The Gulf between oil wealth and economic stability
Talk of stimulating growth using surpluses dominates the GCC region as oil prices plummet and asset values sink ever further downwards
"The Gulf region is pretty much insulated from the credit crunch — the only problem we have is inflation," said one Dubai-based banker last May just as the region was being touted as an ocean of calm amid the global financial storm. Stunningly high oil prices — buoyed by dollar weakness — doused Gulf governments with excess cash. As the Western financial meltdown gathered pace in August 2007, the flurry of infrastructure projects, gushing bank profits and resilient asset prices added momentum to the locally held belief that the region had decoupled from the crisis in developed markets.
However in a post-Lehman Brothers world and a slowing international economy, oil prices have plummeted and global money markets have tightened sharply. Key Gulf Cooperation Council indices have fallen heavily — the MSCI GCC Markets index lost more than 40% of its value last year. In October alone, the Abu Dhabi, Kuwait, Saudi Arabia and Qatar exchanges lost 16%, 24%, 26% and 27% respectively. In total, Gulf equity markets have shed around $500bn.
In addition, there has been an abrupt outflow of capital from banks as besieged foreign investors shed leverage and repriced risk. Banking systems, infrastructure projects and the region’s economic diversification efforts are now under threat from the credit crunch and low oil prices. Growth has replaced inflation as the chief concern of policy makers as they throw national savings to prop up banking systems and ensure a soft landing for their economies.
Domestic credit expansion had reached excessive levels over the past year as foreign banks crashed into the region and GCC central banks slashed interest rates to sustain the currency peg with the dollar. This drove inflation to perilously high levels and negative real interest rates. As a result, speculative foreign exchange positions on GCC currencies gathered pace as investors banked on a sharp appreciation to stem inflation.
The UAE was particularly popular with investors with inflows as high as Dh300bn, mainly in the stock market and the banking sector. But as the dollar strengthened, the central bank governor of the United Arab Emirates Nasser Al Suwaidi in August decisively rejected that a depegging of the dirham would take place in the near-term. This caused around 90% of the hot money to flow out — sapping banks’ liquidity.
Nevertheless, monetary authorities quickly intervened and set up emergency liquidity. Most decisively, on October 7, the Central Bank of Kuwait provided emergency credit lines at low interest rates in an effort to restart the credit cycle.
But a reduction in foreign capital will not spell economic disaster. Government spending and interest rate cuts in tandem with the US Federal Reserve over the past year have mainly generated credit expansion in the Gulf. As a result, commodity prices and fiscal policy will determine the fate of the real economy in 2009. However with oil prices tumbling to below $50 a barrel in December, the Gulf is set to slow down sharply. The latest IMF estimate suggests 6.6% growth in 2009. But this looks optimistic. Merrill Lynch predicts oil could fall to $25 per barrel.
Shock and oil
As the world enters a severe downturn, the Middle East could be set for a big economic shock. The precipitous drop in demand for commodities since the summer will most likely wipe out the current account and fiscal surpluses collected by Gulf economies in the bull run. Jarmo Kotilaine, chief economist at NCB Capital in Bahrain, estimates the trigger oil price levels for budget deficits by the end of 2009 are $64 for Saudi Arabia, $52 for Kuwait, $75 for Bahrain and Oman and $50 for Qatar and the UAE.
In addition, the GCC states could be hit by a double whammy of low oil prices and reduced production as the oil-producing states restrict market supply in the face of weak demand.
Thankfully, GCC governments "by international standards are in an exceptionally good position to support domestic demand due to extremely low levels of national debt and a warchest of $2tr of reserves," says Kotilaine. In addition, oil windfalls of recent years have been prudently accumulated through investment vehicles that are poised to support economic activity this year.
Saudi Arabia has already fired its fiscal ammunition by raising public spending by over 19% in the nine months of 2008 and pledging $2.7bn of bank credit for low-income citizens. In addition, the government will stand firmly behind the $260bn worth of projects under construction — now that capital-starved Western banks are unable to arrange syndicated loans — by providing equity or credit guarantees for priority developments.
But even Saudi Arabia — a country with quite healthy macroeconomic fundamentals and a government that will take up the slack of a declining private sector — is set for marked drop in growth. In 2008, the economy was due to expand by 5% from 3.4% the previous year while the consensus 2009 forecast stands at 2%. Nevertheless, despite the financial deterioration "the economic consequences will be manageable so will not inflict much pain on the ordinary Saudi," said Kotilaine.
Howard Handy, chief economist at Samba in Riyadh, says: "The economy will be largely propelled by government spending as commodity prices are expected to recover at the end of 2009 and GCC authorities have a lot of flexibility to borrow domestically."
Nevertheless, it is the UAE that is increasingly seen as a bellwether for the fortunes of the Gulf region. The emirate of Dubai has aggressively diversified its economy in recent years to become a global financial centre. Dubai has positioned itself as a re-exporting hub for foreign companies that service the region.
So its increasing integration in the financial system has increased its vulnerability in the teeth of a global downturn chaining regional credit cycles to the global market, argues Kotilaine. In addition, the emirate has been built on a thick layer of leverage with Fitch estimating total external debt at the end of 2007 of $145bn — a 70% year-on-year expansion as banks binged on cheap credit.
Just as Western economies have been hit by the bursting of the property market bubble driven by funk financing, the once-vaunted Dubai real estate dream is over. Banks and mortgage companies are demanding higher equity payments on new loans as prices fall, bringing demand to a grinding halt and stopping new developments in their tracks.
Nevertheless, economic fallout could be less severe than feared since property developers have already prepared for the cyclicality in the industry and reduced cashflow, say analysts.
Farouk Soussa, Middle East sovereigns analyst at Standard & Poor’s, argues the government is seeking a long term adjustment in the sector "by the introduction of new mortgage laws and curtailing new developments to reduce supply and smooth the fever of speculation". In fact, Soussa argues that a cooling of the market may actually be a positive step in that it might reduce the risk of oversupply in the market, reduce inflation and sustain asset prices in the long term.
More broadly, the debt refinancing quest could redraw Dubai’s corporate landscape with "its myriad government-backed companies via strategic mergers," says Mushtaq Khan, GCC economist at Citigroup in London.
In any case, highly levered corporate giants such as Dubai World, Bourse Dubai, DIFC and Nakheel are likely to receive government support through bridging loans or even new equity issuance.
And in this new global era of strong state intervention and scarcity of capital, there are growing calls for government-affiliated investment funds that have amassed capital in the bull run to jumpstart domestic economies.
The Kuwait Investment Authority (KIA), the state’s sovereign wealth fund, best illustrated this trend in October. The KIA obeyed the government’s command to snap up plummeting financial stocks and place term deposits with local banks to shore up credit conditions. At the end of November, it was reported that the fund had sold off around Kd1bn ($3.66bn) of foreign assets to invest domestically.
Furthermore, the KIA has come under fire after buying stocks in Citigroup and Merrill Lynch where share prices have fallen sharply. Meanwhile the Abu Dhabi Investment Authority (ADIA), the world’s largest sovereign wealth fund worth an estimated $875bn, has also been hit by its $7.5bn investment for a 4.9% stake in Citigroup in November 2007. According to Handy at Samba, the Gulf’s seven biggest funds — KIA, ADIA, Mubadala Development Co, Istithmar World Capital, an investment arm of Dubai World, Qatar Investment Authority (QIA), Investment Corp of Dubai and the Saudi Arabian Monetary Agency — had a total value of $1.25tr at the end of 2007, but by the end of 2008 were forecast to be worth $1.06tr.
SWFs: domestic saviours?
The drive to support domestic markets and for public money to stay at home may see ADIA’s formal mandate to invest overseas reversed at the behest of its Gulf rulers, say analysts. "Governments always have the power to use all their resources as they see fit, and if they decide that the domestic situation requires the use of the SWF, that is their right," says John Nugee, a leading consultant to SWFs as head of the official institutions group at State Street Global Advisors in London.
He adds: "The crisis has shown that these funds are not immune to domestic criticism and they may be increasingly likely to respond to concerns in the future." As a result, SWFs — once touted as a potential saviour for cash-strapped Western economies — may be radically transformed into domestic funds if the regional credit crunch deteriorates. Following the KIA’s example, the QIA bought around 10%-15% of listed financial stocks in November.
Public money could be used to pay off the external debts of private or government-owned firms or provide emergency credit lines for banks and corporates. Khan at Citi argues: "Abu Dhabi has enough external assets to easily bail out heavily indebted Dubai".
Inward investments have clear economic and political benefits: boosting asset prices, protecting strategic firms from foreign buyers as well as providing dollar and local currency liquidity.
The severity of the regional crunch, the political fallout and the appetite for Western assets given the systemic risk there will determine the extent of domestic investment. Although it is difficult to quantify at this stage, these SWFs as huge capital providers could — along with fiscal ammunition — help ensure a smooth economic landing for the region faced with the precipitous drop in oil prices.
But whether such domestic investments have the potential to create market inefficiencies or are sustainable remains to be seen. "It is very difficult to imagine domestic asset prices or credit conditions to come back to levels before the Lehman Brothers collapse," Khan concludes.