SCENESETTER FOR ASSISTANT SECRETARY SULLIVAN'S VISIT TO

UNCLAS SECTION 01 OF 04 ASTANA 000277

SIPDIS

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FROM CHARGE D'AFFAIRES TO EB ASSISTANT SECRETARY SULLIVAN

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TAGS: PGOV PREL ECON ETRD KZ
SUBJECT: SCENESETTER FOR ASSISTANT SECRETARY SULLIVAN'S VISIT TO
KAZAKHSTAN

Ref: Astana 125

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1. (SBU) Summary: While recent Kazakhstani headlines have been
dominated by discussion of the country's new government, its bid to
assume the OSCE chairmanship, and a democratization initiative
presumed to be in the works, the real, abiding story here is
Kazakhstan's economy. The country's natural resource wealth is
well-known and, by and large, well-managed; much of the USG's
attention in this arena is focused on the development of pipeline
routes to carry oil and gas out of landlocked Kazakhstan. While far
from being Kazakhstan's top trading partner, the U.S. is the largest
foreign investor. The company executives you meet here will tell
you about an investment climate that is, at times, challenging,
while simultaneously discussing expansion plans - or, in private,
bids for new oil blocks.


2. (SBU) Summary, cont.: Kazakhstan has, to date, done an admirable
job of managing its oil wealth. President Nazarbayev seems
determined to take the next, rational step of lessening the
country's dependence on extractive industries; the ambitions of
diversifying the economy and enhancing Kazakhstan's competitiveness
rank high on the Kazakhstani government's agenda. It is clearly in
the USG's political and commercial interests to help Kazakhstan
achieve those goals - through expanded U.S. trade, investment, and
economic cooperation - while reinforcing market mechanisms.
Finally, your visit here comes as the GOK grapples with a new sense
of the country's regional role and responsibilities, earned by its
relative prosperity and stability, and forced upon it by challenges
and opportunities to the South. Here, too, the U.S. can assist, by
helping Kazakhstan find the opportunities and means to increase
trade and infrastructure ties with its Southern neighbors, including
Afghanistan. End summary.

The Political Context
--------------


3. (SBU) Your visit comes at a time of significant personnel changes
in the government, but relative stability as regards economic
policy. President Nazarbayev appointed Karim Masimov as Prime
Minister on January 10 (reftel). Masimov, who had been Deputy Prime
Minister since January 2006 and concurrently Minister of Economy and
Budget Planning since April 2006, was already the most prominent
economic policymaker in the cabinet. In his first weeks on the job
he has emphasized the need to diversify the Kazakhstani economy,
including by attracting foreign investment, and to respect contract
stability. Masimov has also highlighted the need for streamlined
GOK decision-making and improved organization. Other new appointees
include Foreign Minister Marat Tazhin (formerly head of the Security
Council),Deputy Prime Minister Aslan Musin (who also retains his
job as Minister of Economy and Budget Planning),Defense Minister
Daniyal Akhmetov (former Prime Minister and Kazakhstan's first
civilian defense minister),and Minister of Industry and Trade Galym
Orazbakov (who as Deputy Minister from 2001-2003 used to head
Kazakhstan's WTO negotiating team).


4. (SBU) While Masimov is charting a relatively familiar economic
policy course, significant changes are expected on the domestic
political front. (Note: In the Kazakhstani system, the Prime
Minister coordinates economic policy. Foreign policy and domestic
political issues are handled by the Presidential Administration.
End note.) President Nazarbayev has been consolidating the
pro-presidential political parties into one grouping, Nur-Otan,
which controls over 90% of parliamentary seats. He is widely
expected to give a public address in February or March outlining his
vision of political reform, based on the recommendations of the
Democratization Commission which met throughout 2006. While no
details are publicly known, participants in the Commission predict
that while the rhetoric may be sweeping, the actual reform proposals
will be fairly modest. One frequently-heard measure is an increase
in the number of seats in the Mazhilis (lower house of parliament),
which would theoretically make room for more diverse party
representation.


The Macroeconomic Situation
--------------


5. (SBU) Kazakhstan's economy (2006 GDP: $68 billion) is larger than
those of all the other Central Asian states combined, largely due to
the country's vast natural resources and a recent history - rare in
the region - of political stability. Kazakhstan also stands out
among the post-Soviet Central Asian states in its record of
macroeconomic reform. Financial reform has created a banking system
comparable to those in Central Europe, for example, and Kazakhstan
now aspires to be a regional financial center. Kazakhstan has the
economic performance to match its policies, having enjoyed near
double-digit growth (estimated at 10.6% in 2006) over the last six

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years, while keeping inflation in check and avoiding, to date, the
"Dutch Disease" which has plagued many other extractive economies.


6. (SBU) If there a reason for macroeconomic worry, it is tied to
the fact that inflation rose a full point in 2006, to 8.5%. This,
combined with other signs of a potentially overheating economy -
including skyrocketing rates of commercial lending; the emergence of
a housing "bubble" in Almaty and Astana; and a rise in government
spending, especially on salaries - has led many observers to preach
fiscal restraint. Any inflation-driven appreciation of the Tenge
would, of course, hurt the competitiveness of Kazakhstan's
non-extractive exports, thus blunting the GOK's drive to diversify
the economy. The GOK has defused these pressures to date by
steering the vast majority of its oil revenues to the offshore
"National Fund," which now holds over $14 billion in assets and an
improved, rule-based link to the national budget.

Energy: The Economic Engine
--------------


7. (SBU) Kazakhstan's economy is dominated by the energy sector,
with oil exports alone accounting for roughly a third of GDP.
Kazakhstan produced 1.3 million barrels of oil per day (bpd) in 2006
-- all from onshore projects - roughly the production volume as

2005. Overall production will be boosted near year-end 2007, as
Tengiz (U.S. partners: Chevron, ExxonMobil) production doubles.
Kazakhstan is likely to become a top-ten oil producer soon after
2015, as offshore supergiant Kashagan (ExxonMobil, ConocoPhillips)
reaches peak production and other offshore projects come on line.


8. (SBU) The GOK actually closed 2006 by revising its 2015
production estimates from 3 to 2.6 million bpd, due to delays in
Kashagan field development. Your GOK interlocutors may criticize
the Kashagan consortium for delays and cost overruns at that
project. They may also reference an October riot at the Tengiz
field, pitting Kazakhstani against Turkish workers, which delayed
Tengiz production increases by several months and triggered a broad,
ongoing GOK investigation of wage discrimination against Kazakhstani
employees. GOK concerns over "local content" and equity issues in
the oil and gas sector have never been higher.


9. (SBU) While Kazakhstan possesses substantial proven gas reserves
(3 billion cubic meters),it currently exports very little gas,
serving principally as a transit country for Turkmen and Uzbek gas.
The GOK has set ambitious targets for domestic gas production,
forecasting 63 bcms by 2015. Much of this gas will be reinjected in
order to maintain oil field pressure, and the GOK would like to see
some gas used to create a domestic petrochemical industry (most oil
majors are skeptical of the economics); remaining volumes will be
available, later if not sooner, for export.


10. (SBU) Kazakhstan has recently begun to pursue the possibility of
building one or more nuclear power plants over the next decade,
capitalizing on its enormous uranium reserves (Kazakhstan is
currently the world's third leader producer of uranium),an
experienced corps of industry professionals, and well-developed
control systems left over from its Soviet-era nuclear industry.
Kazakhstan and Russia have recently signed several joint nuclear
agreements - most notably to establish an international center for
uranium enrichment in Russia - but there appears to be ample room
for further U.S.-Kazakhstani cooperation in this field, as well as
potential commercial opportunities for U.S. firms.

Gas and Oil Infrastructure Projects
--------------


11. (SBU) All of Kazakhstan's gas exports currently flow through
Russia, leaving the country hostage to GazProm politics and prices.
Two projects under GOK consideration - a Trans-Caspian gas pipeline,
and a gas pipeline to China - would reduce this dependence. The
Kazakhstanis are currently undertaking a feasibility study of the
China route, including a variation which would add Kazakhstani
volumes to a pipeline originating in Turkmenistan. While the GOK
seems cognizant of the risks inherent in building a pipeline which
would serve a single buyer, these concerns are partially offset by
Chinese avidity and the GOK's desire to gasify Southern Kazakhstan
along the pipeline's projected route. If USTDA's feasibility study
proves the viability of a Trans-Caspian pipeline, on the other hand,
the GOK will have to confront Russian (and Iranian) opposition to
the project. Your GOK interlocutors are likely to be cautious in
their support of the Trans-Caspian pipeline project, reflecting
their (wise) reluctance to pick a fight with Russia before the
feasibility of the project is proven.


12. (SBU) Currently the bulk of Kazakhstani crude is exported via
Russia, both through the Transneft system and the independent
Caspian Pipeline Consortium (CPC) pipeline. (Small, but growing,

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volumes are shipped East to China, while negligible quantities are
"swapped" South to Iran.) The majority of Kazakhstan's near-term
oil production increases are projected to flow to market either
through the Baku-Tblisi-Ceyhan pipeline or an expanded CPC. Long
delays in the CPC negotiations have left Tengiz producers scrambling
for alternative export options. (Don't be surprised if your GOK
interlocutors blame one American company for the current impasse.)
As a consequence, they have joined Kashagan producers in seeking the
development of the Kazakhstan Caspian Transportation System (KCTS),
which will join the Kazakhstani fields, by means of a new pipeline,
terminals, and ships, to the BTC. The oil producers signed an
initial MOU with KazMunaiGaz (Kazakhstan's national oil-and-gas
company, and a partner in both the Kashagan and Tengiz projects)
last week; this document defines the technical work needed to launch
the project, as well as defines how the investors will create a
negotiating team which will conduct eventual Host Government
Agreement (HGA) negotiations with the Kazakhstani and Azeri
governments.

On the GOK's Mind: Competitiveness and Diversification
-------------- --------------


13. (SBU) Diversifying the economy away from its dependence on
hydrocarbons is one of Kazakhstan's main challenges. At present,
wheat is Kazakhstan's only significant non-mineral export. GOK
officials address this need, along with the more-amorphous goal of
achieving the status of "one of the world's 50 most competitive
countries," with regularity. To date, the GOK has focused its
diversification efforts on Harvard professor Michael Porter's
"cluster" concept, identifying seven sectors of presumed natural
advantage for priority development: tourism, construction materials,
textiles, metallurgy, food processing, oil-and-gas machinery
building, and transport and logistical services. Prime Minister
Masimov would be an excellent interlocutor with which to share our
own vision of market-based diversification, enabled by improvements
in Kazakhstan's investment climate and an expanded U.S. - Kazakhstan
partnership.

WTO Accession
--------------


14. (SBU) Kazakhstan has targeted 2007 as the year of its WTO
accession. WTO membership is important to Kazakhstan not only for
the economic benefits it will bring, but also as a symbol of
Kazakhstan's presence on the world stage. (Note: Much like two
other public GOK pursuits: the OSCE chairmanship and the Winter
Olympic Games.) To date, Kazakhstan has signed bilateral protocols
with 16 out of the 39 members of its Working Group. In the past,
Kazakhstan's WTO experts have occasionally used high-level USG
visits to lobby for relaxed "WTO Plus" provisions and explain the
burdens of reducing Kazakhstan's agricultural subsidies. Your
conversation with the new Minister of Industry and Trade, Galym
Orazbakov, will be the USG's first, and an important opportunity to
understand his vision for Kazakhstani accession.

Regional Integration
--------------


15. (SBU) Kazakhstan initially greeted Secretary Rice's October 2005
call for increased regional integration in Central and South Asia
with a certain degree of skepticism. As we have clarified our
goals, and reassured the Kazakhstanis that we are not proposing a
political "Greater Central Asia," the Kazakhstani government has
shown increased enthusiasm. The reference to regional integration
in the September 29 joint statement was an important milestone in
this regard. The GOK has long sought to remove trade barriers with
its Central Asian neighbors and to help them improve their own
investment climates. Sustained USG engagement will be needed,
however, to encourage a lasting GOK focus on the broader region --
not just Kazakhstan's immediate neighbors -- and to encourage the
GOK to look at tougher issues such as electricity networks. (The
American firm AES, Kazakhstan's leading electricity generator, is
actively engaged in our efforts to increase regional electricity
trades from surplus to deficit countries; to date, GOK interest has
lagged.) Your interlocutors may ask what became of the USG's summer
2006 proposal to launch a Central Asia Regional Economic Integration
Dialogue (CAREID).

The Investment Climate
--------------


16. (SBU) U.S. companies doing business in Kazakhstan face an
investment climate that is, at times, challenging. Among their
concerns are occasional GOK infringements upon contract sanctity; a
growing tendency to "criminalize" civil disputes; what they view as
overzealousness on the part of federal and local tax authorities,
especially in the framework of ill-defined tax law; and difficulties

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in obtaining work permits for expatriate workers. Particularly
since the October "Tengiz brawl" (par. 8),the GOK has intensified
its scrutiny of the hiring practices of foreign businesses. These
concerns, while significant and worthy of our attention, should not
overshadow the fact that foreign investment in Kazakhstan is growing
at a healthy rate, and that the larger, multi-national corporations,
at least, tend to find strategies for managing their legal and
contractual risks.

MILAS