Kazakhstan should not count on its traditional economic growth drivers to rescue its struggling oil-based economy, as oil prices and its major trading partners are expected to remain relatively subdued for some time. Instead, a senior International Monetary Fund (IMF) official argues, the country should carry out structural reforms to compete head to head with regional rival Uzbekistan, which has signalled its readiness to open up its isolated economy to more regional cooperation.

Thanks to its huge natural resources and openness to foreign investment, Kazakhstan enjoyed an oil boom that helped fuel an average GDP growth rate of 5.16% between 1995 and 2016, which propelled the country into the ranks of middle-income countries. But it is now increasingly facing the middle-income trap, where national incomes stagnate due to low investment, slow growth in the secondary industry, limited industrial diversification and poor labour market conditions.

“We can’t expect either oil prices to remain high or China to grow strongly and save Kazakhstan now,” Mark Horton, mission chief for Kazakhstan in the IMF’s Middle East and Central Asia Department, tells bne IntelliNews in an interview. “The situation is not expected to improve in major trading partners China Russia and the EU over the next five years.”

Low oil and other commodity prices together with a slowdown in the Chinese, Russian and EU economies have cut Kazakh growth rates from 4.2% in 2014 to 1.2% in 2015 and 0.4% in the first three quarters of 2016.

While it will be hard for Central Asia’s richest country to diversify its raw-material based and state-driven economy, especially with the economy growing so slowly, Horton says that to escape the middle-income trap Kazakhstan needs to carry out deep structural reforms, which could be facilitated by the opening up of Uzbekistan that is being pushed by the new president, Shavkat Mirziyoyev, after he took over following the death last year of the dictator Islam Karimov.

The opening-up of Central Asia’s most populous nation to regional cooperation and trade will be good for Kazakhstan in many respects, “as Kazakhstan has not had a real competitor in Central Asian over the last 20 years”, Horton says. “If Uzbekistan ups its game and improves its policy approaches, Kazakhstan will need to do the same and it will give the region a locus of economic weight in Central Asia that we have not seen before.”

Karimov’s isolationist policies led to the situation where Kazakhstan’s cross-border trade with Uzbekistan didn’t exceed 3% of Kazakhstan’s total foreign trade. “If Uzbekistan opens up, it is an additional 35mn people for the regional market and this might also create a positive dynamic in Turkmenistan,” Horton suggests.

Another Central Asian neighbour Turkmenistan, like Uzbekistan, is also one of the world’s most isolated countries, and low prices for its major export, natural gas, could prompt Ashgabat to follow in Tashkent’s footsteps.

Restrictions on foreign trade and foreign exchange operations have led to the creation of a thriving black currency market in Uzbekistan, where there are several forex rates and most foreign investors face problems with repatriating earnings. President Mirziyoyev has instructed the government to study measures to ease the forex situation; if steps are taken, then Uzbekistan could see a boom in investment in its non-extractive sectors.

“That system has been built over a long period of time and that system is difficult to manage and it doesn’t contribute to a broad-based growth,” says Horton, admitting that it might be extremely difficult to change it because of vested interests involved in maintaining the black currency market. However, he stresses that, “there are also interests in reducing some negative elements of the current foreign exchange system.”

The IMF official also believes that the forex reforms in Uzbekistan will eventually lead to wide-ranging reforms to improve the business climate in the country. “To start [reforms] with this shows the intention to address a whole range of business environment issues and this is the most important, the sharpest issue,” he says.

Financial sector remains under strain

Kazakhstan came out of the 2008 crisis relatively quickly on the back of high oil prices, but unresolved problems related to that crisis still haunt the economy.

The financial sector, for example, remains under strain because of the depreciation of the tenge – the national currency has been devalued three times since 2008, losing nearly two-thirds of its value – high interest rates, slow growth and too many bad loans.

The financial crisis caused the property markets in the country’s major urban centres to crash, especially in Almaty, the country’s largest city and its commercial centre. This caused the level of non-performing loans (NPLs) to soar, which still weigh today on commercial banks’ balance sheets. The IMF believes the issue of NPLs, despite falling from nearly 34% in May 2014 to 6.7% in January thsi year, still remain a problem for the Kazakh banking sector. “In fact, that issue was never addressed decisively and banks with weak balance sheets have stayed with Kazakhstan for almost 10 years – that is a critical issue,” Horton notes.

One of Kazakhstan’s top three banks, BTA, was nationalised following the 2008 crisis and was then merged with the country’s largest lender Kazkommertsbank in mid-2015. However, the unresolved problems of the former have forced the merged bank to seek a rescue to the tune of KZT1.5tn ($4.5bn) from the central bank, according to Bloomberg. Later, it emerged that Kazkommertsbank had entered into merger talks with the country’s second largest bank, Halyk.

In the concluding statement of the Article IV mission published on February 8, the IMF said the recognition of loan losses and capital injections by shareholders would be key to strengthening Kazakhstan’s banking sector. “Further forbearance on capital requirements should be strictly limited. Banks should raise the required capital or exit. Mergers should take place on a voluntary, market basis, and mergers involving weak institutions should be avoided.”

In addition to bad loans, dollarisation remains a problem for the Kazakh financial system, where it still stands at around 60% despite the National Bank of Kazakhstan taking steps to lower it. In November 2015, the central bank re-adopted an inflation targeting policy and has managed to bring down inflation from 18% in July 2015 to 8% in January this year. “The National Bank is controlling tenge interest rates in order to control market interest rates to affect prices. When 60% of financial assets and liabilities are in dollars, you are only controlling a small portion of the money supply, which makes it tricky,” Horton explains.

Taxes, land and transparency

Horton believes that the Kazakh government could, as a rule, improve its communications to the public around policy goals and policy intentions.

He suggests that a lack of communication with the public led to the wave of large-scale protests against proposed land reforms last spring. Likewise, part of reducing inflation involves getting people to believe that it will come down. “That requires quite a lot of transparency from the National Bank of Kazakhstan and… the central bank should explain what it is doing and what its aims are.”

The IMF is advising the government to improve tax collection by removing exemptions and eventually increasing taxes to reduce the non-oil deficit in order to maintain long-term sustainability. According to calculations by the Almaty-based Talap Centre for Applied Studies, the tax burden on employees will increase from 17.5% in 2016 to 19% in 2020 and on employers from 11% to 18% respectively, as the government moves to adopt a compulsory medical insurance system. Tax collection increased by 23% in 2016, including VAT by 58%. Further increases in the tax burden for small and medium-sized enterprises will lead to a practice of paying wages under the table, Talap’s Rakhim Oshakbayev believes. At the moment, Kazakh employees are taxed at a flat rate of 10% on their wages.

President Nursultan Nazarbayev has ordered the government to simplify tax legislation and reduce tax exemptions: Talap’s experts calculate that in order to pay VAT (currently at 12%) alone, taxpayers need to know 82 articles, 275 clauses and 489 sub-clauses of the Tax Code, containing 268 references to other articles.

Kazakhstan doesn’t collect enough non-oil taxes for an economy of its level income and level of development, Horton argues. “When you have oil, you don’t need to collect taxes and you can live off oil, but that’s not sustainable,” he explains. “We believe the tax system needs to be improved, the government should reduce tax exemptions and increase the tax base and maybe increase tax rates to make them slightly more progressive.”