Introduction
The Central Asian (CA) economy consists of Armenia, Azerbaijan, Georgia, Kazakhstan, the Kyrgyz Republic, Tajikistan, Turkmenistan and Uzbekistan. The appreciation in global commodity prices has led to a significant economic growth for these countries, due to their vast reserves and exports of oil, gas, agricultural products and metals. This notable growth trajectory has in return attracted a significant amount of attention for the region from international funds. While most of these investments have been in the form of Foreign Direct Investments (FDI) into private projects, the capital markets of the region have also been blossoming, although they remain largely limited in their breadth to commodity stocks. The following is a brief overview of the current state of the financial markets in the region and an assessment of the risks and opportunities they offer.
In the near term, CA economies need to respond to significant inflationary pressures, but outlook for the region remains largely positive as commodity prices should hold up and lead to higher inflows and economic growth. In the medium to long term however, in order to sustain their growth and avoid a significant external shock when commodity prices pull back, CA economies need to ensure that commodity revenues are used efficiently to diversify the economy by building value added manufacturing and tertiary sectors along with continuing structural reforms that enhance the banking system and promote transparency in financial transactions.
Commodities and Decoupling
An understanding of the global commodity markets and the decoupling between developed and emerging markets is essential to analysing capital markets in Central Asia. The region accounts for roughly 4% of the world's oil and gas reserves and 3% of production. By 2015, production is expected to double to 6% of the global total. Central Asia is also abundant in arable land and holds significant reserves in zinc, lead, copper, uranium and gold. Booming commodity prices have clearly been a major factor in propelling GDP growth and driving the development of capital markets in the region. In addition to the resource rich nations in the region, other countries have also benefited from the commodity boom via remittances and foreign capital inflows that are searching for higher yields. This economic activity has largely been agnostic to the slow down in the developed world.
The demand for oil and metals are expected to remain robust, despite the continuing economic softness in the US and Europe. Decoupling between emerging markets and the West is becoming more pronounced. The Baltic Dry Bulk Index hit a new record in May (suggesting that higher commodity prices will prevail for the time being), despite weakening economic fundamentals in most developed countries. This is largely a result of Asian economies (particularly China and India) remaining resilient even with a slowdown in exports to the US. The infrastructure boom, and to a lesser extent, the emergence of a middle class (and the associated higher energy demand) in Asia should continue to keep commodity prices elevated. In addition to resilient demand for these commodities, a depreciating US dollar (resulting from a weakening economic outlook and lower interest rates) and supply bottlenecks globally have further elevated oil prices. Azerbaijan, Turkmenistan and Kazakhstan should benefit from higher oil prices. Kazakhstan also holds approximately 3% of global copper reserves and a little under 5% of iron ore reserves. Both commodities have escalated sharply due to industrial demand from emerging markets and supply shortages, resulting in further export revenues for Kazakhstan.
The region will also play a major role during an era of rising food inflation. Economic growth in emerging markets has resulted in an increased demand for protein, which requires a disproportionate increase in the demand for grains. Additionally, the search for renewable energy derived from grains (particularly corn and sugar based ethanol) has tightened the market further. Kazakhstan has a significant amount of arable land and should benefit from higher agricultural prices. More recently however, the government has employed protectionist measures to ensure that domestic food demand is met first. Earlier this year, this meant placing restrictions on the amount of wheat farmers can export. This could create a long term issue as farmers in Kazakhstan will not be able to reap the benefit of higher global prices and could lead to a drop in their efficiency.
Countries in the region that lack natural resources have been receiving inflows from oil and resource rich nations that are looking to diversify their investments and hedge their exposure to commodity prices. Along with China, there has been a surge of petrodollar created sovereign wealth funds in the Middle East, and this money is seeking higher returns than what the US or Europe can offer at this time. The result is increased capital inflows from these countries into emerging markets, including Central Asian economies. The population of nations that lack natural resources are also benefiting from increased employment opportunities abroad. This has translated into significant remittances for the home country of the labour force.
In the medium to long term, investors need to be cautious of a global risk appetite for emerging markets and oil supply prices. A prolonged economic slow down in the developed world may finally take its toll on Central Asia. A potential recession in the US or Europe could destroy enough demand and result in a significant pull back in oil prices. Furthermore, a protracted economic slowdown in the West could eventually lower the investor risk appetite for emerging markets. This could significantly lower capital inflows into Central Asia. Finally, supply bottlenecks that have lead to the recent rally in oil prices could reverse. There is already chatter about Saudi Arabia looking to significantly increase its output to help bring down oil prices.
Convergence
When analysing the investment merits of the countries in Central Asia, special attention needs to be given to the breadth of economic development in the specific country. Countries that are exposed to a single source of revenue are more vulnerable to external shocks and will therefore carry a higher risk of investment. Economies in the region that are driven by commodities are inevitably exposed to potentially volatile swings in global prices. These prices are largely driven by external factors (global demand and supply, business and credit cycles) that the exporting country has little or no control over. For sustainable economic growth and healthy investment returns, the region needs to efficiently use its gains from commodity exports to broaden the manufacturing and services industries, continue to pass structural reforms and deepen their financial markets. These actions can potentially put the Central Asian economies on a converging path with Russia and Eastern Europe. However, we are still at the very early stages of convergence and investors need to appreciate the shallowness and vulnerability in some of these markets.
On the positive front, the current account surplus of oil exporting countries in the region will continue to increase as commodity prices remain elevated. This has resulted in significantly greater fiscal spending and rising budgetary expenditures by governments in the region. Spending has the potential of generating growth for the non-commodity related sectors of the economy, and the resulting depth in the economies will allow them to better weather a potential downturn in commodity prices.
The growth of the middle class is a good indicator of sustainable economic development. In Kazakhstan, the oil revenues have fuelled growth in the services and construction sectors. However, the credit crunch of 2007 has largely stalled this boom. As a result, the middle class, who accounts for a little under 10% of the population is unlikely to blossom in the near term. The middle class in the rest of the region is also very small - only 8% of Georgia's population and below 5% in other countries. With the absence of a bourgeoning middle class with an appetite for goods and services, investors need to remain cautious of domestic demand driven investment opportunities.
Structural reforms are also at the early stages and need to pick up. According to the World Bank's Ease of Doing Business survey, only Georgia and Armenia ranked in the top 50 globally. For sustained growth, the banking industry in the region also needs to address the issues with their non performing loans and foreign borrowing. Without a sound financial system, domestic markets will continue to be very vulnerable to global credit shocks.
Current Profile of the Markets
The region overall grew by an impressive 12% in 2007 and has been growing over 10% per year over the last four years largely due to soaring commodity prices and the resulting boom in domestic demand. Oil exporting countries in the region - Azerbaijan, Kazakhstan and Turkmenistan - have been direct beneficiaries of this trend. Growth was most impressive at a 20% clip in Azerbaijan, where oil production now accounts for over 60% of the economy. Structural reforms in the business landscape and the resulting credit boom drove the GDP growth in the remaining countries. Georgia is a clear standout on that front. In the near term, inflationary pressures and external debt in some of the countries remain key concerns for investors.
Amongst the capital markets in the region, Kazakhstan is a clear leader in terms of capitalisation and trading volume. Market capitalisation has reached almost $100 billion and daily trading is now a little under $250 million per day. However, the breadth of the market is still rather narrow, with commodity related stocks representing more than 70% of the capitalisation, and domestic banks making up most of the remainder. Higher commodity prices have led to an impressive GDP growth of 10.6% in 2006 and over 8.5% in 2007. Oil driven inflows have fuelled the development of the services sector (particularly financial, banking, telecommunications and transports) and increased construction activity. But there are near term risks associated with the strong pace of economic expansion. Firstly, consumer price inflation is expected to rise from 10.8% in 2007 to almost 17.1% in 2008. The National Bank of Kazakhstan will likely have to continue tightening its monetary policy. This may dampen the pace of domestic investments. Secondly, in order to keep up with the country's growth and meet the booming domestic credit demand, banks accumulated a significant amount of foreign debt over the last two years. Foreign debt was almost 90.5% of 2007 GDP vs. 76% in 2005, leaving Kazakhstan vulnerable to the global credit crunch. The credit issues ahead of Kazakhstan put the local currency at risk of loosing value. Without a strong currency, sustainable development of the domestic markets will be very tough. Weakness in currency usually makes it a lot tougher for the middle class to gain wealth and the non-oil sectors to grow. However, in the medium term, the investment prospects in Kazakhstan look attractive as the development of oilfields will continue to generate high FDI inflows and external debt is projected to retrench to about 73% of GDP at the end of 2008. Kazakh banks may become an interesting investment theme when the current credit crunch abates, and in the meantime there are several public stocks to investment in the oil sector.
The other significant oil exporters in the region - Azerbaijan and Turkmenistan - have also been posting outstanding economic growth in recent years and are worth monitoring. Turkmenistan has grown its GDP over 11% in the last two years and is a very intriguing investment opportunity. Its oil prospects are abundant and sources indicate that by 2015, Turkmenistan's oil and gas production per capita could be at the same level as Kuwait. If the oil related inflows trickle down to the rest of the economy and generate a broad based wealth, the country's economy could be on a path to converge with Russia and Eastern Europe faster than most investors anticipate. The foreign debt position is also accommodating at only 2% of GDP in 2007. However, to materialise these prospects, Turkmenistan needs to carry out significant structural reforms and liberalise its economy. The private sector is still only a fraction of the GDP and faces significant barriers. There have also been challenges with stabilising the currency, and rising inflation (projected to go from 6.4% in 2007 to 12% in 2008) could worsen things. These might create near term volatility in the economy, but the government seems to be moving in the right direction. They have unified the exchange rates of the manat and will be re-denominating the currency in early 2009. There are public energy companies from Turkmenistan that investors should keep an eye on.
Azerbaijan has also benefited substantially from oil driven revenues, growing GDP at 30% in 2006 and 23.4% in 2007. While dealing with inflationary pressures (consumer price inflation is likely to reach 19.6% in 2008) that are common to the rest of the region, Azerbaijan is also facing depleting resources, with oil production likely to peak in 2011 in the absence of any further explorations. Unfortunately, income from oil exports did not trickle down to the rest of the economy and the country still faces steep poverty and unemployment. Absence of a broad economic engine makes Azerbaijan a less appealing investment opportunity.
Georgia is one of the more intriguing non-oil driven economies in the region. While still considered a low income country, Georgia has placed its economy on an impressive growth trajectory, despite lacking the natural resources that are abundant elsewhere in the region. The reform agenda that was spearheaded by Saakashvili has lead to an average GDP growth of 9.3% in the last four years. The agenda included aggressive privatisation, liberalisation of foreign trade and increasing the efficiency of tax collection. The conditions for doing business improved at an outstanding pace and magnitude, attracting significant FDI and leading to broad based pick up in the economy. Dependence on Russian gas remains an issue and the inflationary pressures faced by the region are also present in Georgia. The capital markets lack any meaningful depth and the banking regulation needs to be tightened. It is still too early to invest in the emergence of a middle class in Georgia, but the reforms are keeping the country on the right path.
Conclusion
Rising commodity prices, successful structural reforms and bourgeoning domestic markets have made Central Asia a very unique region for investors. Assets in developed countries are likely to continue to under perform in the near to medium term and capital in search of higher yields is likely to continue to flow into Central Asia. Despite the stellar GDP growth over the last few years, Kazakhstan is still the only noteworthy capital market in the region. But even there, investment opportunities are still largely tied to commodities. At some point, other sectors, driven by booming domestic demand and convergence with Europe and Russia will become attractive, but there are currently very limited ways to invest in the theme. Azerbaijan and Turkmenistan also offer attractive investment opportunities due to their natural resources, but the financial markets are still at an infant stage and the lack of a broad economy make these countries vulnerable to external shocks. Georgia is an important case study in how rewarding structural reforms can be for the region, but again lacks any meaningful depth in its capital markets.
The positive economic outlook for the region should prevail in the near term, but investors must be cautious of the inflationary pressures that are building up across the region and the foreign debt exposure of some of the CA countries. In the long term, sustained growth and the investment appeal of the region will depend on how efficiently current inflows are used to deepen and broaden the capital markets. Governments in the region must also continue to work on implementing market-minded reforms and improving corporate governance under broader transparency.

*Energy Strategist, Former BOTAŞ Chairman and CEO