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Economics Department

Samba Financial Group

P.O. Box 833, Riyadh 11421

Saudi Arabia

ChiefEconomist@samba.com

+9661-477-4770; Ext. 1820 (Riyadh)

+4420-7659-8200 (London)

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GCC Chart Book: Update Executive Summary

GCC Chart Book - Update

Executive Summary

GCC states weathered another sharp decline in average oil prices last year. Spending was cut, further reforms introduced, and governments increasingly took advantage of low debt levels and favourable market conditions to raise external funds to cover large fiscal deficits. Growth generally slowed, and liquidity pressures continued to affect banking systems, although these have begun to ease.

Governments remain focused on reforms and fiscal consolidation

aimed at returning finances to a sustainable path in a low oil price environment, but their positions should be made easier by the expected recovery in oil prices. Assuming reasonable compliance, the November agreement by OPEC and other non-OPEC producers to cut output should see average prices rise 20 percent to $57/b this year, and to over $60/b in 2018.

While welcome, this will not be sufficient to return fiscal balances to surplus in KSA, Bahrain, and Oman. In addition, the convention of transferring revenues to future generation funds, and not recording SWF income in the fiscal balances, suggests that deficits will also continue to be recorded in Qatar and Kuwait. As a result the GCC will still have a large, albeit declining, financing requirement in 2017/18.

Similar to 2016, this is expected to be covered by a combination of drawing on savings, and domestic and external debt issuance. Market perceptions of GCC sovereigns remain favourable. Exchange rate pressures have eased, CDS and yield spreads have recently tightened. However, funding costs are expected to rise in line with US Fed driven increase in global interest rates.

Given the exchange rate pegs, domestic interest rates will also rise in line with the Fed, adding a headwind to economic activity which is already struggling with lower public spending. However, confidence is reviving in tandem with the oil price, such that GCC stock markets posted gains last year. In addition, with government revenues set to rise for the first time in 3 years, capital spending looks set to increase modestly.

GCC debt is rising rapidly, but from very low levels. In addition, with the exception of Bahrain, governments’ net asset positions will remain strongly positive given their large external savings. Central banks continue to hold ample reserves, and GCC current accounts are expected to move back into surplus, except in Bahrain and Oman.

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Oil prices have firmed since OPEC’s November agreement to cut output, and subsequent confirmation of additional cuts from non-OPEC producers, notably Russia and including Oman. Having averaged $48/b in 2016, Brent is projected to rise to $57/b this year, although this will depend on compliance with the cuts. OPEC production is to be cut by 1.2mb/d to 32.5mb/d starting in January for an initial 6 month period. It is early days, and data is not yet available, but indications are good that producers are scaling back supply, with Saudi officials in particular stating that they have already cut output to around 10mb/d. Harder to predict are developments in Libyan and Nigerian production which is exempted from the output cuts. With global demand holding up, production cuts will go a long way to rebalancing the market and supporting prices. However, firmer prices will also encourage increased US shale production. Rig counts and supply are already on the rise, and the strength of this output response will have a major bearing on price developments.

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The key indicator will be whether exceptionally elevated crude stocks start to be drawn down. Recent weekly increases in the US have been unsettling, but it will take time for physical markets to fully adjust to lower supply. As widely expected, the US Fed raised rates 25bps in December. With the US economy close to full employment, wage pressures rising, and fiscal stimulus expected under the new Trump presidency, we now expect 3 more rate rises this year. The dollar is also expected to remain strong reflecting a combination of widening interest rate differentials with other major currencies, and stronger growth and earnings expectations on the back of fiscal stimulus and reforms.

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Given their exchange rate pegs to the US dollar GCC central banks have all followed the Fed and raised their own policy rates 25 bps. Higher policy rates are pressuring GCC interbank rates, although this is being offset by improving liquidity due to a variety of factors including: rising oil revenues and lower fiscal deficits, with governments also shifting financing from domestic sources (deposit drawdown, local bond issuance) to external sources (SWFs, international bond issuance). While still historically low, benchmark US Treasury rates are on the rise and are expected to rise further as the Fed pushes ahead with interest rates rises and inflation begins to pick up.

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Moody's S&P Fitch

Saudi Arabia AA3 Aa- AA

Oman A1 A NR

Qatar Aa2 AA NR

UAE Aa2 NR NR

Bahrain Baa2 BBB BBB

Kuwait Aa2 AA AA

Rating Agencies GCC sovereigns have been active issuers in international bond markets, with KSA launching it’s highly successfully debut bond in November. While funding costs are expected to rise in line with the general increase in yields, the outlook for spreads is variable, with some scope for further tightening as oil prices recover. There has already been an improvement in CDS spreads as markets take comfort from the OPEC output deal, as well as moves towards fiscal reforms and consolidation. In fact, spreads for oil rich Abu Dhabi are back near those prevailing when oil prices were $100/b. That said, the prolonged slump in oil prices and resultant shift into fiscal and current account deficits has led to ratings downgrades for KSA, Oman and Bahrain. All except Bahrain retain investment grades, although Oman’s S&P rating looks vulnerable. Governments retain substantial space to increase debt further, but rating agencies will be looking for progress with reforms and a sustained effective policy response.

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Regional stock markets generally recovered in 2016 as confidence revived along with the oil price and improvements in liquidity as governments increasingly tapped external sources of finance. However, earnings have been squeezed and will likely remain under pressure as governments continue to focus on fiscal consolidation. Government revenues declined again last year as average oil prices fell further. Spending has been cut and reforms introduced, but deficits widened. Oman, Bahrain and KSA were worst hit, and are projected to continue posting large deficits this year. Public finances are in better shape in the UAE, Qatar and Kuwait, particularly when adjusted for SWF income/transfers, but all are under pressure to introduce reforms. A GCC wide VAT is planned for 2018, but its introduction will be institutionally and administratively challenging such that a delay would not be surprising. 2016 marked a second year of cuts to GCC fiscal spending but, on an aggregate basis, spending should hold steady this year as revenues rise for the first time in 3 years, before reviving in 2018. In fact, capital spending should pick up in the region, including in KSA, although recurrent spending will likely remain squeezed.

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GCC governments have built up large fiscal buffers which to varying degrees have been drawn on to offset the slump in oil revenues. They also have low debt levels, and are increasingly issuing domestic and external debt to fund deficits while they look to reform their economies. As a result, public debt is rising fast, but all but Bahrain maintain net creditor positions and are well short of the 60% of GDP EU debt target. 2016 was notable for the surge in sovereign external debt issuance, both in bonds and syndicated loans. Even Kuwait with over 500% of GDP in external savings is preparing a large bond sale to help cover its gross financing needs. Excluding mandatory transfers to its Future Generation Fund and investment income, Kuwait’s annual budget deficit was around 17% of GDP in 2015-16. In general GCC bank deposit growth continued to slow in 2016 in line with declining public revenues/spending/deposits. However, more recent recourse to international financing has helped improve liquidity and should continue to do so this year as public financing needs also decline. Central banks have also directed public institutions to place deposits with banks, while non-resident deposits have surged in Qatar.

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Expanding public sector credit and private sector recourse to bank finance to offset payment delays kept 2016 credit growth in double figures in KSA and Kuwait. Elsewhere credit has slowed, although tight liquidity conditions could ease somewhat this year. Under pressure from lower public spending the non-oil private sector appears to be holding up. The monthly KSA PMI surveys continue to point to expansion, although the employment sub-component is struggling to stay positive. A similar story is apparent in the UAE, and GCC wide it will be critical that the private sector increasingly becomes the engine of growth and employment creation.

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To this end GCC governments have embarked on supportive policies and reforms, and there is scope for substantially improving the environment for business development and growth. Labour market reforms, privatisation, and partnerships with the private sector are all in prospect as governments look to alter incentive structures and boost productivity. Oil sectors are likely to be a drag on growth in the region this year as output is cut in line with the November OPEC agreement. This covers an initial 6 month period to June, but the option exists to extend cuts for the whole year if prices remain weak. Given the drag from oil sectors, and emphasis on sustained fiscal consolidation, GDP growth is likely to remain weak in Oman and KSA. However, project spending in the UAE (Expo 2020), Qatar (2022 World Cup) and Kuwait (improved implementation of 5 year Development Plan) should provide support to growth.

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The US dollar strengthened against most major currencies last year except the euro, but has lost ground this year in the face of further euro strength and a safe haven bounce in the Yen

Rising US yields have pushed up GCC yields, although the strength of major issuers has limited the increase

hinese oil demand growth last year.

In the US, the notion that oil demand might have reached some sort of structural peak is having to be revised. The abundance of cheap shale oil, along with decent population growth, has revived oil demand.

Mixed signals on the demand side are matched by a confused supply picture.

Libya’s output remains depressed amid a chaotic political scene, though there are reports that recent tanker loadings have picked up markedly. Iraq’s output remains volatile—dogged as it is by security and technical issues—but has not been able to recapture the highs registered in mid-2012. Sudan’s production has collapsed again

Past and pending subsidy reforms and tax/fee increases have and will generate spikes in inflation, especially when VAT is introduced. However, weaker economic activity and the impact of a strong dollar will generally keep underlying inflation rates low in the GCC. In addition, real estate prices and rents, which are heavily weighted in GCC consumer price indices, are softening in the region, further dampening inflation. After a long run, Qatar real estate prices fell during 2016. Newly available data for Saudi Arabia also show that both residential and commercial real estate prices have been falling in the kingdom over 2015-16.

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Similarly, data for Dubai suggest that the real estate sector remained weak in 2016, although the overall UAE market is quite variable. The UAE and Kuwait have managed to maintain current account surpluses in the wake of the oil price slump. Qatar is expected to slip into a small deficit this year before recovering. Cuts in spending and slower growth have seen KSA imports drop sharply, such that the current account should move back into surplus this year. Meanwhile, Bahrain, and particularly Oman, face sustained current account pressure. However, Oman’s recent recourse to external financing and draw on public savings has meant that central bank foreign exchange reserves have held up. As they have in Kuwait.

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The main source of reserve drawdown has been in KSA, although the optics are slightly different as (for now) SAMA also manages funds which in other states would be placed with SWFs. Future reporting of KSA reserves may well change as plans to turn the PIF into a large SWF come to fruition. Pressures on GCC exchange rate pegs have eased as fiscal reforms take effect and oil prices recover. However, concerns over Oman’s external balances remain elevated as reflected in the forward exchange rate. Bahrain’s underlying position also looks vulnerable and reserves have reportedly dropped. But the country is assumed to retain the firm backing of KSA and forward rates have fallen back in line with improved sentiment on the kingdom.

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James Reeve Deputy Chief Economist James.Reeve@samba.com Andrew Gilmour Deputy Chief Economist Andrew.Gilmour@samba.com Thomas Simmons Economist Thomas.Simmons@samba.com

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