Kazakhstan

HighlightsRussian negotiators in Vienna say talks with the West over Ukraine have reached a “dead end.” If talks are verifiably discontinued, global investors should reduce risk in their portfolios.Social unrest in Kazakhstan does not reduce the probability that Russia will partially re-invade Ukraine. We still give 50/50 odds of new Russian military action.Our Geopolitical Strategy recommends staying short EM Europe versus DM Europe stocks; short RUB/CAD; short CZK/GBP; and long defense stocks.Risks to Russian financial markets remain very elevated due to the Ukraine situation.For Kazakhstan, our Emerging Markets Strategy recommends that dedicated EM credit investors overweight sovereign Kazakh credit relative to the EM benchmark. Equity investors should underweight Kazakhstani equities versus the emerging market equity benchmark.FeatureOn January 2, Kazakhstan witnessed an explosion of civil disorder, the worst since 1986, when it was still part of the Soviet Union. The government, with Russia’s help, has restored order for the time being. But Kazakhstan’s problems have broader lessons for investors that we explore in this report. Chart 1Global Social Unrest Adds To Supply Risks Global Social Unrest Adds To Supply Risks Global Social Unrest Adds To Supply Risks  First, Kazakh unrest will not prevent Russia from staging a partial re-invasion of Ukraine, the odds of which are 50/50. These odds have not changed after this week’s high-level negotiations between Russia and the West.Theoretically instability in the former Soviet Union will constrain Russia’s foreign policy options. But Ukraine is of unique strategic value to Russia.If Russia believes its domestic politics and broader sphere of influence will become less stable in future, then it has more incentive to act now on long-term strategic objectives, like neutralizing Ukraine.Second, Kazakh unrest corroborates the emerging trend of global social unrest that we have been monitoring since the outbreak of the Covid-19 pandemic. This trend reinforces our strategic theme of populism and nationalism.The Kazakh government has been struggling to maintain popular support amid eight years of economic malaise and is now backtracking on fiscal discipline.Previously we identified the “Shia Crescent” – e.g. Iran and Iraq – as ripe for instability but now we can add Central Asia to the list. Kazakhstan is better off than most of Central Asia, which means that other countries are even more vulnerable to this kind of unrest. Even Russia is vulnerable, which supports the first point above.For investors the chief takeaway is to guard against commodity price overshoots, since Central Asia, like the Middle East and other regions, is vulnerable to production disruptions at a time of tight global supply (Chart 1).Yet investors should stay short Russian ruble and equities, as the showdown over Ukraine is not yet resolved.What Just Happened In Kazakhstan?The unrest began in the western city of Zhanaozen, a restive oil town, but escalated in Almaty, the country’s business center, located far away in the far southeast. The nationwide crisis resulted from two factors: (1) pandemic-induced recession and inflation and (2) an ongoing political leadership transition.To stabilize the situation, the government of President Kassym-Jomart Tokayev gave “shoot to kill” orders to police and invited an extraordinary deployment of nearly 4,000 troops, mostly Russian peacekeepers, under the auspices of the Collective Security Treaty Organization (CSTO). Civil order has been at least temporarily restored and some Russian troops may already be leaving.1Reports indicate 164 civilian deaths and about 12,000 arrests. Authorities shut down the Internet so information about the events remains sketchy. The embers are still burning and further flareups can occur. To understand what happened we need to look at Kazakhstan’s geopolitics and recent political history.Kazakh GeopoliticsKazakhstan is a vast country that covers most of the steppe ranging from Russian Siberia to the mountains of Iran, Afghanistan, Krygyzstan, and China. The flatlands are interrupted only by large inland seas, the Caspian and Aral Seas in the west and Lake Balkash in the east, and Tian Shan mountains in the south.The geopolitical problem for Kazakhstan is how to control this vast area, given that its population, wealth, and technology are insufficient for the task. The strategic solution is to integrate or cooperate with the powerful Russian security apparatus while exploiting natural resources to generate revenues.Strongman former leader Nursultan Nazarbayev – who has immense influence and is apparently still in the country, though rumors say he fled into exile this month – founded Kazakhstan as a fledgling republic when the USSR fell. He sought to solidify the country’s independence by attracting foreign investment from capital-rich, resource-hungry foreign regions, while continuing to cooperate closely with the Russians on strategic security.Nazarbayev balanced Russia by means of new trade and investment partners: the EU and especially a rising China. China views Kazakhstan as the centerpiece of its Belt and Road Initiative, which aims to give China the leading role in developing the economies that lie between China and Russia and Europe.Kazakhstan’s population changes since the USSR fell suggest emerging Kazakh nationalism. Ethnic Kazakhs make up 69% of the population and have gained ever greater control of the state. Ethnic Russians have declined from 38% of the population in 1989 to 19%, and still falling, today. Kazakh nationalism is one of the drivers of today’s unrest, with the common folk feeling deprived of the country’s newfound wealth and blaming Russians, and especially Chinese and other foreigners, for exploiting the country’s resources.2Of course, the Kazakh elite are not unified, there are rival clans, and there is now a power struggle between Nazarbayev and Tokayev intertwined with the social unrest. But the point is that Kazakh nationalism poses a long-term challenge to Russian dominance. Russia will continue to have a major interest in Kazakhstan due to the presence of Russians as well as Russia’s own geopolitical needs, which forbid a truly independent Kazakhstan (Chart 2).3 Chart 2 Russia Has An Interest In Former Soviet States Like Kazakhstan Due To Geography, Strategy, And Russian Ethnic Population Russia Has An Interest In Former Soviet States Like Kazakhstan Due To Geography, Strategy, And Russian Ethnic Population Chart 3 Kazakh Governance Is Not The Worst Kazakh Governance Is Not The Worst Kazakhstan is wealthier and better governed than its central Asia neighbors. Adjusted net national income per capita stands at $6717 versus the central Asian average of $2963. While the country’s governance is poor, it ranks higher than several major emerging markets when it comes to governance. It scores better than Russia, China, and Ukraine on the Economic Freedom Index. Income inequality is lower than in Turkey, China, and Russia. Corruption perceptions are not as bad as in China or Turkey (Chart 3).Having said that, governance is still weak and Kazakhstan’s government is very corrupt even if it scores better than some peers.The takeaway is that while social unrest will pose a persistent challenge, Kazakhstan is not a failed state. Real income growth has been strong enough and can be underpinned by government largesse for now (Chart 4). The recent riots were put down quickly.The country is blessed and cursed with abundant natural resources. Its economic structure is overly dependent on oil and natural gas production and distribution (Chart 5). The Great Recession and the oil price and commodity bust of 2014 caused a downshift in growth rates and initiated the current cycle of unrest. Chart 4Kazakh Real Income Grew Rapidly Pre-Pandemic Kazakh Real Income Grew Rapidly Pre-Pandemic Kazakh Real Income Grew Rapidly Pre-Pandemic ​​​​​​  Chart 5 Kazakh Elite Thrive On Resource Rents Kazakh Elite Thrive On Resource Rents ​​​​​​Succession CrisisUnrest flared in 2011 and sporadically throughout the decade, including around Tokayev’s January 2021 election, and culminated in today’s riots. In 2019 Nazarbayev unexpectedly resigned as president and symbolically “handed power” to President Tokayev. The goal was not only to lay the groundwork for his eventual succession but also to share the blame for sluggish growth in the wake of the commodity boom.Nazarbayev kept the title of national leader, and the chairmanship of the powerful National Security Council, and intended to stay in control of most state functions. But Covid-19 foiled his plans. The global pandemic pushed the country into outright recession and sparked a new wave of social unrest that has evolved into a full-blown succession crisis.The Tokayev administration adopted Nazarbayev’s reform initiatives, and launched some of its own, but structural reforms provoked the seething populace. The proximate cause of today’s crisis was a government hike of liquefied petroleum gas prices. Global price pressures have caused the second major bout of food and fuel inflation since 2014, when the currency came under enormous devaluation pressure and the government was forced to float it (Chart 6). Inflation coinciding with recession and an illiberal succession process made for a noxious combination.Tokayev rose to power as Nazarbayev’s loyalist and is now attempting to purge the state of the former leader’s influence, making Nazarbayev into a scapegoat to appease popular wrath. He reversed the LPG price hike, reshuffled the cabinet, and is promising reforms. Simultaneously he is using a heavy hand against protesters and rioters. It is not known if security forces will remain loyal to him but so far they have cracked down aggressively.4 The Russian troops who came to Tokayev’s assistance reclaimed the Almaty airport.Russian backing will give Tokayev the extra physical and moral force he needs to stay in power for the time being. Beyond that, Tokayev may or may not survive. The power struggle with Nazarbayev’s faction will continue in the coming months and years. Nazarbayev controlled the security forces as well as most of the bureaucracy.Either way, the Kazakh state will persist more or less in its current form, for the following reasons:The country’s leaders, whoever they may be, are willing to use force and the security apparatus is large – Kazakhstan spends 5% of total government expenditure on internal security, more than Russia (Chart 7). Chart 6Inflation Tipped Kazakhstan Into Major Unrest Inflation Tipped Kazakhstan Into Major Unrest Inflation Tipped Kazakhstan Into Major Unrest ​​​​​​  Chart 7 Kazakh Security State Large – Similar To Russia’s Kazakh Security State Large – Similar To Russia’s ​​​​​​The new global business cycle will sustain reasonable commodity prices that give the government fiscal resources to deal with unrest. Benchmark crude prices at $84 today are right in line with Kazakhstan’s fiscal breakeven oil price over the 2018-20 period (Chart 8A). As long as prices do not collapse the regime will be able to use revenues to fund security operations and placate disaffected groups (Chart 8B). Chart 8A Kazakh Fiscal Stimulus Below Global Average, Will Rise To Allay Unrest Kazakh Fiscal Stimulus Below Global Average, Will Rise To Allay Unrest ​​​​​​ Chart 8B Kazakh Regime Has Means As Long As Oil Price Holds Up Kazakh Regime Has Means As Long As Oil Price Holds Up ​​​​​​Russia has a vital interest in preventing a revolution or regime failure in Kazakhstan. The rapid response of the CSTO in its first-ever peacekeeping mission abroad shows Russia’s seriousness. The Kazakh elite will continue to receive Russian backing (even beyond what they asked for!). Chart 9China No Longer Writing Blank Checks To Kazakhstan China No Longer Writing Blank Checks To Kazakhstan China No Longer Writing Blank Checks To Kazakhstan  True, Kazakh nationalism and the exodus of Russian speakers will continue to pose problems for Russia over the long run. But the Kazakh government cannot meet its geopolitical needs without Russia, and there is no alternative – China is far from supplanting Russia’s influence.There is no chance of liberal democracy taking shape or of Kazakhstan revolutionizing its foreign relations: Russia and China would not allow it. The regime would be isolated. If Ukraine and Georgia cannot ally with the West and join NATO, then Kazakhstan cannot even think about it. It is stuck in its geopolitical situation.There is a chance that Russia will gain a little political influence vis-à-vis China once the dust settles, but any change is unlikely to be drastic. Nazarbayev oversaw a period of rising Chinese influence but never had the will or ability to turn away from Russia (Chart 9). Russia only needs to retain control of security in Kazakhstan – it does not oppose Chinese trade and investment as long as it does not threaten that control. Modern Russia is not the USSR and cannot afford to subsidize Kazakhstan on its own.American and European trade and investment with Kazakhstan could come under risk – especially if Russia’s broader showdown with the West results in western sanctions on Russia. But Europe is a dominant trading partner of Kazakhstan and Russia will face even greater trouble in this region if it interferes with EU trade. By contrast Kazakhstan will be an essential way for Russia to bypass western sanctions.Bottom Line: Kazakhstan is seeing a rise in populism and nationalism that will persist. But Kazakhstan’s structural problems are not so bad as to lead to regime failure. Elite infighting will be limited by Russia’s and China’s shared interest in supporting the current regime, as well as the country’s lack of geopolitical options.Will There Be A Global Impact?Kazakhstan’s importance to global economy and financial markets centers on its commodity production and distribution. Commodity output did not suffer much during recent unrest but it is possible that government resource taxes, labor strikes, or further unrest could impede exports.  Chart 10Kazakh Currency Compared To Ukrainian During 2014 War Kazakh Currency Compared To Ukrainian During 2014 War Kazakh Currency Compared To Ukrainian During 2014 War  Kazakhstan makes up 1.7% of global oil production and 3.8% of global exports. A total cutoff of Kazakh oil exports, combined with the recent loss of 400,000 barrels per day of Libyan output, could reduce global oil inventories by 2.1%. There is no indication that a total cutoff is occurring but the country is not yet stable.Kazakhstan provides 0.8% of global natural gas supply, 2.1% of Chinese natgas consumption, and serves as a transit country for Turkmenistan natural gas exports. A total shutdown of this supply would amount to 1.3% of global imports and 3.3% of Chinese imports. Both China and Europe are already struggling with very low natural gas inventories and demand is high in the winter season. Thus while Kazakhstan’s exports so far continue mostly unimpeded, any future disruption would have a global impact.Otherwise Kazakhstan is mostly notable for providing 41% of the world’s uranium exports.Kazakhstan’s situation is very different from that of Ukraine. But if social unrest re-escalates, then the currency, the tenge, will collapse and follow the Ukrainian hryvnia’s trajectory since the 2014 Crimea crisis (Chart 10).The Russian ruble has fallen by 4.4% since the border showdown with Ukraine intensified in September, and 2.5% since the Kazakh unrest began. Russian equities have dropped off by 20% in absolute terms and 16% relative to EM equities since October 2021 (Chart 11). We expect the risk premium to remain high at least until the US and Russia reach some kind of mode of living with each other over the Ukraine standoff. Chart 11Market Pricing Higher Russian Geopolitical Risk, Weighing On Relative Equity Performance Market Pricing Higher Russian Geopolitical Risk, Weighing On Relative Equity Performance Market Pricing Higher Russian Geopolitical Risk, Weighing On Relative Equity Performance  Bottom Line: The Kazakh situation is not yet interrupting commodity supply but disruptions cannot be ruled out. The broader point is that Kazakhstan’s sociopolitical problems are shared across many resource producers – and thus investors should bet on policy-induced supply challenges persisting.How Will Kazakhstan Affect Russia’s Standoff With The West?Kazakh unrest affects our strategic theme of great power struggle. The timing of the unrest is suspicious – it broke out just as Russia attempted to blackmail the US into strategic concessions by threatening to re-invade Ukraine (at least part of it).Tokayev explicitly blames foreign interference for the unrest and Russia may also blame the US at some point. It is possible. But foreign actors do not have to do much to spark unrest other than hold a match to the powder kegs of former Soviet states, which are poor, corrupt, ethnically divided, badly governed, and lacking in prospects for the young.The collapse of the Soviet Union and rise of independent republics structurally encourages nationalism and works against Russian centralism. The Eurasian Economic Union is a pathetic alternative to the European Union. The Internet spreads ideas about how life could be better.If Kazakhstan or other Central Asian states destabilize further, it could reduce the odds of Russian taking military action in Ukraine in the near term. Especially if Russia does not want to incur the costs of re-invading Ukraine anyway. But that does not appear to be the case so far.Renewed military conflict in Ukraine cannot be ruled out, for reasons we discussed in a recent special report, “Russia/Ukraine: Don’t Be Complacent.”Unlike Kazakhstan, Ukraine could integrate with the West both economically and militarily over the long run. If Russia believes that it will face greater troubles in its sphere of influence in the coming years – not only in Kazakhstan, but also in Belarus and Turkmenistan, and even at home – then it has all the more reason to settle the Ukrainian strategic question now, while it still has the advantage. Given that Tokayev and his Russian backers appear to have restored order quickly, Russia will turn back to Ukraine promptly.Russia’s goal in the newly opened negotiations with the US is to rule out NATO’s eastward expansion and force a halt to western arms sales and defense cooperation. If the US refuses to rule out NATO expansion and continues to provide arms and defense support for Ukraine (and Georgia), then Russia will take aggressive action. This is probably true even if the coals in Kazakhstan are still burning. Ukraine is long-term strategic threat to Russia, whereas Kazakhstan is ultimately isolated.Looking beyond Ukraine and the short term, Russia will probably have to start paying more attention to maintaining order within Russia and the former Soviet space, rather than clawing back control of parts of the Soviet space that it lost. If Kazakhstan is relatively well off compared to other central Asian states, then its current crisis suggests other crises await.Belarus has already seen the first rumblings of its own succession crisis and instability – and it is more susceptible to western influence than Kazakhstan. Turkmenistan is another candidate for political change. Kyrgyzstan is already in tumult. There are several former Soviet countries whose autocratic leaders, like Nazarbayev, have been in power too long – including Russia’s own President Putin. Post-pandemic economic troubles and inflation will accelerate the decay of these administrations (Chart 12). Chart 12 Aging Autocratic Leaders In Former Soviet Union A Major Source Of Future Political Upheaval Aging Autocratic Leaders In Former Soviet Union A Major Source Of Future Political Upheaval Kazakhstan also shows that even a carefully arranged succession, in which the autocrat tries to keep power behind the scenes but phase out his rule gradually, can instantly give way to factional struggle and national chaos as soon as something goes wrong for the new administration. Chart 13Putin Has Record Of Boosting Domestic Support Via Foreign Adventures Putin Has Record Of Boosting Domestic Support Via Foreign Adventures Putin Has Record Of Boosting Domestic Support Via Foreign Adventures  Nazarbayev is the founding father of Kazakhstan – the capital was just renamed Nur-Sultan, in his honor, in 2019 – and yet his best laid plans were overturned in a week. Now he is on the verge of exile, and his faction may or may not avoid being purged. This is a serious problem for Putin to consider – and if Russia’s succession is not smooth then the world will experience a huge increase in uncertainty.A risk to the view would be that Russia drastically cuts back on its foreign ambitions – and settles with the US over Ukraine – because it recognizes sociopolitical instability as the massive challenge that it is in Russia and its sphere of influence. But we have clear evidence from the past 30 years that Russia responds to domestic weakness with foreign adventurism (Chart 13). Maybe Kazakhstan will mark a change to that pattern. But the thing to watch will be US-Russia strategic negotiations, not Kazakhstan.Regarding US-Russia negotiations, this week’s important diplomatic talks have not lowered the risk of conflict. The US did not offer the required concessions: it did not rule out Ukraine joining NATO someday and did not forswear future defense cooperation with Ukraine. Russia carried out tank drills near Ukraine in a signal that it will not negotiate forever. As we go to press, there is no basis for lowering the risk level of renewed military conflict.Bottom Line: Russia and the former Soviet Union face rising political instability in the coming years. Moscow has a record of pursuing foreign adventures when troubled at home. We still would not rule out a limited re-invasion of Ukraine if the US does not concede limits to NATO expansion and defense cooperation.An Unbalanced EconomyKazakhstan’s economic outlook still hinges by and large on commodity prices, especially oil and natural gas prices. Importantly, the unrest appears to have left the country’s natural resource production unaffected, for now.As long as global resource prices stay elevated, they will provide the Kazakhstani government with the financial means to bolster income and keep the economy going despite lingering political uncertainty.Historically, economic activity and financial markets have tracked the 6-month average of commodity prices (Chart 14). So, major trends in commodity prices, not their short-term fluctuation, have mattered for the Kazakh economy and its equity and sovereign credit relative performance versus EM and frontier market peers.    Chart 14Medium-Term Oil Prices Drive Economy & Markets Medium-Term Oil Prices Drive Economy & Markets Medium-Term Oil Prices Drive Economy & Markets  In the past 12 months, oil and natural gas have represented 50% of overall export revenues, and government revenues from this industry accounted for almost a third of the total. Kazakhstani oil production will be constrained by the OPEC+ agreement at least until December 2022. Afterwards, oil output will most likely surpass the 2020 peak (Chart 15, top panel). Chart 15Commodity Production Commodity Production Commodity Production ​​​​​​ Other non-energy commodities represent the other half of export revenues. Since 2016, the country’s production of non-oil commodities has been rising (Chart 15, bottom 3 panels). Rising output volumes along with elevated prices, for now at least, will provide the government with sufficient revenues to support income and economic growth.In the long run, however, government stimulus and spending can sustain high nominal growth but not real growth. In any economy, real GDP growth is solely determined by the nation’s productivity and labor force growth (Chart 16) Chart 16Real Vs. Nominal GDP Real Vs. Nominal GDP Real Vs. Nominal GDP  The structural growth outlook is dismal:Productivity growth has slowed to a mere 1% (Chart 17, top panel). Stagnant productivity translates to mediocre real per capita income.    Chart 17Meager Productivity Growth Meager Productivity Growth Meager Productivity Growth ​​​​​​ Working age population is projected to grow by 1% annually over the next decade according to UN projections (Chart 17, bottom panel). The country has had negative net immigration balance, i.e., more people are leaving the country than entering it. This will only get worse following the protests and increased political uncertainty. Chart 18Large Profit Repatriation By Multinationals Large Profit Repatriation By Multinationals Large Profit Repatriation By Multinationals  Kazakhstan has failed to develop a domestic manufacturing capacity. Even though authorities have been promoting import substitution in key sectors, these policies have failed to produce tangible results. It is unlikely to be different going forward despite the intentions of President Tokayev to launch structural reforms.Finally, the country has not reaped the full benefits from commodity export revenues. Even though the trade balance was boosted by the country’s commodity export revenues, most of these revenues are being repatriated out of the country through multinational companies’ profits.The country has been running trade surpluses but current account deficits. Chart 18 demonstrates that over 13% of GDP (or $24 billion) in the form of income leaves the country, which is much larger than the trade surplus (Chart 18). This is unlikely to change because multinationals have invested heavily in Kazakhstan’s resource industries, and they will continue reaping a large share of the profits from these industries.     Bottom Line: High commodity prices will enable more government spending, which will sustain the nation’s nominal growth over the medium term. However, beyond the medium term, real economic growth will underwhelm due to the lack of productivity gains.Easy Fiscal + Tight Monetary Policy = Stable Exchange RateInflation in Kazakhstan will prove to be sticky. Headline and core inflation are well above the central bank’s target of 4-6% (see Chart 6 above). Inflation is a politically and socially sensitive issue and persistent high inflation could once again fuel public discontent. Hence, Kazakhstani authorities have a strong political incentive to moderate inflation. Chart 19Wages Outpacing Productivity Wages Outpacing Productivity Wages Outpacing Productivity  Overall, policymakers will adopt a tight monetary and loose fiscal policy mix. This will ensure currency stability for now.On the one hand, the National Bank of Kazakhstan (NBK) will continue hiking interest rates. Interestingly, before the recent unrest, President Kassym-Jomart Tokayev was calling on the central bank to raise interest rates to curb accelerating inflation.On the other hand, fiscal spending will be strong, exerting upward pressure on inflation. Government spending plans for FY 2022 prior to the unrest were geared towards public wage increases alongside direct transfers to households from the National Fund. Now, chances are that these measures will be even larger, and front loaded to appease the population.Soaring nominal wages and lack of productivity gains entail surging unit labor costs (Chart 19). The latter will prolong inflationary pressures.Currency depreciation will fuel higher inflation. Hence, achieving currency stability will for now be the key macro objective for policymakers.To avoid residents converting local currency deposits into US dollars, the central bank needs to offer positive real rates in the tenge deposits by pushing interest rates above the inflation rate. Real (deflated by core CPI) interest rates on domestic local currency deposits have turned to almost a full 1% negative. As a result, aggressive rate hikes by the central bank should be expected in the coming months.Finally, the central bank has adequate foreign exchange reserves to counter capital flight by the country’s elites and to service foreign debt obligations due in the next 12 months.Bottom Line: Faced with strong inflationary pressures, the central bank will be forced to hike interest rates considerably. By doing so, it will maintain elevated enough real interest rates to avert the currency from dropping meaningfully and driving inflation higher.Investment ConclusionsGreat Power Struggle: Russia’s critical negotiations with the West (the US, NATO, and the OSCE) have not produced a diplomatic breakthrough this week. Media reports suggest the talks have gone badly but talks are ongoing as we go to press. If talks are verifiably discontinued, it will be a risk-off sign for global investors.We expect Russian and Eastern European financial assets to suffer a high risk premium until a diplomatic solution presents itself. This is true despite high energy/commodity prices that would otherwise benefit Russia. In the event of a partial reinvasion of Ukraine and western sanctions on Russia, energy prices could spike and harm global demand.Populism and Nationalism: Kazakhstan’s situation has stabilized temporarily but it could easily flare up again given the negative cyclical & structural macroeconomic and political backdrops. Kazakh unrest highlights the high risk of social unrest in the former Soviet Union and in other EMs in the wake of the global pandemic.Risks to Russian markets remain very elevated due to the Ukraine situation. We continue to recommend underweighting Russian stocks, a neutral stance on local bonds and overweighting sovereign credit relative to the their respective EM benchmarks.Kazakhstan's exchange rate will be stable for now. Authorities will avoid any major downside moves in the currency in the medium term and they have the means – in the form of large foreign exchange reserves – to do so.As such, we recommend that dedicated EM credit investors overweight sovereign Kazakh credit relative to the EM respective benchmark. Low public debt and adequate foreign exchange reserves (including the National Fund) will support the ability of government to service its foreign debt.Lastly, equity investors should underweight Kazakhstani equities versus the emerging market equity benchmark. Matt Gertken Vice PresidentGeopolitical Strategymattg@bcaresearch.com Andrija VesicAssociate Editorandrijav@bcaresearch.com Footnotes1      For a breakdown of the troop deployments by country, see Catherine Putz, "CSTO Deploys to Kazakhstan at Tokayev’s Request," The Diplomat, thediplomat.com, January 6, 2022.2     For Kazakh nationalism, see Paul Goble, "New Wave of Kazakh Nationalism Changing Astana’s Domestic and Foreign Policies," Eurasia Daily Monitor 16:32, March 7, 2019, and Serik Rymbetov, "Anti-China Sentiments Grows [sic] in Kazakhstan as Economic Cooperation Stalls," Eurasia Daily Monitor 18:118, July 26, 2021, Jamestown Foundation, Jamestown.org.3     Dosym Satpayev, "Identity Politics," in "Kazakhstan: Tested By Transition," Chatham House Report, November 27, 2019, chathamhouse.org.4     Paul Stronski, "Kazakhstan’s Unprecedented Crisis," Carnegi Endowment for International Peace, January 6, 2022, carnegiendowment.org.

Highlights We estimate total Belt & Road Initiative (BRI) investment will rise from US$120 billion this year to about US$170 billion in 2020. The size of BRI investments is about 47 times smaller than China's annual gross fixed capital formation (GFCF). Therefore, a slump in domestic capital spending in China will fully offset the increase in demand for industrial goods and commodities as a result of BRI projects. Pakistan, Kazakhstan and Ghana will benefit the most among major frontier markets from BRI. Investors should consider buying these bourses in sell-off. On a positive note, BRI leads to improved global capital allocation, allows China to export its excess construction and heavy industry capacity, and boosts recipient countries' demand for Chinese exports. Feature China's 'Belt and Road' Initiative (BRI) is on an accelerating path (Chart I-1), with total investment expected to rise from US$120 billion to about US$170 billion over the next three years. Chart I-1Accelerating BRI Investment From China bca.ems_sr_2017_09_13_s1_c1 bca.ems_sr_2017_09_13_s1_c1 The BRI has been one of the central government's main priorities since late 2013. The primary objectives of the BRI are: To export China's excess capacity in heavy industries and construction to other countries - i.e., build infrastructure in other countries; To expand the country's international influence via a grand plan of funding investments into the 69 countries along the Belt and the Road (B&R) (Chart I-2); To build transportation and communication networks as well as energy supply to facilitate trade and provide China access to other regions, especially Europe and Africa; To facilitate the internationalization of the RMB; To speed up the development of China's poor (and sometimes restive) central and western regions, namely by turning them into economic hubs between coastal China and the BRI countries in the rest of Asia; To boost China's strategic position in central, south, and southeast Asia through security linkages arising from BRI cooperation, as well as from assets (like ports) that could provide military as well as commercial uses in the long run. From a cyclical investment perspective, the pertinent questions for investors are: How big is the current scale of BRI investment, and where is the funding coming from? Will rising BRI investment be able to offset the negative impact from a potential slowdown in Chinese capex spending? Which frontier markets will benefit most from Chinese BRI investment? Chart I-2The Belt And Road Program China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's BRI: Scale And Funding Scale China has been implementing its strategic BRI since 2013. To date it has invested in 69 B&R countries through two major approaches: infrastructure project contracts and outward direct investment (ODI). The first approach - investment through projects - is the main mechanism of BRI implementation. BRI projects center on infrastructure development in recipient countries, encompassing construction of transportation (railways, highways, subways, and bridges), energy (power plants and pipelines) and telecommunication infrastructure. The cumulative size of the signed contracts with B&R countries over the past three years is US$383 billion, of which US$182 billion of projects are already completed. However, the value of newly signed contracts in a year does not equal the actual project investment occurred in that year, as generally these contracts will take several years to be implemented and completed. Table I-1 shows our projection of Chinese BRI project investment over the years of 2017-2020, which will reach US$168 billion in 2020. This projection is based on two assumptions: an average three-year investing and implementation period for BRI projects from the date of signing the contract to the commercial operation date (COD) of the project, and an average annual growth rate of 10% for the total value of the annual newly signed contracts over the next three years. Table I-1Projection Of Chinese BRI Project Investment Over The Years 2017-2020 China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? The basis for the first assumption is that the majority of the completed BRI projects were by and large finished within three years, and most of the existing and future BRI projects are also expected to be completed within a three-year period.1 The second assumption of the 10% future growth rate is reasonable, given the 13.5% average annual growth rate for the past two years, but from a low base. These large-scale infrastructure projects were led mainly by Chinese state-owned enterprises (SOEs), and often in the form of BOTs (Build-Operate Transfers), Design-Build-Operate (DBOs), BOOT (Build-Own-Operate-Transfers), BOO (Build-Own-Operate) and other types of Public-Private Partnerships (PPPs). After a Chinese SOE successfully wins a bid on an infrastructure project in a hosting country, the company will typically seek financing from a Chinese source to fund the project, and then execute construction of the project. After the completion of the project, depending on the terms pre-specified in the contract, the company will operate the project for a number of years, which will generate revenues as returns for the company. The second approach - investing into the recipient countries through ODI - is insignificant, with an amount of US$14.5 billion last year. This was only 12% of BRI project investment, and only 8.5% of China's total ODI. Chinese ODI has so far been mainly focused on tertiary industries, particularly in developed countries that can educate China in technology, management, innovation and branding. Besides, most of the Chinese ODI has been in the form of cross-border M&A purchases by Chinese firms, with only a small portion of the ODI targeted at green-field projects, which do not lead to an increase in demand for commodities and capital goods. Therefore, in this report we will only focus on the analysis of project investment as a proxy of Chinese BRI investment, as opposed to ODI. The focal point of this analysis is to gauge the demand outlook for commodities and capital goods originating from BRI. The Sources Of Chinese Funding The projected US$120 billion to US$170 billion BRI investment every year seems affordable for China. This is small in comparison to about US$3-3.5 trillion of new money origination, or about US$3 trillion of bank and shadow-bank credit (excluding borrowing by central and local governments) annually in the past two years. The financing sources for China's BRI investment include China's two policy banks (China Development Bank and the Export-Import Bank of China), two newly established funding sources (Silk Road Fund and Asia Infrastructure Investment Bank), Chinese commercial banks, and other financial institutions/funds. Table I-2 shows our estimate of the breakdown of BRI funding in 2016. Table I-2BRI Funding Sources In 2016 China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China Development Bank (CDB): As the country's largest development bank, the CDB has total assets of US$2.1 trillion, translating into more than US$350 billion of potential BRI projects over the next 10 years, which could well result in US$35 billion in funding annually from the CDB. The Export-Import Bank of China (EXIM): The EXIM holds an outstanding balance of over 1,000 BRI projects, and has also set up a special lending scheme worth US$19.5 billion over the next three years. This will increase EXIM's BRI lending from last year's US$5 billion to at least US$6.5 billion per year. Silk Road Fund (SRF): The Chinese government launched the SRF in late 2014 with initial funding of US$40 billion to directly support the BRI mission. This year, Chinese President Xi Jinping pledged a funding boost to the SRF with an extra 100 billion yuan (US$15 billion). Therefore, SRF funding to BRI projects over the next three years will be higher than the US$6 billion recorded last year. The Asian Infrastructure Investment Bank (AIIB): The AIIB was established in October 2014 and started lending in January 2016. It only invested US$1.7 billion in loans for nine BRI projects last year. The BRI funding from the AIIB is set to accelerate as the number of member countries has significantly expanded from an original 57 to 80 currently. Chinese commercial banks: Chinese domestic commercial banks, the largest source of BRI funding, have been driving BRI investment momentum. Chinese commercial banks currently fund about 62% of BRI investment and the main financiers are Bank of China (BoC) and Industrial & Commercial Bank of China (ICBC). After lending about US$60 billion over the past two years, the BOC plans to provide US$40 billion this year. The ICBC has 412 BRI projects in its pipeline, involving a total investment of US$337 billion over the next 10 years, which will likely result in an annual US$34 billion in BRI investment. The China Construction Bank (CCB) also has over 180 BRI projects in its pipeline, worth a total investment of US$90 billion over the next five to 10 years. Only three commercial banks will likely fund US$80 billion of BRI projects over the next three years. A few more words about the currency used in BRI funding. The U.S. dollar and Chinese RMB will be the two main currencies employed in BRI funding. Chinese companies can get loans denominated either in RMBs or in USDs from domestic commercial banks/policy banks/special funds/multilateral international banks to buy machinery and equipment (ME) from China. For some PPP projects that involve non-Chinese companies or governments (i.e. those of recipient countries), the local presence can use either USD loans or their central bank's Chinese RMB reserves from the currency swap deal made with China's central bank. China has long looked to recycle its large current account surpluses by pursuing investments in hard assets (land, commodities, infrastructure, etc.) across the world, to mitigate its structural habit of building up large foreign exchange reserves that are mostly invested in low-interest-bearing American government securities. Risky but profitable BRI infrastructure projects are a continuation of this trend. China had so far signed bilateral currency swap agreements worth an aggregate of more than 1 trillion yuan (US$150 billion) with 22 countries or regions along the B&R. The establishment of cross-border RMB payment, clearing and settlement has been gaining momentum, and the use of RMB has been expanding gradually in global trade and investment, notwithstanding inevitable setbacks. Bottom Line: We estimate total BRI investment with Chinese financing will rise from US$120 billion this year to about US$170 billion in 2020, and Chinese financial institutions will be capable of funding it. Can BRI Offset A Slowdown In China's Capex? From a global investors' perspective, a pertinent question around the BRI program is whether the BRI-funded capital spending can offset the potential slowdown in China's domestic investment expenditure. This is essential to gauge the demand outlook for industrial commodities and capital goods worldwide. Our short answer is not likely. Table I-3 reveals that in 2016, gross fixed capital formation (GFCF) in China was estimated by the National Bureau of Statistics to be at RMB 32 trillion, or $4.8 trillion. Table I-3China's GFCF* Vs. China's BRI Investment Expenditures China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? Meantime, China-funded BRI investment expenditure amounted to US$102 billion in 2016. In a nutshell, last year GFCF in China was about 47 times larger than BRI investment expenditures. The question is how much of a drop in mainland GFCF would need to take place to offset the projected BRI investment. The latter will likely amount to US$139 billion in 2018, US$153 billion in 2019 and US$168 billion in 2020. Provided estimated sizes of Chinese GFCF in 2017 are RMB 33.5 trillion (US$4.9 trillion), it would take only 0.4% contraction in GFCF in 2018, 0.3% in 2019 and 2020 to completely offset the rise in BRI-related investment expenditure (Table 3). Chart I-3Record Low Credit Growth... bca.ems_sr_2017_09_13_s1_c3 bca.ems_sr_2017_09_13_s1_c3 We derive these results by comparing the expected absolute change in BRI capital spending expenditures with the size of China's GFCF. The expected increases in BRI in 2018, 2019 and 2020 are US$20 billion, US$14 billion and US$15 billion. Given the starting point of GFCF in 2017 was US$4.9 trillion, it will take only about 0.4% of decline in $4.9 trillion to offset the $20 billion rise in BRI. In the same way, we estimated that it would take only an annual 0.3% contraction in nominal GFCF in China to completely offset the rise in BRI capital spending in both 2019 and 2020. To be sure, we are not certain that the GFCF will contract in each of the next three years. Yet, odds of such shrinkage in one of these years are substantial. As always, investors face uncertainty, and they need to make assessments. Is an annual 0.4% decline in China's GFCF likely in 2018? In our opinion, it is quite likely, based on our money and credit growth, as illustrated in Chart I-3. Importantly, interest rates in China continue to drift higher. A higher cost of borrowing and regulatory tightening on banks and shadow banking will lead to a meaningful deterioration in China's credit origination. The latter will weigh on investment expenditures. The basis is that the overwhelming portion of GFCF is funded by credit to public and private debtors, and aggregate credit growth has already relapsed. Chart I-4 and Chart I-5 demonstrate that money and credit impulses lead several high-frequency economic variables that tend to correlate with capital expenditure cycles. Chart I-4Negative Money Credit Impulses Point To... ...Negative Money Credit Impulses Point To... ...Negative Money Credit Impulses Point To... Chart I-5...Slowing Capital Expenditure ...Slowing Capital Expenditure ...Slowing Capital Expenditure Therefore, we conclude that meaningful weakness in the GFCF is quite likely in 2018, and that it will spill out to 2019 if the government does not counteract it with major stimulus. By and large, odds are that a slump in domestic capital spending in China offset the rise in BRI-related capital expenditures. BCA's Emerging Markets Strategy service has written substantively on motives surrounding China's capital spending and how it is set to slow, and we will not cover these topics. Some reasons why investment spending is bound to slow include: considerable credit excesses/high indebtedness of companies; misallocation of capital and resultant weak cash flow position of companies; non-performing assets on banks' and other creditors' balance sheets and their weak liquidity position. To be sure, investors often ask whether or not material weakness in mainland growth will lead the authorities to stimulate. Odds are they will. Yet, before the slowdown becomes visible in economic numbers, financial markets will likely sell-off. In brief, policymakers are currently tightening and will be late to reverse their policies. Finally, should one compare the entire GFCF, or only part of it? There is a dearth of data to analyze various types of capital spending. In a nutshell, Chart I-6 reveals that installation accounts for roughly 70% of investment, while purchases of equipment account for the remaining 18%. Therefore, we guess the composition of BRI projects will be similar to structure of investment spending in China, and hence it makes sense to use overall GFCF as a comparative benchmark. In addition, the GFCF data is a better measure for Chinese capital spending over Chinese fixed asset investment (FAI) data, as the FAI number includes land values, which have risen significantly over the years and already account for about half of the FAI (Chart I-7). Chart I-6Chinese Fixed Investment Structure Chinese Fixed Investment Structure Chinese Fixed Investment Structure Chart I-7GFCF Is A Better Measure Than FAI GFCF Is A Better Measure Than FAI GFCF Is A Better Measure Than FAI Bottom Line: While it is hard to forecast and time exact dynamics over the next several years, odds are that the next 12-24 months will turn out to be a period of a slump in China's capital spending. This will more than offset the increase in demand for industrial goods and commodities as a result of BRI projects. Implication For Frontier Markets The BRI, which currently covers 69 countries, will keep expanding its coverage for the foreseeable future. Insofar as it is a way for China to create new markets for its exports, Beijing has no reason to exclude any country. In practice, however, certain countries will receive greater dedication, for the simple reason that their development fits into China's political, military and strategic interests as well as economic interests. As most of the investments are infrastructure-focused, aiming to improve transportation, energy and telecommunication connectivity as well as special economic zones, the recipient countries, especially underdeveloped frontier markets, will benefit considerably from China's BRI. Table I-4 shows that Pakistan, Kazakhstan and Ghana will benefit the most among major frontier markets, as the planned BRI investment in those countries amounts to a significant amount of their GDP. Chart I-8 also shows that, in terms of current account deficit coverage by the Chinese BRI funding, the three countries that stand to benefit most are also Pakistan, Kazakhstan and Ghana. Table I-1The B&R Countries That Benefit From ##br##China's BRI Investment (Ranged From High-To-Low) China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? Chart I-8Chinese BRI Funding's Impact On ##br##External Account Of B&R Countries China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? Of these, clearly Pakistan and Kazakhstan have the advantage of attracting China's strategic as well as economic interest: Kazakhstan offers China greater access into Central Asia and broader Eurasia; Pakistan is a large-population market that offers a means of accessing the Indian Ocean without the geopolitical complications of Southeast and East Asia. These states also neighbor China's restive Xinjiang, where Beijing hopes economic development can discourage separatist and terrorist activities. Pakistan Pakistan is a key prospect for China's exports in of itself, and in the long run offers a maritime waystation and an energy transit hub separate from China's other supply lines. For China, it is a critical alternative to Myanmar and the Malacca Strait. In April 2015, China announced a remarkable US$46.4 billion CPEC (China-Pakistan Economic Corridor) investment plan in Pakistan, equal to 16.4% of Pakistani GDP. It is expected to be implemented over five years. In particular, the planned US$33.2 billion energy investment will increase Pakistan's existing power capacity by 70% from 2017 to 2023. On the whole, China's CPEC plan will be significantly positive to economic development in Pakistan in the long run, but in the near term it is still not enough to boost the nation's competitiveness (Chart I-9A, top panel). Chart I-9AOur Calls Have Been Correct Top 3 Frontier Markets Benefiting Most From Chinese BRI Investment Top 3 Frontier Markets Benefiting Most From Chinese BRI Investment Chart I-9BTop 3 Frontier Markets Benefiting Most ##br##From Chinese BRI Investment Our Calls Have Been Correct Our Calls Have Been Correct Also, as about 40% of the investment has already been invested over the previous two years, odds are that China's CPEC investment will go slower and smaller this year and over the next few years. BCA's Frontier Markets Strategy service's recent tactical bearish call on Pakistani stocks has been correct, with a 25% decline in the MSCI Pakistan Index in U.S. dollar terms since our recommendation in March (Chart I-9B, top panel).2 We remain tactically cautious for now. Kazakhstan Kazakhstan is a key transit corridor for Chinese goods to enter Europe and the Middle East. In June 2017, Chinese and Kazakh enterprises and financial institutions signed at least 24 deals worth more than US$8 billion. China's BRI investment in Kazakhstan facilitated the country's accelerated economic growth (Chart I-9A, middle panel). BCA's Frontier Markets Strategy service reiterates its positive view on Kazakhstan equities because of a recuperating economy, considerable fiscal stimulus and rising Chinese BRI investment (Chart I-9B, middle panel).3 Ghana Ghana is not strategic for China (it is a minor supplier of oil). Instead, it illustrates the fact that BRI is not always relevant to China's strategic or geopolitical interests. Sometimes it is simply about China's need to invest its surplus U.S. liquidity into hard assets around the world. Of course, Ghana itself will benefit considerably from the committed US$19 billion BRI investment, which was announced only a few months ago. This is a huge amount for the country, equaling 45% of Ghana's 2016 GDP. This massive fresh investment will boost Ghana's economic growth in both the near and long term (Chart I-9A, bottom panel). BCA's Frontier Markets Strategy service upgraded its stance on the Ghanaian equity market from negative to neutral in absolute terms at the end of July, and we also recommended overweighting the bourse relative to the broader MSCI EM universe (Chart I-9B, bottom panel).4 Our positive view on Ghana remains unchanged for now and we are looking to establish a long position in the absolute terms in this bourse amid a potential EM-wide sell-off. Other Macro Ramifications Industrial goods and commodities/materials are vulnerable. BRI will not change the fact that a potential relapse in capital spending in China will lead to diminishing growth in commodities demand. If there is a massive slowdown in property market like China experienced in 2015, which is very likely due to lingering excesses, Chinese commodity and industrial goods demand could even contract (Chart I-10). Notably, mainland's imports of base metals have been flat since 2010, and imports of capital goods shank in 2015 even though GDP and GFCF growth were positive (Chart I-11). The point is that there could be another cyclical contraction in Chinese imports of commodities and industrial goods, even if headline GDP and GFCF do not contract. Chart I-10Chinese Capital Goods Imports Could Contract Again bca.ems_sr_2017_09_13_s1_c10 bca.ems_sr_2017_09_13_s1_c10 Chart I-11Imports Of Metals Could Slow Further Imports Of Metals Could Slow Further Imports Of Metals Could Slow Further As China accounts for 50% of global demand of industrial metals and it imports about US$ 589 billion of industrial goods and materials annually, either decelerating growth or outright demand contraction will be negative news for global commodities markets and industrial goods producers. China's Exports Have A Brighter Outlook China's machinery and equipment (ME) exports account for 47% of total exports, and 9% of its GDP (Table I-5). The BRI investment will boost Chinese ME exports directly through large infrastructure projects. Table I-5Structure Of Chinese Exports (2016) China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? Meantime, robust income growth in the recipient countries will boost their demand for household goods (Chart I-12). China has a very strong competitive advantage in white and consumer goods production, especially in low-price segments that are popular in developing economies. Therefore, not only is China exporting its excess construction and heavy industry capacity, but the BRI is also boosting recipient countries' demand for Chinese household and other goods exports. Adding up dozens of countries like Ghana can result in a meaningful augmentation in China's customer base. Notably, Chinese total exports have exhibited signs of improvement as Chinese ME exports and exports to the major B&R countries have contributed to a rising share of total Chinese exports since 2015 (Chart I-13). Chart I-12BRI Will Lift Chinese Exports Of ##br##Capital And Consumer Goods BRI Will Lift Chinese Exports Of Capital And Consumer Goods BRI Will Lift Chinese Exports Of Capital And Consumer Goods Chart I-13Signs Of Improvement In Chinese Exports ##br##Due To Rising BRI Investment Signs Of Improvement In Chinese Exports Due To Rising BRI Investment Signs Of Improvement In Chinese Exports Due To Rising BRI Investment BRI Leads To Improved Global Capital Allocation BRI is one of a very few global initiatives that improves the quality of global capital allocation. Therefore, it is bullish for global growth from a structural perspective. By shifting capital spending from a country that has already invested a lot in the past 20 years (China) to the ones that have been massively underinvested, BRI boosts the marginal productivity of capital. One billion dollars invested in the underinvested recipient countries will generate more benefits than the same amount invested in China. Risks To BRI Projects Notable deterioration in the health of Chinese banks may meaningfully curtail BRI funding, as Chinese non-policy banks will likely need to provide 60% of BRI projects' funding. Political stability/changes in destination countries: As most infrastructure projects have been authorized by the top government and need their cooperation, any changes in the recipient countries' governments or regimes may slow down or deter BRI projects. China already has a checkered past with developing countries where it has invested heavily. This is because of its employment of Chinese instead of local labor, its pursuit of flagship projects seen as benefiting elites rather than commoners, its allegedly corrupt ties with ruling parties, and perceived exploitation of natural resources to the neglect of the home nation. As China's involvement grows, local politics will be more difficult to manage, requiring China to suffer occasional losses due to political reversals or to defend its assets through aggressive economic sanctions, or even expeditionary force. For now, as there are no clear signs that any these risks are imminent, we remain positive on the further implementation of China's BRI program. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 China has long been known to use three-year periods - as distinct from its better known "five year plans" - for major domestic initiatives. In 2016, the National Development and Reform Commission re-emphasized three-year planning periods for "continuous, rolling" implementation. 2 Please see BCA's Frontier Markets Strategy Special Report "Pakistani Stocks: A Top Is At Hand", published March 13, 2017. Available at fms.bcaresearch.com. 3 Please see BCA's Frontier Markets Strategy Special Report "Kazakhstan: A Touch Less Dependent On Oil Prices", published March 28, 2017. Available at fms.bcaresearch.com. 4 Please see BCA's Frontier Markets Strategy Special Report "Ghana: Sailing On Chinese Winds", published July 31, 2017. Available at fms.bcaresearch.com.