-à-vis the rest of the world estimated at 15% of GDP in 2022. However, the country’s gross external debt has been rising at a fast pace in recent years, particularly within the public and financial sectors. In our view, this increase primarily reflects the opening of the economy and its significant investment and development needs. We note that a large proportion of the rise is attributed to official rather than commercial creditors--both for the public as well as banking sectors. Nevertheless, we consider that, if this continues, sustained growth in external leverage could present risks, particularly if some of the related debt-funded projects fare worse than expected. Our current external forecasts are based on the expectation of a pronounced moderation in the pace of foreign debt accumulation over the forecast horizon.

We estimate that Uzbekistan’s usable foreign exchange reserves will decline through 2025 mainly due to falling prices of gold. The Central Bank of Uzbekistan’s (CBU) holdings of monetary gold comprise nearly 80% of total usable reserves. The CBU is the sole purchaser of gold mined in Uzbekistan. It purchases the gold with local currency, then sells U.S. dollars in the local market to offset the effect of its intervention on the Uzbekistani sum. We exclude UFRD assets in the CBU’s reserve assets because we consider them as fiscal assets. Our view is supported by the budgetary use of external UFRD assets in the domestic economy over the past four years, with this portion declining to an estimated US$8.4 billion at end-June 2022 (11 % of GDP) from about US$12.3 billion in 2017 (20% of GDP).

Uzbekistan’s monetary policy effectiveness has been on an improving trend in recent years. One of the most significant reforms in that regard was the liberalization of the exchange rate regime in September 2017 to a managed float from a crawling peg, which was heavily overvalued compared with the parallel-market rate. The CBU intervenes in the foreign exchange market intermittently to smooth volatility and mitigate the increase in local currency from its large gold purchases.

The CBU is moving toward inflation targeting, with an official aim to reach 5% inflation by 2024. We currently do not view this as achievable, particularly amid global price pressures. Higher imported inflation this year will likely increase the average annual rate to 12.5% from 10.9% in 2021. Growth in public sector wages and the liberalization of regulated prices could also add to inflationary pressure over the forecast period. The CBU reduced the policy rate in June and July to 15%, after raising it by 300 basis points to 17% in March, given stabilization in the macro conditions and exchange rate. We forecast gradual currency depreciation of 3%-4% annually through 2025.

We consider that Uzbekistan’s monetary policy flexibility remains constrained by the lack of perceived operational independence of the CBU. In our view, the large footprint of state-owned banks in the sector, at above 80% of total assets, and preferential government lending programs reduce the effectiveness of the monetary transmission mechanism. Domestic dollarization also remains high at about 46% of resident loans and 37% of deposits as of September, although it has been declining. The large drop in dollarization at year-end 2019 was due to the transfer of US$4 billion in U.S.-dollar-denominated loans to the UFRD’s balance sheet from banks. The UFRD-funded loans had been lent via banks to SOEs. In addition, to improve capitalization in the system, the UFRD granted about US$1.5 billion in loans to banks to convert into local currency and retain as equity. We expect local currency deposit growth will outpace that in foreign currency because of interest rate variances and differences in the reserve requirement for banks.

We also note that Uzbek companies and banks could be subject to the risk of secondary sanctions due to the high level of trade with Russia. We understand that one private company, Promcomplektlogistic, reportedly breached Russian sanctions, leading to secondary sanctions being imposed by the U.S. However, the CBU is taking additional measures to strengthen compliance and controls within the banking sector.

We expect that Uzbekistan’s banking sector will continue to show resilience over the next two years. We anticipate that credit growth will moderate to 15%-18% over 2022-2023 from about 30% in 2020 due to more stringent regulatory requirements and increased uncertainty. We consider that economic recovery and low penetration of retail lending in Uzbekistan (with household debt to GDP at below 10% in 2021, among the lowest in the peer group) will remain among the key factors contributing to lending demand growth in the next few years. We believe that credit costs will remain elevated, at about 2% in 2022 from 2.1% in 2021. We also expect that nonperforming loans will remain high at 4%-6% in 2022-2023. The funding profiles of Uzbekistani banks are largely stable, supported by funding from the state and growth in corporate and retail deposits, but access to long-term funding remains scarce. While the recent withdrawal of Turkiston Bank’s license suggests a cleaning up of weaker institutions, it also underpins our view of a less predictable and transparent approach to regulatory actions.