EXECUTIVE SUMMARY

The outlook for GDP growth over the next few years is not optimistic. The economic collapse in Russia is having a strong negative effect on Kazakhstan’s economy. This is likely to continue the next several years. Russia has been Kazakhstan’s major trading partner, purchasing about one-third of Kazakhstan’s exports. Kazakhstan has turned off the gas pipelines to Russia due to Russia’s inability to pay for the gas. Exports are key to growth in the Kazakhstani economy—they represent nearly a third of the country’s GDP.

The Government continues to promote a market-oriented policy reform program with the aim of promoting greater investment. But the pace of reform is slower than in Armenia or Georgia. Still, unlike in Georgia, Kazakhstan is able to draw on the IMF for support. In the past few years, the Government has achieved some success in stabilizing its currency and reducing inflation from an annual rate of 1,164% in 1994 down to 9.0 % in 1998. There have also been a number of laws and treaties which improve the prospects for investors including: State Support of Direct Investments; Laws on Oil and Gas; Law on Joint Stock Companies; Foreign Investment Law; a new tax code; and the U.S.-Kazakhstan Avoidance of Double Taxation Treaty. In the past couple of years, overall production of oil has increased, thereby reversing a five year decline. A major long term goal of the Government is to promote the development of their transportation and communications sectors. Kazakhstan’s national railway (KTZ) is a large, profit-making concern. It has secured an EBRD loan to start modernizing its operations and is looking for international private sector participation (see below and project profiles).

This U.S. support will be particularly important since there are still some significant obstacles to doing business in the country. Some high profile investments are being disputed and several are in international arbitration, which has made investors wary. Also, the country’s arbitrary implementation of key laws, lack of transparency in the tax code, along with corruption and a weak banking system have constrained business development.

ECONOMIC OUTLOOK

The Government is now entering the second phase of its reform program. By the end of 1997, majority shares of virtually all of the eligible small- and medium-sized enterprises had been sold, share packages in most enterprises for mass privatization had been offered, and all but a few of 2,000 state and collective farms had been privatized. Management contracts have been let for many of the largest industrial firms and many oil, gas and mineral reserves were awarded to foreign investors. The Government has begun a major Pension Reform Program which will change radically the pension system, while increasing the security of the system and strengthening the financial and securities markets in the country.

Kazakhstan’s medium- and long-term economic prospects are promising due to its vast hydrocarbon and mineral resources, low external debt obligations, and well-trained work force. New legislation on foreign investment, taxation, oil and sub-soil rights are expected to improve the climate for foreign investment. In the next several years, GDP growth will depend greatly on commodity prices, particularly the price of oil. Oil discoveries under Kazakhstan's portion of the Caspian seabed (the first exploratory well will be drilled early this spring) also will be an important factor. Major finds would spur a new surge of outside investment. However, without a return to the level of mid-1997 prices for oil (and if offshore discoveries prove disappointing), the rate of GDP growth will likely remain quite low until new export routes enable Kazakhstan to significantly boost its onshore oil production. Overall, Kazakhstan needs to diversify its economy away from a reliance on natural resources to protect itself from future shocks in oil and other commodity markets.

BUSINESS AND INVESTMENT CLIMATE

An unfavorable trend has emerged, beginning in the summer of 1997 and culminating with key cabinet changes in October 1997 and April 1998: domestic investors will be given priority over foreigners in most contracts. President Nazarbayev, Prime Minister Balgimbayev, and the new cabinet have made very clear statements in recent months, complaining that previous privatizations were done too quickly and did not take into account the potential of domestic investors. In this vein, senior Government officials have warned that the Government will scrutinize major existing privatizations to determine whether the foreign investor has fulfilled its obligations. This emphasis on domestic investors could be problematic since it is uncertain whether domestic concerns have the medium-to long-term financial capacity to invest in new projects or the management and technical skills needed to rehabilitate obsolescent and debt-burdened State Owned Enterprises. Moreover, there has been a recent push for enterprises to increase their use of Kazakhstani employees in positions often occupied by expatriate experts.

In recent years, four major pieces of legislation affecting foreign investment have been implemented by the Government of Kazakhstan. These are: (1) the Law on Foreign Investment, 1994 (amended in July 1997); (2) the Tax Code of 1995; (3) the Law on State Support for Direct Investment, 1997; and (4) the Law on Government Procurement, 1997. In addition, Kazakhstan has applied for membership in the World Trade Organization (WTO). Joining the WTO will help integrate Kazakhstan into the world economy, as well as conform its trade regime to international standards. Kazakhstan's effort to join the WTO has slowed since the resignation of former Prime Minister Kazhegeldin; Kazakhstan is unlikely to join the WTO before 2001.

POLITICAL CLIMATE

The major political issues affecting the business climate are: a centralization of power around the President; constant personnel and portfolio changes at senior levels of the Government; increasing Government harassment of foreign investors over concern that they are not meeting their contract obligations; and upcoming parliamentary and presidential elections in 1999 and 2000, respectively. While the Government continues to take steps to combat corruption (e.g., passage of a new criminal code, establishment of a Higher Disciplinary Council), the prosecution of senior officials is rare.

SOURCES OF FINANCING

Over the past four years, a combination of increased competition, closures, and failure to meet legislative requirements has reduced the number of banks in Kazakhstan from 184 in 1994 to 76 (as of May 1, 1998). This number should drop to 50 as the National Bank of Kazakhstan continues to enforce tougher capital requirements ($13 million minimum by the year 2000) and the banks continue to merge. Overall capital levels of the consolidated banking sector have improved, as 51 banks, or 67 percent of the financial institutions, have capital in excess of $1 million, as compared with 33 banks, or 18 percent, at year-end 1994. Still, most Kazakhstani banks are undercapitalized and unable to finance major projects.

Finally, there is the Central Asian-American Enterprise Fund (CAAEF), which makes loans to small enterprises for private sector development. This U.S. Government-sponsored $150 million fund makes equity investments, approves loans, and offers technical assistance to new private companies and entrepreneurs in the Central Asian republics.

SECTORAL OVERVIEW POWER

The wholesale distribution and much of the retail distribution of electricity is done by the Kazakhstan Electricity Grid Operating Company (KEGOC). KEGOC’s network and most of its infrastructure were built in the 1970s and have not been maintained or updated. High-priority needs include: replacing high-voltage equipment at about half of the 63 substations; and replacing the protective relaying systems at all the substations; a new dispatch control system; and institutional development and training to allow KEGOC’s staff to operate the modernized system. KEGOC and the Government have already privatized three regional distribution networks: Almaty Power Consolidated (100% privately owned); Karaganda (70% privately owned); and one at Petropaviovsk which was put through bankruptcy and sold at auction. KEGOC and the Government plan to privatize at least 15 more regional retail distribution systems and possibly one generation plant that are now under KEGOC’s control. In the longer term, there has been some discussion of privatizing KEGOC itself.

KEGOC is capable of raising funds on the international capital markets on reasonable terms. For a company in a transition economy, it has been rated highly by international credit rating firms. The World Bank and USAID may provide up to half of the financing needed to carry out the modernization program. The World Bank has held discussions with a number of local companies and the Government of Kazakhstan on the possibility of establishing an initial project with a budget of $10 million to: establish institutional frameworks for developing micro hydro power plants (MHPP); identify consumer demand for MHPP installations: construct pilot MHPPs in various regions of Kazakhstan; and prepare feasibility studies for hydro power stations.

Business opportunities exist in this area. The World Bank’s Global Environmental Facility (GEF) makes grants to help construct facilities that reduce greenhouse gas emissions (i.e., by reducing the need for coal-fired electricity production) that would not otherwise be commercially viable. Typically, the GEF prefers to work with a public-private partnership to develop its projects, including MHPPs.

TRANSPORTATION

The Project includes the design and construction of improvements to the Airport runways, taxiways, parking aprons and access roads to the terminal and support facilities and a complete upgrade of the air navigation control and landing system. The Project also includes improvements to the Terminal buildings increasing the throughput capacity of the airport to 30,000 passengers per year. The Project includes efforts to privatize the operation of the airport, terminal, air cargo and other operating facilities of the Airport.

KTZ, the railway company, had total revenues of $1.1 billion in 1997, mainly derived from its freight activity (75%) and employs about 145,000 people. KTZ generated a profit in 1997, but suffers from liquidity problems. KTZ plans to: upgrade the tank wagon fleet; re-power 76 2TE10 locomotives; purchase 160 - 190 new diesel/electric locomotives; modernize the electric locomotive shops; modernize the diesel locomotive shop; build an automated wheel shop; modernize its central computer hardware and software; and privatize the maintenance shops. In addition, using EBRD funding, KTZ plans to: purchase modern track maintenance equipment; provide technical assistance so that the KTZ is able to conduct an open tendering process; strengthen KTZ’s accounting and control skills; and improve the legal framework to increase private sector participation in the railway sector. All the rail projects represent excellent opportunities for U.S. producers of the needed equipment and for potential investors.

The World Bank, Asian Development Bank, and Japan’s aid organization (OECF) are together assembling a project to rebuild and expand the Almaty – Astana highway. As it seems now, the ADB will do the links closest to Almaty, the World Bank will finance the middle links, and the OECF will finance the links closest to Astana. The Asian Development Bank is also financing the restructuring and upgrading of the Almaty – Bishkek road. Both roads represent good business opportunities for U.S. equipment suppliers and firms specializing in design and construction supervision

TELECOMMUNICATIONS

The telecoms market in Almaty continues to grow dramatically with significant demand both from individuals and businesses for a “converged basket” of telecom solutions including digital fixed voice, value added voice services (e.g. voice mail, caller ID, three-way calling, etc), Internet and potentially other multimedia services. The roll-out of WLL in Almaty will in the first phase have a potential of 20,000 subscribers with the potential to make an even greater market with aggressive pricing.

URBAN DEVELOPMENT

There is strong evidence that the oil reserves in the North Caspian Sea are quite large. Test drilling will begin this spring to determine the richness of the deposits. Atyrau is the city that is to be used as the closest urban center to support the drilling activities in the North Caspian Sea. A host of private companies, donor organizations, and government units are planning to develop Atyrau into an efficient urban center to support the activities in the North Caspian. This requires major infrastructure investments as well as the construction of high-end office space and housing. As the oil companies increasingly place their staff in the city, the need for hospitals, restaurants, and other service outlets will grow rapidly.

The OKIOC Consortium, formed to explore and operate the offshore properties, has nine members: Shell/BP; British Gas; Total; Agip; Philips Petroleum; Impex; Statoil; and Mobil. They will likely divide an annual investment sum of $5 million between the Atyrau and Mangistau Oblasts (the two Oblasts in Kazakhstan that share the Caspian coastline). In Atyrau, the two primary investments have been the sports complex and constructing 100 apartments for their employees. As the North Caspian resources are developed, their need for expatriate housing is certain to increase. While not based on the resources of the North Caspian, Tengischevroil has already invested over $150 million to help establish a Business Advisory Center, support for the EBRD Small Business Loan Fund, a bakery, a sports facility a hospital, an auxiliary heating system, and a school in Atyrau. They are also spending $2.3 billion to develop three processing lines to better tap into the Tengiz filed that is south and east of Atyrau. They expect to need housing for 3,000 expatriate staff over the next 5 years. The company is also constructing a new office complex.

The Central Asian-American Enterprise Fund is also planning to be active in the development of Atyrau. See the financing section above. The UNDP is acting as a coordinator of development activities in the city.

OIL AND GAS

Kazakhstan has opened its resources to development by foreign companies. International oil projects have taken the form of joint ventures, production sharing agreements (PSAs), and exploration/field concessions. By far the largest of these is the Tengizchevroil joint venture. In April 1993, Chevron concluded a $20 billion joint venture (Tengizchevroil) to develop the Tengiz oil field, with 6-9 billion barrels of estimated oil reserves. Current members of the joint venture are Chevron (45%), Kazakhoil (25%), Mobil (25%) and LukArco (5%; joint venture between Arco and Lukoil). Tengizchevroil exports about 170,000 bbl/d of crude oil through the Russian pipeline system; by barge and rail to the Baltic; and by ship, pipeline, and rail to the Black Sea. Given adequate export outlets, Chevron believes it can reach peak production of 750,000 b/d from the field by 2010.

Kazakhstan needs to resolve two major issues in order for it to further increase oil production. Development of the offshore potential of Kazakhstan in the Caspian Sea has been slowed by a dispute over ownership rights. This disagreement ties in with a broader debate among Caspian Sea Region states over how the Caspian Sea should be treated under international law. In 1997, Kazakhstan signed a communique with Turkmenistan pledging to divide their sections of the Caspian along median lines; and in July 1998 Kazakhstan signed a bilateral agreement with Russia (not yet ratified) dividing the northern Caspian seabed along median lines between the two countries. The other major issue is the development of export routes to bring Kazakhstan's oil to world markets. Under the former Soviet Union, all of Kazakhstan's oil was exported through the Russian pipeline system. Kazakhstan still views Russia as a viable export option, and the existing export pipeline to Russia may be expanded by 1999. In addition, the CPC pipeline will also pass through Russia en route to the Black Sea. Other oil export pipeline options from the Caspian Sea region are also being explored. Trans-Caspian oil pipelines could be built that would connect in Azerbaijan with other export pipelines, such as the proposed Main Export Pipeline from Baku (Azerbaijan)-Ceyhan (Turkey).

TDA Caspian Region Briefing Book