S&P Global Ratings affirmed its long- and short-term foreign and local currency ratings on Uzbekistan at ‘BB-/B’. The outlook remains negative.

The negative outlook reflects our view that Uzbekistan’s external and fiscal debt could continue to increase rapidly.

S&P Global Ratings could lower the ratings over the next 12 months if it thoughts that the rapid accumulation of government external debt in recent years would not moderate in line with its projections, for instance because ongoing investment needs lead to higher-than-expected fiscal or external deficits.

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

“We could affirm the ratings if the pace of external or fiscal debt accumulation slows over the medium term, in line with our base case, as economic growth and current account receipts increase to mitigate additional external borrowing,” the agency noted in the statement.

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 SOE financial resiliency. Further diversification of the government’s revenue base or the composition of exports would also support the ratings.

“The negative outlook reflects our view that the accumulation of external and fiscal debt might not moderate through 2023. Up until now, Uzbekistan has been using the significant flexibility provided by the very strong fiscal and external asset positions it began with in 2018. In our view, the room for significant further external debt accumulation, at the current rating level, has narrowed. This follows the sharp increase in government external debt in recent years, related to the government’s plans to improve infrastructure and modernize the economy. We also expect external debt to increase over the near term because of COVID-19-related spending. However, we expect a more selective approach to project implementation over through 2023, which should see the increase in gross external debt moderate. Whether the economic benefits from the infrastructure investments will be sufficient to mitigate the deterioration of the fiscal and external balance sheets remains uncertain, and more likely will materialize beyond 2023,” S&P Global Ratings states.

Uzbekistan’s external position remains relatively strong compared with similarly rated peers. The government’s net debt burden is low and supports the ratings. The agency expects government debt net of liquid assets will climb to 8% 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 4.6% over 2021-2023. This would be a sharp deceleration compared with our estimate of an average increase of about 8% of GDP in 2019-2020. In 2020, the government expects to spend an extra US$1.3 billion (2.2% of GDP) related to COVID-19, but most of the borrowing will be to finance current government expenditure and the significant investment plans. Continuing rapid debt accumulation could, in our view, reduce the government’s fiscal flexibility. The government predominately borrows from abroad, although a large portion of government debt is concessional,” the statement reads.

“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,” the agency noted.

“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. However, 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 future succession remains, despite the relatively smooth transfer of power to President Shavkat Mirziyoyev in 2016,” S&P Global Ratings said.

Broad-based policy reforms have included measures 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 reforms in the agricultural sector are expected, after the abolition of state orders for cotton.

The government is also working on reforms of SOEs and the banking sector. Major SOEs are implementing measures to improve corporate governance and increase transparency, including by producing audited financial statements. The government is working to unbundle and corporatize large SOEs in the mining and energy sectors. We have also seen the notable recent creation of the Ministry of Energy, which will have regulatory purview over the oil, gas, and electricity sectors. The government intends to prepare several smaller companies for privatization, as well, which should pave the way for the more challenging and economically rewarding prospect of privatizing the larger SOEs.

The government initiated comprehensive banking sector reforms in October 2019. The reforms aim to help banks operate in a more commercially focused manner. Over US$4 billion in loans from the Uzbekistan Fund for Reconstruction and Development (UFRD), previously lent through the banking sector to SOEs, were returned to the UFRD balance sheet. In addition, to improve capitalization in the system, the UFRD granted about US$1.5 billion in loans to banks to convert into equity. These measures also reduced dollarization in the banking sector. Along with these balance-sheet changes, the government has introduced regulations to reduce subsidized lending and encourage lending in the local currency. We understand the government plans to partially privatize several banks before 2025.

We consider that continued moving away from a state-led economy could improve productivity, attract foreign direct investment (FDI), and reduce outflows from the budget. Attracting FDI is a priority for the government, with current inflows low and concentrated in the extractive industries, particularly natural gas. Net FDI increased in 2019 to about US$2.3 billion from about US$600 million in 2018.

We expect growth will decelerate this year to 0.5% 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 its own borders. Large events were cancelled and schools and universities moved to remote learning. There were also restrictions on retail stores. The strongest lockdown measures were in March-May and July-August. The government has begun a phased lifting of restrictions as the number of new cases declines. During the restriction periods, large segments of the economy still continued to operate. The agricultural sector and the important industrial sector--including food processing, manufacturing, oil refining, and metals and mining--continued to operate. Large infrastructure and investment projects also continued, but at a slower pace for additional safety measures.

The government introduced stimulus measures to counteract the effects of the pandemic. The original amount was about US$1 billion but was increased in anticipation of a second wave of COVID-19 cases. It has spent about US$1.1 billion of the US$1.3 billion (2.2% of GDP) of additional COVID-19-related spending this year from the budget:

About US$100 million on health-related measures to mitigate the impact of the virus;

US$870 million to support entrepreneurship, employment, and infrastructure projects; and

About US$70 million to support low income households,

The central bank set up revolving credit facilities of about US$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 eligible for zero-cost debt service deferrals. 

We expect GDP growth will average about 5% annually 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.

Uzbekistan’s population is young. Almost 90% are 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 US$1,700 at year-end 2020.

In 2020, we expect a government deficit of 7.5% of GDP as the government increases spending in response to COVID-19 and the pace of government investment and modernization spending remains elevated. After 2020, we anticipate the government will continue increasing social spending on areas such as education and health care, and that capital expenditure will remain elevated, given the government’s investment plans. Currently, social expenditure makes up over 50% of government expenditure. The government implemented tax reforms in 2019, which help increase revenue in 2019 by 25% over 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 extrabudgetary spending onto the budget, for instance with the UFRD. 

We estimate general government debt at US$21 billion (37% of GDP) at year-end 2020. 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, increasing the level of debt in local currency terms. Besides the government’s Eurobonds and local currency debt (about Uzbekistani sum 5.2 trillion, or US$500 million, at year-end 2020), 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 of 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 about 2% 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 18% of GDP by 2023. The government’s assets, about 25% 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 moderate in 2020 to about 5.4% of GDP, down from 5.8% in 2019. The current account, despite lower exports (including lower gas exports) and weaker tourism receipts (an increasing component of services exports), has been supported by higher gold prices, restrained imports, and stable 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. 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 6% 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. Our measure of external liquidity (gross external financing needs to current account receipts, plus usable reserves) is relatively strong at 85%, because of the long-dated nature of the economy’s external debt and the high level of reserves. We expect FDI will increase over our forecast period. The authorities have increased the external statistical capacity related to coverage, timeliness, and transparency.

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, currently at about 49% in October, will remain around 50% over the next year before declining, because of banking sector reforms. In addition to the removal of US$4 billion in dollar-denominated loans from the banking sector, 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 at about 43% as of October 2020, 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 average about 10% over our forecast period. 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. Reducing credit to the economy will have a deflationary impact over the forecast period to 2023. In response to COVID-19 and lower inflationary expectations, the central bank lowered its refinancing rate to 14% 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.