The days of using the vast government balance sheet to raise or provide funds indiscriminately are now over
Low oil price has taught GCC states fiscal prudence
Despite the recent bounce in the oil price, the long-term prospects remain uncertain. The US Energy Information Administration (EIA) announced in November the United States produced a record 9.62 million barrels of oil per day (bpd) – the highest ever since records began in the 1980s. The current equilibrium seems to be in the US$50 to $60 a barrel range and – in the absence of yet more political volatility or risk – the Arabian Gulf countries are unlikely to again benefit from the post-crisis windfall of $100 oil, despite the expected rise in emerging markets demand from Asia (China, India etc).
However, it should be emphasised the region has a very unusual relationship with political risk. The higher it climbs, the more uncertain businesses, residents and tourists feel, dampening investment as well as their spending/consumption.
Though simultaneously with this increase in risk perception – the oil price typically rises.
This rise improves government revenues and public-sector finances, which in turn allow a combination of (1) strengthening of reserve buffers and/or sovereign wealth funds, (2) more investment activity (international and/or domestic) or (3) reduced deficits – all positive for the economy.
Having wisely learnt their lessons from the past, the Gulf countries have prudently banked much of the oil windfall of the Q4 of 2010 to Q2 of 2014 period to collectively reach almost $3 trillion as of March 2017. These savings have proven to be key to moderating the recent downturn in prices and are supporting critical and far reaching economic diversification efforts across the GCC. Also, such high oil prices meant that the GCC was an exporter of capital – not just oil.
Now, the IMF estimates that the cumulative budget deficit will be around $320 billion for the 2018 to 2020 period, reversing its fiscal position.
While there are many impacts of lower oil prices, they will give a much-needed boost to the development of local debt and sukuk capital markets.
A more financially disciplined public sector
One of the positive aspects of low oil is that the need for financial prudence at the public sector level is no longer “optional”. Across the GCC, many state-owned entities (SOEs) or Government Related Entities (GREs) dominate the economy as the oil wealth is recycled into the economy via these companies (often through the local government banks).
However, unlike the private sector and the large family-owned groups, these entities would often benefit from government funding or alternatively – when borrowing from the banks – they would also receive favourable interest rates. Their government status gives them a low risk of default, which is positive from a banking asset quality and capital standpoint, although sometimes not necessarily attractive from a profitability standpoint.
The days of using the vast government balance sheet (and associated strong credit ratings) to raise or provide funds indiscriminately are now over. Indeed, some officials have welcomed this new “austerity” to drive better fiscal discipline. In this context, this means that (sensibly) government related projects and corporates need to demonstrate more longer-term viability and sustainable value to raise funding from external sources.
This new accountability has already started to stimulate the growth of regional debt and sukuk capital markets – as expected 2017 looks set to be another record year with total debt/sukuk issuance likely to hit $90bn level by year end ($80bn in 2016 vs and average of around $40bn for the prior eight years) and in the longer term will provide more financing diversity for the local economy which is crucial for the long-term health of the country.
Despite low or near zero bond yields in Europe and elsewhere, and over $1tn of emerging markets inflows expected next year, the GCC cannot be complacent. A domestic institutional investor base is key – but it is still very undeveloped and international investors have a wealth of opportunities open to them and the region is incongruently characterised by theme of almost continuous event risk.
Nonetheless there still are large reserve buffers to ensure very low levels of credit risk for the stronger countries, and we would propose even the weaker ones would likely receive regional support to avoid contagious regional instability.
The GCC has been very fortunate that the $4.5tn of quantitative easing (QE) from global central banks has coincided with low-oil and massively distorted the global risk premium for pretty much all investment assets, especially regional sovereign bonds and sukuk (although there is some correlation of QE with shale production). Hence the region has issued over $180bn of paper at record low rates – easing the painful path to fiscal discipline and taking the regional total outstanding to around $400bn.
Corporate issuance prospects are improving
While banks and now sovereigns are anchor issuers in GCC capital markets, corporate activity has been relatively low. The key driver of this has been, with some short-term volatility, robust levels of bank liquidity especially for locally owned companies.
When they can regularly borrow/refinance at rates not available in the public markets, the costs and complexity involved in bonds and sukuk are often a rational disincentive to issue and hence suppress volumes.
Name lending is still a factor as the expatriate ownership of much of the private sector requires additional levels of due diligence and competencies from lenders to accurately assess risks. Postive for UAE corporate governance on the accounting side will be the application of IFRS9 for banks and as a side effect of value added tax introduction for corporates. Secured and collateral-based lending are common comforts for banks despite difficulties involved in enforcement as noted by the credit rating agencies such as Moody’s and Fitch who often assign limited value to such security.
Banks can suddenly cut lines to de-risk their own balance sheet and preserve their own liquidity and can still rely on the unconstructive criminality of security cheques to drive repayment.
Much of the SME defaults and “skips” of Q4 2015 were self-inflicted by the banks in a short-term “race” to enforce, until the UAE Banking Federation wisely intervened to promote more constructive and collective “standstill” arrangements to encourage workouts.
However, it has been observed that facing a tighter and more challenging funding environment going forward, many prudent CFOs are now looking more closely at the premium paid for long term unsecured public markets (often 2 to 4 per cent over bank lending depending on the rating level) in an effort to lock in longer term funding that is sensibly uncorrelated from the pressures and volatility of the local banks.
This risk/profitability trade-off results in more stable financing conditions and many, regional pioneering corporates in sectors like Damac, (BB/S&P), Dar Al Arkan (B1/Moody’s) and Majid Al Futtaim (BBB/Fitch) are already borrowing independently of local banks from international investors. This is a positive trend Acreditus expects to see rise as we head further into a lower oil and more fiscally disciplined future.
Khalid Howladar is the managing director of Acreditus, a boutique GCC risk, rating and Islamic finance advisory, which is a member of The Gulf Bond and Sukuk Association