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---

### I. RESOLVING NONPERFORMING LOANS — Introduction and background
- Banks face a high and rising stock of nonperforming loans (NPLs); system-wide NPLs likely to peak at over 30 percent (on a 90-day basis).
- Failure to adopt a comprehensive and transparent resolution strategy could:
  - Result in further capital losses and contingent fiscal risks.
  - Threaten banks’ compliance with regulatory standards.
  - Limit banks’ ability to lend and impede economic recovery.
- A centralized approach to asset resolution may be warranted and could be based on a reinvigorated Distressed Asset Fund (DAF).
- Any strategy must be supported by a full, forward looking assessment of banks’ balance sheets and strengthened prudential frameworks.

### I.B Balance sheet vulnerabilities — key findings
- Main vulnerabilities:
  - Excessive lending in foreign exchange to the nontradeables sector.
  - Reliance on wholesale funding from abroad.
  - Shortcomings in the regulatory and supervisory framework.
- Recent interventions and supports:
  - Authorities intervened in two top banks, took stabilizing equity stakes in two other leading banks, and provided widespread liquidity support, including targeted placement of deposits of state owned enterprises.
- Provisioning and capital dynamics:
  - Aggregate provisioning-to-90-day NPLs reported above 100 percent but the ratio has been falling over time.
  - Restructured loans are not fully reflected; a percentage may revert to NPL status, driving provisioning coverage below 100 percent for most top banks.
  - Regulatory capital has declined by $17.7 billion from end 2007, even taking into account equity injections by SK in BTA, Alliance, Halyk and KKB amounting to $2.7 billion.
  - As of April 2010, regulatory capital was equivalent to -2.9 percent of GDP (mainly reflecting insolvency of BTA, Alliance, and Timur Bank). Regulatory capital for other banks remained just over 8 percent of GDP.
- Forward-looking implications:
  - Slow recovery or further declines in hard-hit sectors (real estate, construction, nontradeables) could leave banks undercapitalized and credit growth stalled.
  - A credit crunch could induce additional borrower stress and generate a vicious circle of credit deterioration.
  - Even banks with CARs above minimums may find those levels insufficient for international borrowing under stricter prudential norms.

### I.C Forward-looking balance sheet sensitivity — key statistics (selected figures preserved)
- Actual Data (End March 2010):
  - NPLs (90 Day Basis): 25.1
  - NPLs (90 Day Basis) 2/: 21.7
  - Bad Debt Write Offs 2/: 4.1
  - Provisions/90 Day NPLs 1/: 1.5
  - Capital Adequacy Ratio (%): -3.8
  - Number of banks below 12% CAR: 3.0
  - Number of top 6 banks below 12% CAR: 2.0
  - Number of banks with negative capital: 3.0
  - Number of top 6 banks with negative capital: 2.0
  - Recapitalization requirements for return to 12% CAR (US$ bn): 12.6
  - In % of 2010 GDP: 10.2
- Scenario 1 (30% NPLs for all Banks):
  - NPLs (90 Day Basis): 30.0
  - NPLs (90 Day Basis) 2/: 30.0
  - Bad Debt Write Offs 2/: 6.0
  - Provisions/90 Day NPLs 1/: 1.3
  - Provisions/90 Day NPLs 3/: 0.9
  - Capital Adequacy Ratio (%): -16.2
  - Capital Adequacy Ratio (%) 3/: 19.4
  - Number of banks below 12% CAR: 10.0
  - Number of top 6 banks below 12% CAR: 4.0
  - Number of banks with negative capital: 5.0
  - Number of top 6 banks with negative capital: 4.0
  - Recapitalization requirements for return to 12% CAR (US$ bn): 21.6
  - In % of 2010 GDP: 17.5
- Scenario 2 (40% NPLs for all Banks):
  - NPLs (90 Day Basis): 40.0
  - NPLs (90 Day Basis) 2/: 40.0
  - Bad Debt Write Offs 2/: 8.0
  - Provisions/90 Day NPLs 1/: 1.0
  - Provisions/90 Day NPLs 3/: 0.7
  - Capital Adequacy Ratio (%): -22.8
  - Capital Adequacy Ratio (%) 3/: 8.7
  - Number of banks below 12% CAR: 13.0
  - Number of top 6 banks below 12% CAR: 6.0
  - Number of banks with negative capital: 5.0
  - Number of top 6 banks with negative capital: 4.0
  - Recapitalization requirements for return to 12% CAR (US$ bn): 25.0
  - In % of 2010 GDP: 20.2
- Table notes:
  - All scenarios assume (i) average provisioning of 33 percent on NPLs less than 90 days, and 75 percent on NPLs over 90 days that include bad debts not recognized and 100 percent on write offs; (ii) bad debt write offs are 20 percent of NPLs; and (iii) excludes impact of restructuring agreements to be finalized in 2010.
  - 2/ In percent of total loans.
  - 3/ Excludes restructuring banks.

### I.D Current resolution practices and institutional features
- Inconsistent and insufficient resolution processes:
  - Industry reports indicate 15 to 25 percent of loans at top banks have been restructured and only 4 percent written off.
  - Banks reluctant to write off loans due to adverse tax consequences and expectations of asset value recovery.
- Distressed Asset Fund (DAF) status:
  - DAF established in 2008 to absorb toxic assets as part of the ACP; its mandate has been altered toward providing targeted lending to SMEs and specific construction projects.
  - To date, the DAF has only made placements and loans to banks using its entire capital base of $500 million.
- Policy initiatives supporting priority sectors (including subsidized credits) risk distorting market activity and generating additional NPLs.

### I.E Options for NPL resolution — approaches and international lessons
- Three broad approaches:
  1. Centralized public sector asset management company (AMC) for system-wide resolution.
  2. Decentralized public sector AMC focused on a single bank or group of banks.
  3. Bank-centric approach: private banks manage their own NPLs (internal AMCs, work out units, loan forbearance).
- International experience:
  - Centralized AMC often more effective for comprehensive cleanup, but choice must weigh fiscal cost, moral hazard, and need for speed, transparency, and consistency.
  - Managing NPLs requires complex skills; restructuring should be swift, transparent, consistent, and time-bound.
- Risks of decentralized/private approaches:
  - “Extend and pretend” model leaves lingering bad assets, limits liquidity, delays lending recovery, and avoids marking assets to current prices, mitigating immediate capital injection needs but risking contingent fiscal liabilities.

### I.F Policy considerations and recommendations — synthesized priorities
- Conduct a full, forward looking assessment of banks’ balance sheets to determine actual provisioning and capital needs.
- Consider a centralized resolution vehicle (reinvigorated DAF/AMC) given scale of NPLs and regulatory/legal shortcomings.
- Strengthen prudential frameworks and align supervisory practices with evolving international standards (higher capital and liquidity buffers, enhanced risk management).
- Avoid policy measures that distort market pricing or encourage moral hazard (for example, subsidized credit to priority sectors that may create future NPLs).
- Implement time-bound, transparent, and consistent restructuring programs with clear incentives for write-offs where appropriate.
- Prepare for potential recapitalization needs: scenarios indicate recapitalization requirements of $12.6 billion (Actual baseline) up to $25.0 billion (40% NPLs scenario), equivalent to 10.2 percent to 20.2 percent of 2010 GDP respectively.

*Prepared by IMF staff team (Ana Lucía Coronel, Dmitriy Rozhkov, Ali Al-Eyd, Neil Saker) — June 28, 2010.*

---

### 12. The authorities create and capitalize an AMC to purchase NPLs from all commercial banks — purpose, mechanics, and standards

### AMC purpose and operational mechanics
- NPLs are exchanged with government issued (or backed) bonds or cash.
- Process is typically facilitated by a full diagnostic audit and forward looking assessment of banks’ assets and capital.
- Freed from nonperforming assets, banks are better able to restart lending activities, while the AMC disposes of or restructures the NPLs for future sale.
- A centralized AMC can help preserve the value of bank assets by effectively setting a minimum price and preventing assets being sold at a “fire-sale” when markets are thin.

### Minimum conditions and standards for successful AMCs
- Successful AMCs are supported by:
  - (1) sufficient capital;
  - (2) strong regulatory, prudential, and corporate governance frameworks;
  - (3) adequate legal frameworks (effective collateral, foreclosure, and bankruptcy laws);
  - (4) transparency and accountability (regular reporting and public oversight);
  - (5) appropriate asset valuation methods.
- Appropriate asset valuation requires banks to mark assets to market values, which must then be offset by additional capital—potentially taking current shareholders to zero and/or topping up the remaining requirement with government capital.
- Note: Assets marked at face value would initially preserve banks’ balance sheets, but would raise fiscal costs as the AMC would bear the burden of eventual write downs.
- Regulatory forbearance practices: incremental capital requirements have been used to ease burdens, but such “institutional regulatory forbearance” must be transparent and supported by a strong regulatory framework.

### Decentralized public-sector AMC model
- Authorities can create and capitalize an AMC to purchase NPLs from a single large bank (public sector decentralized AMC).
- More than one AMC can be created to address NPLs in alternate banks where problem loans are concentrated in particular groups or sectors.
- Example experiences cited: Kazakhstan in the mid-1990s; China in 1999 when four AMCs were created and funded by the Ministry of Finance for the four large state owned commercial banks.

### Private-sector AMC and internal bank procedures
- Individual banks may establish their own AMCs or restructuring programs via:
  - (1) internal “workout unit” (good bank/bad bank model) where bad assets are transferred and held for disposal or restructuring and future sale; or
  - (2) lengthening maturities of existing loans (“extend and pretend”, or “evergreen”) leaving assets unmarked until potential recovery.
- Workout units may remain within the bank or be transferred to separate subsidiaries with their own balance sheets.
- Authorities can facilitate private-sector AMCs via laws or fiscal incentives (for example, removing tax distortions).
- Risks of the “extend and pretend” model: lingering bad assets that limit liquidity and delay lending recovery; it avoids marking assets to current prices and so mitigates immediate capital injection needs.
- Decentralized approaches require regulatory forbearance and the ability to maintain depositor confidence—potentially needing public support (continued placement of public entity deposits and/or enhanced deposit insurance).
- A key risk is contingent fiscal liability should private sector asset values fail to recover.

### Kazakhstan experience (Box I.2) — facts and lessons
- By 1994, three AMCs had been created: Rehabilitation Bank (RB), Agricultural Support Fund (ASF), and Exim Bank.
- Loans amounting to 11 percent of GDP were transferred to these AMCs, while state bank exposure to SMEs remained on banks’ books.
- Authorities promoted loan restructuring instead of foreclosure to guard against negative social and economic impacts.
- Prudential and regulatory frameworks were strengthened with new capital requirements and limits on exposures, accompanied by regulatory forbearance permitting banks to meet new requirements over time, backed by enhanced surveillance of noncompliant banks.

### Key lessons from international AMC experience
- Centralized AMCs are most effective when systemic fragility and weak legal infrastructure exist; government backing provides coordination, legal process support, timeliness, and concentration of expertise.
- Risks if AMCs are poorly designed or resourced:
  - Fiscal costs: substantial upfront budget resources could raise the public sector’s debt burden.
  - Operational costs: inefficient management can incur high operational costs, slow resolution, and erode asset value; importance of experienced personnel and profit-maximizing management.
  - Reputational costs: susceptibility to political interference and corruption; operational independence is crucial. Placement under the budget administration from inception promotes transparency.

### Policy considerations for Kazakhstan — DAF operational and design principles
- A centralized AMC (the DAF) may be most suitable given the scale of NPLs, ongoing asset quality deterioration, and shortcomings in legal and regulatory structures.
- Operational and design principles:
  - Avoid incentives for moral hazard; ensure operational independence, transparency, and public accountability.
  - Require banks to recognize current losses; this may create capital adequacy issues and confidence concerns.
  - Consider an incremental approach to capital adequacy in cooperation with the FSA, aiming to meet future international minimum standards, while avoiding regulatory forbearance.
  - Establish a recapitalization program to support NPL carve outs.
  - Maintain appropriate incentives via profit sharing mechanisms with banks to preserve loan value and reduce fiscal costs; tax structure should support loan sales to the DAF.
  - Undertake corporate sector restructuring to address underlying causes of NPLs and avoid recurrence, especially where policies subsidize or guarantee lending to priority sectors.
  - Ensure speedy disposal of NPLs, including to foreign investors, balancing fire-sale risks against rapid deterioration of NPL values.
  - Impose a time-bound operating horizon with hard performance targets for the DAF to limit bureaucratic entrenchment and perception as a dumping ground.

### Conclusion and operational imperatives for NPL strategy
- Kazakhstan should undertake a consistent, comprehensive NPL resolution approach to complement ongoing initiatives; timely, proactive, country-tailored measures are valuable.
- Any strategy must be accompanied by:
  - A full diagnostic assessment of all systemically important banks based on recapitalization needs;
  - Stress and sensitivity analysis to assess the size and depth of the problem;
  - Identification and remediation of gaps in regulatory, prudential, governance, tax, and legal frameworks, and appropriate enhancements undertaken.

*Source: _cr10237 - 12.      The authorities create and capitalize an AMC to purchase NPLs from all*

---

### 3. Commodity producing countries often choose to target some measure of fiscal — fiscal rules, oil revenues, and Kazakhstan

### Fiscal rules and commodity revenue volatility — rationale and recommendations
- Commodity producers often target a fiscal balance that excludes commodity export revenues to insulate the budget from commodity price volatility and avoid boom-bust cycles.
- Policy recommendations commonly given:
  - (1) The non-commodity balance should feature prominently in the formulation of fiscal policy.
  - (2) The non-commodity balance, especially expenditure, should be adjusted gradually to avoid destabilizing aggregate demand.

### Preconditions and limits of fiscal rules
- Fiscal rules aim to constrain suboptimal government choices and are conceptually similar to self-imposed constraints used by individuals.
- Empirical evidence suggests fiscal rules tend to bring intended benefits and have been linked with improved fiscal performance, but:
  - Direction of causality is not always clear.
  - Rules work best with a track record of good policies and stable conditions.
  - Rules can encourage “creative accounting,” especially when targets are complicated.
- Preconditions for effective rules:
  - Strong political commitment, credibility, transparency, accountability.
  - Strong public financial management (PFM): reliable data, technical forecasting, timely reporting, credible audits.

### Global tendencies and illustrative country cases
- Number of countries with some form of fiscal rule increased from 7 in 1990 to 80 in 2009 (IMF, 2010).
- Illustrative cases summarized:
  - Australia: Fiscal Responsibility Law with broad targets; expenditure rule restraining real growth in spending to 2 percent per year after economy grows above trend until surplus reaches at least 1 percent of GDP.
  - Chile: explicit numerical rule targeting structural balance; structural balance targets noted for 2002-09.
  - Norway: numerical rule targeting non-oil structural deficit equal to the long-run real return on the Government Pension Fund – Global (assumed 4 percent).

### Kazakhstan: terms of trade, oil revenues, and fiscal stance (2003–09)
- Terms of trade increased by over 40 percent between 2003 and 2007.
- Oil accounts for almost one fourth of GDP, 60 percent of total exports, and 40 percent of total budget revenues.
- Oil fiscal outcomes:
  - Fiscal revenues from oil increased from $1 billion in 2001 to $17 billion in 2008 (or from 4½ to 12½ percent of GDP).
  - National Oil Fund (NFRK) assets reached $27.5 billion by end-2008.
  - At the peak of oil prices in 2006-07, about 60 percent of oil revenues were saved in the NFRK.
- Spending and debt:
  - Government spending remained relatively constant as a percentage of GDP until 2008.

### National Fund of the Republic of Kazakhstan (NFRK) — composition and rules
- Currency composition of NFRK assets as of end-March 2010:
  - 56 percent in U.S. dollars.
  - 26 percent in euros.
  - 7 percent in U.K. pounds.
  - 7 percent in Japanese yen.
  - 4 percent in Australian dollars.
- New NFRK concept (early 2010) sets:
  - limit on the annual guaranteed transfer at $8 billion (calculated as the average actual transfer in U.S. dollar terms during the last 5 years),
  - minimum NFRK balance of 20 percent of projected GDP at the end of the respective fiscal year,
  - guaranteed annual transfer to be reduced if expected balance falls short of the minimum requirement.

### 2008–09 fiscal response and fiscal impulse
- Anti-crisis measures: automatic stabilizers, tax cuts in non-extractive sectors, increases in pensions, public sector wages, and social benefits.
- Fiscal impulse estimates:
  - Total fiscal impulse from the general government budget in 2008-09 at about 4½ percent of GDP.
  - Including off-budgetary spending, estimate increases to about 7½ percent of GDP.
- Outcomes:
  - Overall fiscal balance went into deficit in 2009; non-oil deficit exceeded 11 percent of GDP.
  - Deficit expected to increase further in 2010; estimated structural balance moved from a surplus of 3½ percent of GDP in 2007 to a deficit of 4 percent of GDP in 2009 and 2010.

### Need for fiscal consolidation and role for a fiscal rule in Kazakhstan
- Maintaining current deficit levels would result in either a rundown of oil savings or rapid increase in government debt.
- Substantial fiscal consolidation required to return fiscal position to pre-crisis levels.
- A formal fiscal rule could be useful within a medium-term framework to support credibility; key decision is how much to spend out of oil revenues.

### Sustainable spending from oil revenue — projection approach and results (Perpetuity Equivalent, billions of 2009 U.S. dollars)
- Assumptions: production reaches about 120 million tons a year (2.5 million barrels per day) in 2016-17; two oil price scenarios; calculations in constant 2009 U.S. dollars; horizons 2010-50 and 2010-75; discount rates 3, 4, and 5 percent.
- High Price Scenario:
  - Discount Rate 3 percent: Horizon 2050 = 11.2; Horizon 2075 = 13.2
  - Discount Rate 4 percent: Horizon 2050 = 12.7; Horizon 2075 = 14.3
  - Discount Rate 5 percent: Horizon 2050 = 13.6; Horizon 2075 = 14.9
- Low Price Scenario:
  - Discount Rate 3 percent: Horizon 2050 = 9.0; Horizon 2075 = 10.6
  - Discount Rate 4 percent: Horizon 2050 = 10.2; Horizon 2075 = 11.5
  - Discount Rate 5 percent: Horizon 2050 = 10.9; Horizon 2075 = 11.9
- Interpretation:
  - Calculations suggest annual spending out of oil revenues of $10-11 billion in constant 2009 dollars should be affordable in the medium term.

---

### 20. The actual annual spending of oil revenues could be set at a level lower than $10-11 billion — practical guidance

### Fiscal framework for spending oil revenues
- Recommendation: actual annual spending of oil revenues could be set at a level lower than $10-11 billion for the moment, to allow spending to grow in line with GDP.
- Projection: Real GDP is projected to grow at a 4-6 percent rate in the medium term.
- Practical proposal: The $8 billion per year ceiling set in the new NFRK concept could be a good starting point in 2010, but could be allowed to grow in later years in line with GDP.
- Rationale: Keeping expenditure constant as percentage of GDP would, over the next decade, produce total expenditure equivalent to the $10-11 billion per year suggested by staff calculations.

### Numerical targets and non-oil fiscal balance
- Suggested ceiling on spending out of oil revenues is equivalent to 6-7 percent of GDP.
- Policy design: Set 6-7 percent of GDP as an explicit ceiling for the non-oil deficit (implying a zero overall balance).
- Historical comparison:
  - Non-oil deficit was less than 5 percent of GDP in 2007.
  - Current level of non-oil deficit reported as 11 percent of GDP in 2009, and expected to reach 14 percent in 2010.
- Note: The 6-7 percent non-oil deficit target appears more realistic than the target of 3 percent of GDP for the non-oil deficit by 2020 set in the new NFRK concept.

### Choice and timing of fiscal rule
- Preference: Focus on the non-oil balance rather than debt variables given low public debt.
- Alternative: A simple non-oil balance rule is preferable to a structural balance target due to complexity and sensitivity of structural calculations.
- Timing: Introduce fiscal rule after establishing a clear and credible medium-term consolidation plan and having a one or two year record of successful implementation.

### Composition of consolidation and revenue options
- Primary focus: Expenditure side; prioritize current expenditures to ensure quality of public spending consistent with growth objectives.
- Possible revenue measures if needed:
  - Strengthening broad-based taxes such as VAT.
  - Increasing externality-reducing taxes (alcohol, tobacco, fuel, property).
  - Strengthening tax compliance.

### Technical and procedural issues for an explicit deficit target
- Resolve technical issues such as preannounced steps for deviations, possible need for an independent fiscal agency, timing of implementation.
- Ensure coverage includes consolidated fiscal sector and off-budget transactions by government owned companies.
- IMF technical assistance could support addressing these issues if requested.

---

### Banking sector vulnerabilities, financial market development, and coordinated liquidity management

### Banking sector vulnerabilities and facts
- Crisis exposure: funding structure heavily reliant on foreign borrowing, leading to high dollarization of banks’ liabilities.
- Consequences:
  - Banks traded currency risk for credit risk by lending in foreign currency to unhedged corporations and households.
  - Mismatches became unsustainable when foreign capital inflows stopped, domestic currency depreciated, and recession ensued.
- Preserved specific facts and trends:
  - Deposits both in domestic and foreign currencies were about 30 percent of GDP in 2008.
  - Over 2002–07, banking sector external debt grew to about 44 percent of GDP by 2007.
  - Loan-to-GDP ratio peaked at nearly 60 percent of GDP in 2007.
  - Loan-to-deposit ratio nearly doubled, peaking above 200 percent in 2007.
  - Foreign currency deposits amounted to around 20 percent of GDP as the crisis struck in 2007, about double the figure for tenge-denominated deposits.
- Observation: Banks have relatively little exposure to sectors generating income in foreign currency (oil and gas and other minerals).

### Development priorities for domestic financial markets
- Strategic focus:
  - Increase market activity and depth, broaden investor participation, expand instrument types.
- Sequencing:
  - Deepen domestic money and bond markets; establish a government benchmark yield curve.
  - Leverage pension funds and the Kazakhstan Stock Exchange (KASE).
  - Incent private-sector innovation to spur derivatives markets as tenge-based markets evolve.
- Money and bond market reforms:
  - Broaden instruments and lengthen maturities within cohesive liquidity and public debt management guidelines.
  - Use a well defined market based interest rate structure.
  - Adopt a government bond issuance schedule with less frequent but larger auctions of standard longer-term paper; set issuance schedule for a reasonable period in advance and make it transparent.

### Coordination between government and NBK on liquidity management (summary of Section 13)
- Coordination is crucial to develop indirect policy instruments and improve monetary transmission.
- Government should increase its share of domestic securities as the NBK reduces direct presence to enable market rates to respond to NBK signals.
- Recent measures: pension funds required to hold at least 30 percent of portfolios in official domestic securities.
- IMF FSAP finds a domestically-derived yield curve should be minimum duration of 7 to 10 years.
- Benefits of deeper bond markets:
  - Well-defined benchmark yield curve, immediate domestic funding sources, improved monetary transmission, support for market-oriented government funding.
- Derivatives market development:
  - Provide hedging and price discovery; require well-functioning money and bond markets and supportive legal/regulatory frameworks.
  - Traditional outright forward markets are the appropriate starting point.
- Role of NBK and public-sector involvement:
  - NBK could initially operate forward exchange markets but must pre-commit to exposure limits and a phasing out timetable.
  - Initial public-sector steps include capitalization of a fund to provide exchange cover to importers, replenished by purchases of forward foreign exchange from exporters.
- Monetary, exchange rate, and capacity-building measures:
  - Exchange rates and interest rates must be supportive; highly liquid interbank spot and interest rate markets are necessary.
  - NBK should lead continuous training for market participants.
- Coordination among policymakers:
  - High degree of coordination across MoF, NBK, and FSA required via forward-looking fiscal strategies, supportive monetary and exchange rate policies, and enhanced legal, regulatory, and macro-prudential frameworks.
  - High-frequency information sharing (government cash flow projections, deposit access) is critical.
  - FSA can encourage institutional investor participation through prudential regulation and possible permission for pension funds to participate in derivatives markets.
- Strengthening regulation, monitoring, and risk measurement:
  - Macro-prudential frameworks must be adapted to manage exchange rate risk.
  - The FSA is implementing measures to discourage banks from assuming foreign currency liabilities and assets through NPL reclassifications, changes to capital adequacy ratios, and additional shareholder requirements.
  - Increased monitoring of corporate and household sectors is required via regular surveys capturing currency composition of incomes, foreign debts, and hedging operations.
  - Complement net and gross open position measures with forward-looking risk management techniques and standardized models across the financial sector.
- Conclusion and policy implications:
  - Reform agenda needed to develop domestic financial markets and mitigate foreign currency mismatch risks.
  - Development of markets must be accompanied by sound macro-prudential framework delivering low and stable inflation, medium-term fiscal framework, and monetary and exchange rate policies geared toward lower inflation and increased currency flexibility.
  - Effective communication and close coordination among policymakers should drive the process.

*Source: Excerpt from IMF staff discussion in the supplied content unit.*

### 2010. The views expressed in this document are those of the staff team and do not necessarily reflect

### I. RESOLVING NONPERFORMING LOANS

### A. Introduction and Background
- Banks face a high and rising stock of nonperforming loans (NPLs); system-wide NPLs likely to peak at over 30 percent (on a 90-day basis).
- Failure to adopt a comprehensive and transparent resolution strategy could:
  - Result in further capital losses and contingent fiscal risks.
  - Threaten banks’ compliance with regulatory standards.
  - Limit banks’ ability to lend and impede economic recovery.
- A centralized approach to asset resolution may be warranted and could be based on a reinvigorated Distressed Asset Fund (DAF).
- Any strategy must be supported by a full, forward looking assessment of banks’ balance sheets and strengthened prudential frameworks.

### B. Balance Sheet Vulnerabilities — key findings
- Main vulnerabilities:
  - Excessive lending in foreign exchange to the nontradeables sector.
  - Reliance on wholesale funding from abroad.
  - Shortcomings in the regulatory and supervisory framework.
- Recent interventions and supports:
  - Authorities intervened in two top banks, took stabilizing equity stakes in two other leading banks, and provided widespread liquidity support, including targeted placement of deposits of state owned enterprises.
- Provisioning and capital dynamics:
  - Aggregate provisioning-to-90-day NPLs reported above 100 percent but the ratio has been falling over time.
  - Restructured loans are not fully reflected; a percentage may revert to NPL status, driving provisioning coverage below 100 percent for most top banks.
  - Regulatory capital has declined by $17.7 billion from end 2007, even taking into account equity injections by SK in BTA, Alliance, Halyk and KKB amounting to $2.7 billion.
  - As of April 2010, regulatory capital was equivalent to -2.9 percent of GDP (mainly reflecting insolvency of BTA, Alliance, and Timur Bank). Regulatory capital for other banks remained just over 8 percent of GDP.
- Forward-looking stress (summary of implications):
  - Slow recovery or further declines in hard-hit sectors (real estate, construction, nontradeables) could leave banks undercapitalized and credit growth stalled.
  - A credit crunch could induce additional borrower stress and generate a vicious circle of credit deterioration.
  - Even banks with CARs above minimums may find those levels insufficient for international borrowing under stricter prudential norms.

### C. Forward-Looking Balance Sheet Sensitivity (Table I.1 — selected figures preserved)
- Actual Data (End March 2010):
  - NPLs (90 Day Basis): 25.1
  - NPLs (90 Day Basis) 2/: 21.7
  - Bad Debt Write Offs 2/: 4.1
  - Provisions/90 Day NPLs 1/: 1.5
  - Capital Adequacy Ratio (%): -3.8
  - Number of banks below 12% CAR: 3.0
  - Number of top 6 banks below 12% CAR: 2.0
  - Number of banks with negative capital: 3.0
  - Number of top 6 banks with negative capital: 2.0
  - Recapitalization requirements for return to 12% CAR (US$ bn): 12.6
  - In % of 2010 GDP: 10.2
- Scenario 1 (30% NPLs for all Banks):
  - NPLs (90 Day Basis): 30.0
  - NPLs (90 Day Basis) 2/: 30.0
  - Bad Debt Write Offs 2/: 6.0
  - Provisions/90 Day NPLs 1/: 1.3
  - Provisions/90 Day NPLs 3/: 0.9
  - Capital Adequacy Ratio (%): -16.2
  - Capital Adequacy Ratio (%) 3/: 19.4
  - Number of banks below 12% CAR: 10.0
  - Number of top 6 banks below 12% CAR: 4.0
  - Number of banks with negative capital: 5.0
  - Number of top 6 banks with negative capital: 4.0
  - Recapitalization requirements for return to 12% CAR (US$ bn): 21.6
  - In % of 2010 GDP: 17.5
- Scenario 2 (40% NPLs for all Banks):
  - NPLs (90 Day Basis): 40.0
  - NPLs (90 Day Basis) 2/: 40.0
  - Bad Debt Write Offs 2/: 8.0
  - Provisions/90 Day NPLs 1/: 1.0
  - Provisions/90 Day NPLs 3/: 0.7
  - Capital Adequacy Ratio (%): -22.8
  - Capital Adequacy Ratio (%) 3/: 8.7
  - Number of banks below 12% CAR: 13.0
  - Number of top 6 banks below 12% CAR: 6.0
  - Number of banks with negative capital: 5.0
  - Number of top 6 banks with negative capital: 4.0
  - Recapitalization requirements for return to 12% CAR (US$ bn): 25.0
  - In % of 2010 GDP: 20.2
- Notes from table:
  - All scenarios assume (i) average provisioning of 33 percent on NPLs less than 90 days, and 75 percent on NPLs over 90 days that include bad debts not recognized and 100 percent on write offs; (ii) bad debt write offs are 20 percent of NPLs; and (iii) excludes impact of restructuring agreements to be finalized in 2010.
  - 2/ In percent of total loans.
  - 3/ Excludes restructuring banks.

### D. Current Resolution Practices and Institutional Features
- Resolution processes have been inconsistent and insufficient:
  - Industry reports indicate 15 to 25 percent of loans at top banks have been restructured and only 4 percent written off.
  - Banks reluctant to write off loans due to adverse tax consequences and expectations of asset value recovery.
- Distressed Asset Fund (DAF) status:
  - DAF established in 2008 to absorb toxic assets as part of the ACP; its mandate has been altered toward providing targeted lending to SMEs and specific construction projects.
  - To date, the DAF has only made placements and loans to banks using its entire capital base of $500 million.
- Policy initiatives supporting priority sectors (including subsidized credits) risk distorting market activity and generating additional NPLs.

### E. Options for NPL Resolution — analysis of approaches
- Three broad approaches observed in international experience:
  1. Centralized public sector asset management company (AMC) for system-wide resolution.
  2. Decentralized public sector AMC focused on a single bank or group of banks.
  3. Bank-centric approach: private banks manage their own NPLs (internal AMCs, work out units, loan forbearance measures such as loan duration extensions).
- International experience suggests a centralized AMC is often more effective for comprehensive cleanup, but strategy choice must weigh fiscal cost, moral hazard, and need for speed, transparency, and consistency.
- Managing NPLs requires complex skills and competence; restructuring should be swift, transparent, consistent, and time-bound.

### F. Policy Considerations and Recommendations (synthesized)
- Priorities for authorities and banks:
  - Conduct a full, forward looking assessment of banks’ balance sheets to determine actual provisioning and capital needs.
  - Consider a centralized resolution vehicle (reinvigorated DAF/AMC) given scale of NPLs and regulatory/legal shortcomings.
  - Strengthen prudential frameworks and align supervisory practices with evolving international standards (higher capital and liquidity buffers, enhanced risk management).
  - Avoid policy measures that distort market pricing or encourage moral hazard (for example, subsidized credit to priority sectors that may create future NPLs).
  - Implement time-bound, transparent, and consistent restructuring programs with clear incentives for write-offs where appropriate.
  - Prepare for potential recapitalization needs: scenarios indicate recapitalization requirements of $12.6 billion (Actual baseline) up to $25.0 billion (40% NPLs scenario), equivalent to 10.2 percent to 20.2 percent of 2010 GDP respectively.

*Prepared by IMF staff team (Ana Lucía Coronel, Dmitriy Rozhkov, Ali Al-Eyd, Neil Saker) — June 28, 2010.*

### 12.      The authorities create and capitalize an AMC to purchase NPLs from all

### 12.      The authorities create and capitalize an AMC to purchase NPLs from all commercial banks

### AMC purpose and operational mechanics
- NPLs are exchanged with government issued (or backed) bonds or cash.
- Process is typically facilitated by a full diagnostic audit and forward looking assessment of banks’ assets and capital.
- Freed from nonperforming assets, banks are better able to restart lending activities, while the AMC disposes of or restructures the NPLs for future sale.
- A centralized AMC can help preserve the value of bank assets by effectively setting a minimum price and preventing assets being sold at a “fire-sale” when markets are thin.

### Minimum conditions and standards for successful AMCs
- Country experience indicates successful AMCs are supported by:
  - (1) sufficient capital;
  - (2) strong regulatory, prudential, and corporate governance frameworks;
  - (3) adequate legal frameworks (namely effective collateral, foreclosure, and bankruptcy laws);
  - (4) transparency and accountability (maintained through regular reporting and public oversight);
  - (5) appropriate asset valuation methods.
- Appropriate asset valuation requires banks to mark assets to market values, which must then be offset by additional capital—potentially taking current shareholders to zero and/or topping up the remaining requirement with government capital.
- Note: Assets marked at face value would initially preserve banks’ balance sheets, but would raise fiscal costs as the AMC would bear the burden of eventual write downs.
- Regulatory forbearance practices: incremental capital requirements have been used to ease burdens, but such “institutional regulatory forbearance” must be transparent and supported by a strong regulatory framework.

### Decentralized public-sector AMC model
- Authorities can create and capitalize an AMC to purchase NPLs from a single large bank (public sector decentralized AMC).
- More than one AMC can be created to address NPLs in alternate banks where problem loans are concentrated in particular groups or sectors.
- Example experiences: Kazakhstan in the mid-1990s; China in 1999 when four AMCs were created and funded by the Ministry of Finance for the four large state owned commercial banks.

### Private-sector AMC and internal bank procedures
- Individual banks may establish their own AMCs or restructuring programs via:
  - (1) internal “workout unit” (good bank/bad bank model) where bad assets are transferred and held for disposal or restructuring and future sale; or
  - (2) lengthening maturities of existing loans (“extend and pretend”, or “evergreen”) leaving assets unmarked until potential recovery.
- Workout units may remain within the bank or be transferred to separate subsidiaries with their own balance sheets.
- Authorities can facilitate private-sector AMCs via laws or fiscal incentives (for example, removing tax distortions).
- Risks of the “extend and pretend” model: lingering bad assets that limit liquidity and delay lending recovery; it avoids marking assets to current prices and so mitigates immediate capital injection needs.
- Decentralized approaches require regulatory forbearance and the ability to maintain depositor confidence—potentially needing public support (continued placement of public entity deposits and/or enhanced deposit insurance).
- A key risk is contingent fiscal liability should private sector asset values fail to recover.

### Kazakhstan experience (Box I.2)
- After independence, Kazakhstan used a mix of AMCs (mainly for NPLs of seven state banks) and internal workout units (mainly for commercial banks' NPL exposure to SMEs).
- By 1994, three AMCs had been created:
  - Rehabilitation Bank (RB): handled NPLs from mining and metallurgy; prioritized enterprise rehabilitation over liquidation and provided resources for enterprise downsizing financing.
  - Agricultural Support Fund (ASF): handled loans from Agroprom and other banks to insolvent farms; limited technical expertise constrained ASF’s capacity to rehabilitate or liquidate farms, resulting in rescheduling and unpaid debts.
  - Exim Bank: absorbed loans funded by export credit agencies with government guarantees, limiting its ability to manage NPLs and resulting in fiscal costs to authorities.
- In total, loans amounting to 11 percent of GDP were transferred to these AMCs, while state bank exposure to SMEs remained on the banks’ books.
- Authorities promoted loan restructuring instead of foreclosure to guard against negative social and economic impacts.
- Prudential and regulatory frameworks were strengthened with new capital requirements and limits on exposures, accompanied by regulatory forbearance permitting banks to meet new requirements over time, backed by enhanced surveillance of noncompliant banks.

### Key lessons from international experience with AMCs
- Centralized AMCs are most effective when there is systemic financial fragility and weak legal infrastructure for debt resolution. Government backing provides externalities including:
  - Coordination of markets to avoid individually rational actions that produce poor collective outcomes (for example, a "fire-sale" of assets);
  - Use of legal processes when weak collateral provisions and inefficient legal processes delay restructuring;
  - Timeliness of restructuring by attaching conditions such as recapitalization and change in business models;
  - Concentration of expertise enabling system-wide understanding and specialized resolution of NPLs.
- Risks and potential burdens if AMCs are poorly designed or resourced:
  - Fiscal costs: substantial upfront budget resources could raise the public sector’s debt burden.
  - Operational costs: inefficient management can incur high operational costs, slow resolution of NPLs, and erode value of un-restructured assets; importance of experienced personnel and profit-maximizing management to avoid subsidizing banks.
  - Reputational costs: susceptibility to political interference and corruption; operational independence is crucial. Placement under the budget administration from inception promotes transparency and shields the central bank from conflicts between regulation and monetary policy.

### Policy considerations for Kazakhstan
- A centralized AMC (the DAF) may be the most suitable model given the scale of NPLs, ongoing asset quality deterioration, and shortcomings in legal and regulatory structures.
- Key operational and design principles for the DAF:
  - Avoid incentives for moral hazard; ensure operational independence, transparency, and public accountability.
  - Require banks to recognize current losses; this may create capital adequacy issues and confidence concerns.
  - Consider an incremental approach to capital adequacy in cooperation with the FSA, aiming to meet future international minimum standards, while avoiding regulatory forbearance.
  - Establish a recapitalization program to support NPL carve outs.
  - Maintain appropriate incentives via profit sharing mechanisms with banks to preserve loan value and reduce fiscal costs; tax structure should support loan sales to the DAF.
  - Undertake corporate sector restructuring to address underlying causes of NPLs and avoid recurrence, especially where policies subsidize or guarantee lending to priority sectors.
  - Ensure speedy disposal of NPLs, including to foreign investors, balancing fire-sale risks against rapid deterioration of NPL values.
  - Impose a time-bound operating horizon with hard performance targets for the DAF to limit bureaucratic entrenchment and perception as a dumping ground.

### Conclusion and operational imperatives
- Kazakhstan should undertake a consistent, comprehensive NPL resolution approach to complement ongoing initiatives; timely, proactive, country-tailored measures are valuable.
- Any strategy must be accompanied by:
  - A full diagnostic assessment of all systemically important banks based on recapitalization needs;
  - Stress and sensitivity analysis to assess the size and depth of the problem;
  - Identification and remediation of gaps in regulatory, prudential, governance, tax, and legal frameworks, and appropriate enhancements undertaken.

*Source: _cr10237 - 12.      The authorities create and capitalize an AMC to purchase NPLs from all*

### 3.      Commodity producing countries often choose to target some measure of fiscal

### _cr10237 - 3.      Commodity producing countries often choose to target some measure of fiscal

### Fiscal rules and commodity revenue volatility
- Commodity producing countries often target a fiscal balance that excludes revenues from commodity exports to insulate the budget from commodity price volatility and avoid boom-bust cycles.
- Policy recommendations commonly given to commodity producers:
  - (1) The non-commodity balance should feature prominently in the formulation of fiscal policy.
  - (2) The non-commodity balance, especially expenditure, should be adjusted gradually to avoid destabilizing aggregate demand (Barnett and Ossowski, 2003).

### Analogy to individual self-imposed rules and behavioral rationale
- Fiscal rules are conceptually similar to self-imposed constraints used by individuals (e.g., pension plans) to counter behavioral biases where consumption is excessively sensitive to income and various forms of wealth are not seen as close substitutes.
- Rules aim to shift government behavior closer to the optimum by constraining suboptimal choices.

### Empirical evidence on fiscal rules: benefits and limits
- Available empirical evidence suggests fiscal rules tend to bring intended benefits and have been linked with improved fiscal performance.
- Fiscal rules have contributed to the success of fiscal consolidation in OECD countries (Guichard and others, 2007) and supported several large fiscal adjustments.
- Caveats:
  - Direction of causality is not always clear; rules work best in countries with a track record of good policies and stable fiscal conditions.
  - Rules typically do not specify composition of required fiscal adjustment; where starting fiscal position is far from target, adoption of a rule must be complemented by a clear and credible consolidation plan.
  - Rules can encourage “creative accounting,” especially when targets are relatively complicated, potentially undermining policy credibility.

### Preconditions for effective fiscal rules: credibility, transparency, accountability, and PFM
- Key prerequisites for any effective fiscal rule:
  - Strong political commitment to follow the rule once adopted.
  - Credibility, transparency, and accountability.
- A strong public financial management (PFM) system is integral and often more important than choice of target. Key elements include:
  - (1) Availability of reliable data and capacity for technical forecasting of budget variables.
  - (2) Ability to produce in-year and timely end-year reports through a comprehensive budget reporting system.
  - (3) Credible internal and external audit systems.
- Comprehensive and timely public releases of fiscal data strengthen credibility; a strong PFM system alone can sometimes impose fiscal discipline even without formal rules.

### Global tendencies and illustrative country cases
- The number of countries with some form of fiscal rule increased from 7 in 1990 to 80 in 2009 (IMF, 2010).
- Commodity-producing country experiences vary; three illustrative cases:
  - Australia: no numerical rule; Fiscal Responsibility Law requires a fiscal strategy statement covering the next four years with broad targets including budget surpluses on average over the cycle, maintaining taxes as a share of GDP on average below the 2007-08 level, and improving financial net worth. An expenditure rule restrains real growth in spending to 2 percent per year once the economy grows above trend until the surplus reaches at least 1 percent of GDP.
  - Chile: explicit numerical rule targeting structural balance. Expenditures are budgeted ex ante in line with structural revenues (full potential output; long-term copper and molybdenum prices; long-term returns on accrued financial assets). Structural balance target: 1 percent of GDP in 2002-07; reduced to 0.5 percent of GDP in 2008; 0 percent of GDP in 2009. Key inputs provided by an independent body; credibility of that body is central.
  - Norway: numerical rule targeting non-oil structural deficit equal to the long-run real return on the Government Pension Fund – Global, assumed to be 4 percent. Oil revenues explicitly excluded; guidelines allow temporary deviations over the business cycle.

### Limits exposed by large shocks and the global financial crisis
- The 2008-09 global financial crisis showed limits of fiscal rules: extreme shocks made it difficult to stick to rules; some rules were revised or adjusted.
- Fiscal rules need flexibility and well-designed escape clauses.
- Despite the crisis, many countries continued to adopt rules (examples noted: Austria, Germany, Hungary).

### Kazakhstan: terms of trade, oil revenues, and fiscal stance (2003–09)
- Kazakhstan experienced a significant terms of trade boom in 2003-08; terms of trade increased by over 40 percent between 2003 and 2007.
- Oil’s share in the economy and public finance:
  - Oil accounts for almost one fourth of GDP, 60 percent of total exports, and 40 percent of total budget revenues.
- Oil revenue and saving outcomes:
  - Kazakhstan’s fiscal revenues from oil increased from $1 billion in 2001 to $17 billion in 2008 (or from 4½ to 12½ percent of GDP).
  - National Oil Fund (NFRK) assets reached $27.5 billion by end-2008.
  - At the peak of oil prices in 2006-07, about 60 percent of oil revenues were saved in the NFRK.
- Spending and debt:
  - Government spending remained relatively constant as a percentage of GDP until 2008.
  - These outcomes demonstrated the authorities’ ability to maintain fiscal discipline even without formal fiscal rules.

### National Fund of the Republic of Kazakhstan (NFRK): purpose, funding, and rules
- Purpose: reduce economic impact of volatile oil prices and save part of oil income for future generations; off-budget fund managed by the NBK; all assets invested abroad.
- Currency composition of NFRK assets as of end-March 2010:
  - 56 percent in U.S. dollars.
  - 26 percent in euros.
  - 7 percent in U.K. pounds.
  - 7 percent in Japanese yen.
  - 4 percent in Australian dollars.
- Sources of funds: direct taxes from oil sector (corporate income tax, royalties, share under production-sharing agreements, rent tax on exported crude oil and gas condensate); proceeds from privatization in mining, extraction, manufacturing; proceeds from sale of agricultural land.
- Use of funds: guaranteed annual transfer established by law for financing budget development programs. New NFRK concept (early 2010) sets:
  - limit on the annual guaranteed transfer at $8 billion (calculated as the average actual transfer in U.S. dollar terms during the last 5 years),
  - minimum NFRK balance of 20 percent of projected GDP at the end of the respective fiscal year,
  - guaranteed annual transfer to be reduced if expected balance falls short of the minimum requirement.

### 2008–09 fiscal response, fiscal impulse, and deterioration
- Anti-crisis measures in 2008-09:
  - Automatic stabilizers were allowed to operate; tax cuts in non-extractive sectors; increases in pensions, public sector wages, and social benefits.
- Fiscal impulse estimates:
  - Staff estimates the total fiscal impulse from the general government budget in 2008-09 at about 4½ percent of GDP.
  - Including off-budgetary spending, the estimate increases to about 7½ percent of GDP.
  - Some off-budget anti-crisis expenditures (such as increases in public deposits in the banking system) were excluded from the fiscal impulse calculations.
- Outcomes:
  - Overall fiscal balance went into deficit in 2009; non-oil deficit exceeded 11 percent of GDP.
  - Deficit expected to increase further in 2010; inclusion of non-budgetary outlays would improve fiscal stance somewhat with recovery.
  - Estimated structural balance moved from a surplus of 3½ percent of GDP in 2007 to a deficit of 4 percent of GDP in 2009 and 2010.

### Need for fiscal consolidation and role for a fiscal rule in Kazakhstan
- Maintaining the current level of deficit would result in either a rundown of oil savings or rapid increase in government debt.
- Substantial fiscal consolidation is required to return fiscal position to pre-crisis levels.
- A formal fiscal rule could be a useful tool within the medium-term framework to support credibility and underscore authorities’ commitment to fiscal soundness.
- Given Kazakhstan’s economic structure, the key decision is how much to spend out of oil revenues; saved oil revenues are used to:
  - achieve intergenerational equity,
  - limit appreciation pressures on the real exchange rate,
  - stabilize financial flows and provide a shock absorber,
  - potentially finance productive investments that convert oil wealth into other forms of wealth without value loss.

### Sustainable spending from oil revenue: projection approach and results
- Method: project flows of oil revenues, compute total present value, convert to perpetuity equivalent to estimate annual sustainable spending that preserves oil wealth.
- Assumptions:
  - Oil production follows authorities’ and Fund staff projections: reaches about 120 million tons a year (equivalent to 2.5 million barrels per day) in 2016-17 when Kashagan field reaches full production; production constant until 2040 then declines by 1 percent a year.
  - Two oil price scenarios in constant 2009 U.S. dollars:
    - “High price” scenario: oil price reaches $90 per barrel in 2015 and remains unchanged in real terms thereafter.
    - “Low price” scenario: oil price drops to $60 per barrel in 2010 and remains at that level in real terms.
  - Calculations in constant 2009 U.S. dollars.
  - Present value horizons: 2010-50 and 2010-75; real discount rates used: 3, 4, and 5 percent.
- Key quantitative results (Perpetuity Equivalent of Future Oil Revenues, billions of 2009 U.S. dollars):
  - High Price Scenario:
    - Discount Rate 3 percent: Horizon 2050 = 11.2; Horizon 2075 = 13.2
    - Discount Rate 4 percent: Horizon 2050 = 12.7; Horizon 2075 = 14.3
    - Discount Rate 5 percent: Horizon 2050 = 13.6; Horizon 2075 = 14.9
  - Low Price Scenario:
    - Discount Rate 3 percent: Horizon 2050 = 9.0; Horizon 2075 = 10.6
    - Discount Rate 4 percent: Horizon 2050 = 10.2; Horizon 2075 = 11.5
    - Discount Rate 5 percent: Horizon 2050 = 10.9; Horizon 2075 = 11.9
- Interpretation:
  - Calculations suggest annual spending out of oil revenues of $10-11 billion in constant 2009 dollars should be affordable in the medium term (based on the presented scenarios and discount rates).
  - Expanding projection horizon beyond 2075 does not materially change present value results.

_Italic: Source — IMF staff chapter text from the provided content unit._

### 20.      The actual annual spending of oil revenues could be set at a level lower than $10-

### _cr10237 - 20.      The actual annual spending of oil revenues could be set at a level lower than $10-

### Fiscal framework for spending oil revenues
- Recommendation: actual annual spending of oil revenues could be set at a level lower than $10-11 billion for the moment, to allow spending to grow in line with GDP.
- Projection: Real GDP is projected to grow at a 4-6 percent rate in the medium term.
- Practical proposal: The $8 billion per year ceiling set in the new NFRK concept could be a good starting point in 2010, but could be allowed to grow in later years in line with GDP.
- Rationale: Keeping expenditure constant as percentage of GDP would, over the next decade, produce total expenditure equivalent to the $10-11 billion per year suggested by staff calculations.

### Numerical targets and non-oil fiscal balance
- Suggested ceiling on spending out of oil revenues is equivalent to 6-7 percent of GDP.
- Policy design: Set 6-7 percent of GDP as an explicit ceiling for the non-oil deficit (implying a zero overall balance) to create a clear and transparent fiscal framework ensuring sustainability of public finances in the medium and long term.
- Historical comparison:
  - Non-oil deficit was less than 5 percent of GDP in 2007.
  - Current level of non-oil deficit reported as 11 percent of GDP in 2009, and expected to reach 14 percent in 2010.
- Note: The 6-7 percent non-oil deficit target appears more realistic than the target of 3 percent of GDP for the non-oil deficit by 2020 set in the new NFRK concept; the concept does not set intermediate targets or specify the size and composition of the fiscal adjustment needed to reach the target.

### Choice of fiscal rule and timing of adoption
- Preference: Focusing on the non-oil balance is preferable to rules based on debt variables given the current low level of public debt.
  - Rationale: A debt-based rule would either not bind or constrain public debt at an unreasonably low level.
- Alternative: A simple non-oil balance rule is preferable to a structural balance target.
  - Rationale: Structural balance rules are more complicated, rely on accurate calculation of structural balance, and require choosing an appropriate long-term oil price, which may result in frequent revisions undermining credibility.
- Timing: Introduce fiscal rule after establishing a clear and credible medium-term consolidation plan and having a one or two year record of successful implementation to enhance credibility.
  - Empirical note: Fiscal rules can contribute to the success of fiscal consolidations, but credibility is key and prior consolidation helps.

### Composition of fiscal consolidation (guidance)
- Primary focus: The brunt of consolidation effort is likely to fall on the expenditure side of the budget.
  - Rationale: Need to diversify the economy; some expenditure reductions will occur naturally as temporary anti-crisis spending measures are phased out.
- Prioritization objective: Prioritization of existing current expenditures to ensure quality of public spending consistent with growth objectives.
- Possible strategic goal: Freeze per capita spending in real terms over the medium term.
- Contingency: If expenditure measures are insufficient, revenue measures can be used, including:
  - Strengthening broad-based taxes on relatively immobile bases, such as VAT.
  - Increasing externality-reducing taxes, for example on alcohol, tobacco, fuel, property.
  - Strengthening tax compliance.
- Administrative scope: Discussions with the authorities suggest scope for increasing revenues by strengthening tax administration and reducing tax evasion.
- Illustrative scenario: Figure II.4 (referenced) shows a medium-term fiscal consolidation scenario with the main effort on the expenditure side.

### Technical, procedural, and coverage issues for an explicit deficit target
- Technical issues to resolve if adopting an explicit deficit target:
  - Specify a preannounced set of steps to follow if a deviation from the target happens (including various sanctions).
  - Consider the possible need for an independent fiscal agency.
  - Decide on timing of implementation.
- Coverage requirement: Ensure that the fiscal rule encompasses the consolidated fiscal sector, including any off-budget transactions by government owned companies.
- Implementation support: These technical issues could be the subject of technical assistance from the Fund, if requested by the authorities.

### Banking sector vulnerabilities and the role of financial market development
- Crisis exposure: The banking sector had significant vulnerabilities arising from a funding structure heavily reliant on foreign borrowing, leading to high dollarization of banks’ liabilities.
- Consequences:
  - Banks traded currency risk for credit risk by lending in foreign currency to unhedged corporations and households.
  - Resultant mismatches became unsustainable when foreign capital inflows stopped, domestic currency depreciated, and recession ensued.
- Policy focus post-crisis:
  - Promote confidence in the tenge.
  - Replace foreign borrowing with domestic savings to minimize boom/bust risks.
  - Enhance regulatory, legal, and macro-prudential frameworks to eliminate currency mismatch risks.
  - Develop deeper and more liquid domestic financial markets, including forward foreign exchange markets.
- Role for authorities: Authorities may take a direct, but temporary and well-defined, role in market making activity to develop forward FX and related instruments (examples cited: Bank of Israel, National Bank of Poland).

### Specific banking sector facts and trends (preserved exactly)
- Deposits both in domestic and foreign currencies were about 30 percent of GDP in 2008.
- Over 2002–07, banking sector external debt grew to about 44 percent of GDP by 2007.
- Loan-to-GDP ratio peaked at nearly 60 percent of GDP in 2007.
- Loan-to-deposit ratio nearly doubled, peaking above 200 percent in 2007.
- Foreign currency deposits amounted to around 20 percent of GDP as the crisis struck in 2007, about double the figure for tenge-denominated deposits.
- Foreign currency lending as a share of total lending noted across dates: Mar-04, Mar-06, Mar-08, Mar-10 (figure referenced).
- Lending by sector (end-March 2010): Construction, Trade, Non-productive sphere, Industry excl Construction, Transport & Communications, Agriculture, Forestry & Fisheries, Entrepreneurship (figure referenced).
- Observation: Banks have relatively little exposure to economic sectors that generate income in foreign currency, notably the oil and gas and other minerals sectors.

### Development priorities for domestic financial markets
- Strategic focus areas:
  - Increase market activity and depth.
  - Broaden investor participation.
  - Expand the types of instruments traded.
- Sequencing:
  - Deepen and further develop domestic money and bond markets, including establishing a government benchmark yield curve.
  - Leverage existing institutions, including the pension fund system and the Kazakhstan Stock Exchange (KASE).
  - As tenge-based markets evolve, incent private sector innovation to spur derivatives markets (forwards, futures, swaps, options).
- Money and bond market reforms:
  - Broaden available instruments and lengthen maturities within a clear and cohesive set of guidelines for liquidity and public debt management.
  - Use a well defined and fully market based interest rate structure.
  - Adopt a government bond issuance schedule comprising less frequent, but larger auctions of standard longer-term paper; set the issuance schedule for a reasonable period in advance and make it transparent to the market.

*Source: Excerpt from IMF staff discussion in the supplied content unit.*

### 13.      Coordination between the government and the NBK on liquidity management is

### 13.      Coordination between the government and the NBK on liquidity management is

### Coordination between government and NBK; market development objectives
- Coordination between the government and the NBK on liquidity management is crucial to develop indirect policy instruments and improve monetary transmission.
- Government should increase its share of domestic securities in the market as the NBK reduces direct presence to enable the NBK to transmit signals so interbank and deposit/lending rates respond more effectively to the NBK’s refinancing rate.
- The fiscal needs associated with anti-crisis measures have encouraged a larger medium-term market in MoF securities; pension funds were required to hold at least 30 percent of their portfolios in official domestic securities.
- Recent IMF FSAP analysis finds that a domestically-derived yield curve should be of a minimum duration of 7 to 10 years.
- Trading volumes of MoF securities remain relatively low and concentrated at shorter tenors, highlighting the need for a more vibrant primary market and deeper secondary market activity.
- Non-financial corporate sector participation in the bond market remains small and may benefit over the medium-term from enhanced corporate governance and a sound framework for credit rating and evaluation.
- Increasing the choice of tenge-denominated securities may contribute to a decrease in the incidence of dollarization by facilitating tenge lending and providing alternatives to U.S. dollar deposit accounts.
- The Asian Development Bank has already issued tenge-denominated bonds and the European Bank for Reconstruction and Development has similar plans; in 2007 the ADB issued $50 million of tenge-denominated (6 billion tenge) bonds on the Luxembourg Stock Exchange.

### Benefits of deeper and more liquid domestic bond markets
- Well-defined benchmark yield curve.
- Immediate sources of domestic funding.
- Improved avenues for monetary transmission.
- Support for market-oriented funding of government operations as part of a medium-term fiscal strategy centered on prudent saving of oil revenues.

### Development of derivatives markets (strategy and prerequisites)
- Derivatives markets provide hedging and price discovery, boosting liquidity and transparency in underlying markets (fixed income and foreign exchange) with implications for monetary transmission and government financing costs.
- Derivatives must be supported by well-functioning domestic money and bond markets and set within dynamic regulatory, legal, and tax frameworks.
- The foreign exchange market is a key underlying market for derivatives; volatility, market size, and participatory structure are crucial.
- A high incidence of two-way exposure is a prerequisite for successful derivatives activity to encourage demand for risk management.
- Greater exchange rate flexibility by authorities will facilitate derivatives market development, accompanied by an alternative nominal anchor and appropriate intervention strategy.
- Traditional outright forward markets are the most appropriate starting point, as forward operations over the interbank market typically do not require up-front margin costs or significant volumes.

### Role of the NBK and initial public-sector involvement
- The NBK could initially be directly involved in developing and operating forward exchange markets (acting as broker or operator through a commercial bank), but must weigh:
  - the trade-off between market development and bearing direct exchange rate risk;
  - the balance between initial public-sector roles and fostering private-sector ownership and innovation; and
  - the need for a clear exit strategy.
- Initial policy steps include capitalization of a fund to provide exchange cover to importers, replenished by purchases of forward foreign exchange from exporters.
- The NBK should pre-commit to exposure limits and a phasing out timetable, pass operations to commercial banks or suitable market makers, avoid crowding out private-sector behavior, and ensure operations are fully transparent and preannounced as necessary.

### Monetary, exchange rate, and capacity-building measures
- Monetary and exchange rate policies must be supportive: exchange rates and interest rates significantly out of equilibrium preclude transition to forward exchange rates on commercial terms.
- Highly liquid interbank spot and interest rate markets are necessary, along with continuous monitoring of domestic monetary and financial market conditions relative to international developments.
- The NBK should lead continuous training for market participants on functioning and operations of forward and other derivatives markets.

### Coordination among policymakers
- Proliferation of well-functioning domestic financial markets requires high degree of official coordination across MoF, NBK, and FSA via forward-looking fiscal strategies, supportive monetary and exchange rate policies, and enhanced legal, regulatory, and macro-prudential frameworks.
- Synchronization of government funding needs, debt management strategy, and central bank monetary operations improves the NBK’s ability to manage domestic liquidity.
- High-frequency information sharing (e.g., government cash flow projections and deposit access at the central bank) is critical for accurate liquidity forecasting and management.
- The FSA can encourage domestic institutional investor participation (notably pension funds) through improved prudential regulations promoting diversified asset structures and by considering permission for pension funds to participate in derivatives markets and relaxing crisis-induced minimum portfolio requirements on holding government securities.
- Development of liquid foreign exchange forwards markets enables effective hedging of resultant foreign exchange exposure.
- Coordination supports gradual enhancement of exchange rate flexibility; the NBK needs to upgrade its monetary policy framework by reestablishing an effective interest rate corridor and day-to-day liquidity management: repo operations, standing facilities (with appropriate penalty rates), reserve requirements, and deposit facilities.

### Strengthening regulation, monitoring, and risk measurement
- High levels of financial dollarization create risks that may not be fully addressed by current international regulatory standards; macro-prudential frameworks must be adapted to manage exchange rate risk, including limiting, monitoring, and measuring such risks.
- The FSA is implementing measures to discourage banks from assuming foreign currency liabilities and assets through NPL reclassifications (and consequent provisioning), changes to capital adequacy ratios, and additional shareholder requirements for deposit-taking institutions.
- Increased monitoring of corporate and household sectors is required to assess indirect exchange rate risks to banks; this can be achieved through regular surveys capturing sources and currency composition of incomes, foreign debts, and hedging operations.
- There is a need to complement net and gross open position measures with forward-looking risk management techniques, possibly via standardized models of risk applied across the financial sector and coordinated with a move to increased exchange rate flexibility.
- Banks’ internal risk procedures should be enhanced to better account for exchange rate exposure, supported by improved governance standards.

### Conclusion and policy implications
- The global financial crisis exposed weaknesses in financial sector and regulatory frameworks; Kazakhstan can benefit from an encompassing reform agenda to develop domestic financial markets and mitigate risks from foreign currency mismatches on domestic balance sheets.
- The key challenge is balancing effective regulation with market development and innovation, requiring careful planning and an effective, transparent communication strategy.
- Development of domestic financial markets alone is not sufficient to reduce credit dollarization; it must be accompanied by a sound macro-prudential framework delivering low and stable inflation, and tightly linked with financial sector reform, a medium-term fiscal framework, and monetary and exchange rate policies geared toward lower inflation and increased currency flexibility.
- Effective communication and close coordination among policymakers should drive this process.

*Source: IMF staff chapter text titled "13.      Coordination between the government and the NBK on liquidity management is" from the provided PDF content.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr10237.pdf_