This article was originally written for CFA Institute and was published in various newspapers including Gulf News and Arab Times
The GCC is witnessing a period of rapid transformation as oil prices, which were once at a cushy $100 per barrel, has fallen below $50 over the past 18 months. The stable oil prices between 2012 and 2014 enabled GCC to earn more than $3 trillion in export revenues. Thanks to that, GCC governments are now sitting on strong cash reserves.
However, that is only a short-term comfort. Given the extremely high dependence on oil revenues of GCC governments and their lack of economic diversification, the depletion rate of those precious reserves has been highlighted as a major cause for concern. GCC countries now require the oil price to be much higher than $50 in order to balance their budgets. Since prices are still significantly lower than that rate, the region’s governments will face successive years of fiscal and current account deficits; which they will have to plug through additional reserve depletion or through borrowings. Given this context, I would like to specifically look at the financial challenges this period of low oil prices will pose to four specific stakeholders: Government, Banks, Corporates and Individuals.
The biggest pressure is on governments, who face a bloated bureaucratic structure and increasing levels of expenditure largely comprising of salaries and subsidies. Therefore, there is little flexibility for them due to the current social welfare model and the strong social contract with nationals. While rationalising subsidies and reducing wasteful expenditure can be prioritised, this may not reduce deficits within the urgent time frame that is required. Hence, the biggest financial challenge for GCC governments will be funding growing deficits. The IMF estimates GCC countries to pose a fiscal deficit of about 12% of GDP or $150 billion in 2016. I expect this to be met through a judicious combination of reserves, local debt and foreign debt. Research estimates by Marmore point to the cumulative debt increasing from $250 billion to $390 billion by 2020, a significant jump from $72 billion raised cumulatively between 2008-2014. Such a massive growth in debt raising is bound to have an impact on the overall economy in multiple ways. Saudi Arabia, for the first time in eight, had to secure a loan of approximately $26 billion from domestic banks in 2015. It is also in talks to raise $10 billion from a consortium of international banks in an effort to address their growing budget deficit. Most notably the credit rating will be lowered as a consequence of the increasing Debt to GDP ratio. Sovereign ratings of Bahrain, Oman and Saudi Arabia have already been downgraded recently with further downgrades expected in the future. Another point of impact will be the Credit Default Swap (CDS) spreads. In the last six months, CDS spreads of Abu Dhabi, Qatar and Bahrain have doubled while Saudi Arabia’s has tripled. The current macroeconomic conditions will also increase the cost of capital for governments.
The financial challenge for banks will come in the form of lower levels of liquidity. Banks, to a great extent, largely depend on government deposits for their liquidity; which have experienced significant decreases. With stagnating growth in deposits, banks will have lesser amounts to lend at a lower spread; which will have a negative impact on their profitability. On the other hand, the sovereign bond issuances will see high levels of subscription by banks because of the attractive yields and their risk free nature; this will crowd out lending to the private sector. The pressure this will introduce to the margins of banks will result in lower profitability. Additionally, the financial challenges for corporates will mean deteriorating asset quality and a rise in Non-Performing Assets. As a result, the credit rating for banks will remain on the downward trajectory.
Banks being crowded out will directly impact the private sector, since fund raising will be increasingly difficult and expensive. Many companies have solely depended on government spending for projects. In this climate, project delays are inevitable and may affect working capital. Advance payments for projects have been slashed from 20% to 5% of contract value. Since corporates access banks for most of their short-to-medium funding requirements, access to funding may become difficult and expensive given the pressures banks face resulting from lower liquidity and tighter margins. Debt markets may be an attractive source of funding for governments but not for the corporate sector due to wider spreads demanded by lenders. We have already noticed a weak corporate issuance of debt due to the drying up of liquidity. Where funding is absolutely necessary, it will come at higher cost of capital which adds additional pressurise on margins and profits. Introduction of VAT may also impact corporate profitability. These developments will have a substantial impact on Small and Medium Enterprises (SME’s); who will be crowded out the most.
Financial challenges for individuals will come in different forms. Firstly, the generous government policies in the form of subsidies will see cuts; especially for the three most highly subsidised amenities which are petrol, water and electricity. As subsidies are reduced, the cost of services will increase and lead to higher inflation. Individuals will also have less access to financing options from Banks as lending procedures are tightened. Simultaneously, borrowing costs will also increase. Such market conditions may lead to increased debt defaults. Also, governments employ a majority of citizens in the public sector more as a social contract rather than genuine need. The absorption rate will come down as a consequence of growing federal deficits.
As many experts say, challenges can also be viewed as opportunities. Increasing government debt will induce financial discipline, better management of fiscal expenditure and more importantly, the much needed development of debt markets and improvement of the yield curve. Efforts to reduce wasteful expenditure will improve productivity levels across sectors and banks will look for overseas expansion opportunities to improve profitability. The current economic conditions will also encourage the adoption of advanced technological products and services to reduce the cost of service offerings. Corporates will focus heavily on efficiency and productivity gains and align corporate planning with thoroughly researched market needs. Mergers and Acquisitions will be on the rise along with alternative financing avenues such as private equity, crowd funding and sukuks. It will be a period of financial reform to navigate through this challenging period for both the government and private sector!