Historically, the Middle East’s economic growth was largely underpinned by oil exports. Between 2008 and 2014, high oil prices contributed to an enormous accumulation of wealth, particularly in the regional sovereign wealth funds. Between 2003 and 2014, the GCC region ran aggregate cumulative budget and current account surpluses of US$1.4trn and US$2.4trn, respectively, according to HBSC. Those surpluses were more than enough to cover at least five years of fiscal deficits.
Although the size of the region’s sovereign wealth funds remains largely undisclosed, they provided significant confidence to investors in the regional governments’ ability to meet any liquidity shortfalls. This has been demonstrated post-2008 financial crisis as both Abu Dhabi and Qatar provided loans to their top-tier banks by using these wealth funds. In 2009 for instance the Abu Dhabi government provided generous support to the government of Dubai to prevent a default on Eurobonds issued by Dubai-based real estate developer Nakheel.
The sharp decline of oil prices since 2014 led to a material draw-down of the Middle East sovereign wealth funds as regional currencies remained pegged to the US dollar and relatively high fiscal break-even oil price assumptions remained unchanged for most of 2015. As the oil price is expected to remain low in 2016, the GCC countries opted for a number of reforms which included reviewing their subsidy policies, fiscal expenditures and sources of revenues outside oil exports. Adopting these policy changes after decades of wealth exuberance might have been considered a good first step, but as they are ongoing should be perceived as positive. In particular, it would lead to a reduction of state-dominance in the regional economy via privatisation, stimulating competition and the development of a tax base. However, there is a risk that all attempts for structural reforms could be abandoned should the oil price recover sharply.
Geopolitical risks in the region are also contributing to increasing capital flight, mainly for capital preservation reasons. The society is far from homogeneous due to tribal and religious differences. The social stability in countries with larger populations such as Saudi Arabia and Iran are paramount for their respective government policies. Hence, the ability to implement reforms by liberalising their domestic economies is likely to face resilience from the establishment as political accountability is still at a nascent stage.
Whilst changing the peg is not considered as the base case by the GCC monetary authorities in 2016, the depletion of the sovereign wealth funds and withdrawals of government deposit from the domestic banking system increased concerns about the liquidity in the largest banks. This coupled with inability of the regional banks to maintain high credit growth due to slowdown of economic activities, put pressure on funding sources and asset quality. The expected increase of non-performing loans would be largely driven by previous years of double digit retail and consumer growth and the lack of flexible labour market and personal bankruptcy law. It is widely expected, therefore, that regional banks are likely to tap international debt capital markets for funding mainly via subordinated debt instruments. According to Moody’s research, GCC countries, with the exception of Saudi Arabia, have not expressed any intention to adopt and implement statutory resolutions and bail-in regimes. Government support is still largely assumed to be the way to deal with a potential banking crisis in the region, but this could change should oil price remain low throughout 2016.
Another source of financial challenges for banks could be the real estate sector. Although exposure to the sector has largely been reduced since 2009, the sector accounts for on average 15% of the regional banks’ loan books. Some of the most bankable real-estate markets in the region show decline in the value of real estate transaction by 7% and 16% in UAE and Saudi Arabia, respectively, in annualised terms in September 2015 (based on JLL).
Quasi-sovereigns in the GCC continue to benefit from implicit government support, as reflected in their investment grade ratings linked to the sovereign. Following the 2009 Dubai debt crisis, all regional quasi-sovereigns were encouraged to improve their stand-alone credit profile. This has largely been achieved by relatively conservative debt-issuance in international capital markets, debt liability management, changes of financial management, and subdued M&A activities. Hence, the potential sovereign support in relation to the external debt issued by the quasi-sovereign and government related entities is likely to remain as long as their outstanding public debt is manageable.
The secondary market for Middle East Eurobonds benefits from continuous local demand for short duration debt, which account for the bulk of the regional issuance. However, pending supply from sovereigns are likely to crowd out scarce local liquidity, whilst international demand could be limited due to tighter spreads, lack of visibility of the size of the issuances needed (some estimates suggest c.US$170bn funding needs in the region for 2016), rising concerns about re-rating of the region against the backdrop of low oil prices and security concerns.
Debt refinancing in the region is also an area of concern according to HSBC’s figures. The latter pointed out that the GCC will see about US$94bn in bonds and syndicated loans maturing in 2016-17, half of which are in the banking sector. This could add further to the liquidity challenges faced by GCC banks and encourage them to adopt a more aggressive approach to debt capital markets (e.g. increase size of benchmark deals and new issue premium). According to Barclays, GCC outstanding Eurobonds account for US$112bn, of which 32% are issued by sovereigns, 26% are issued by banks, 15% from utility companies, 6% of TMT and another 6% from real estate companies, with just 4% coming from oil and gas issuers.
It is largely agreed that 2016 will be the year that tests fiscal adjustments in emerging markets against a backdrop of weaker growth more broadly. Bringing deficits to more sustainable levels is a key policy priority in emerging markets and the Middle East is no exception. The oil exporting countries in GCC still benefit from ample liquidity buffers thanks to sovereign wealth funds. However, the demographics of those countries, which are largely consisting of a young population, require a balancing act between structural reforms and social stability. The ruling elite in the GCC has also changed for the last decade, as the transfer of power moved to second and third generation, which is more likely to be prone to reforms, albeit within the existing religious framework and traditions on the ground. The remaining liquidity buffers in oil-exporting countries could also be used to support quasi-sovereigns and banks, although their stand-alone credit profile has improved for the last five years and such support is unlikely to be needed. Furthermore, this support could be extended to GCC countries, where oil-exports were less abundant in the past, and where they currently face more acute fiscal challenges. This has been demonstrated post the Arab spring in 2011.
In a sense many may not necessarily appreciate, the low oil price is a blessing for GCC countries as it enables them to focus on policy adjustments and reforms previously neglected in the faster pace of wealth accumulation. It could also prompt a compromising foreign regional policy, which could bring various parties to the negotiating table and remove the cloud of geopolitical uncertainties.