GCC Economic Outlook. Report Series. March Highlights

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1 March 29 Report Series GCC Economic Outlook Highlights The long economic boom in the GCC came to a shuddering halt during the third quarter of 28 as the global financial crisis hit home and oil prices collapsed. Capital flows, assets prices, and oil revenues fell steeply, severely denting investor confidence and forcing a substantial scaling back of infrastructure and construction projects in the region. Banks have also had to curb soaring credit growth and rebalance their books. While the phase of huge fiscal and current account surpluses may be coming to an end, GCC governments have saved much of the recent oil price windfall, and are thus much better placed to weather the downturn and run countercyclical policies. Despite this, overall GCC real GDP growth is still projected to fall steeply from 6.5 percent in 28 to.5 percent in 29, with a pick up possible in 21 assuming the global economy and oil prices recover. Record oil revenues during 28 allowed for sustained additions to aggregate GCC foreign assets which, including Sovereign Wealth Funds, held at an estimated $1.2 trillion, despite large losses stemming from the collapse in global asset values. This should provide substantial funds to help compensate for lower capital flows, to inject liquidity into banking sectors, and to sustain public spending levels in the face of lower oil prices. With oil prices falling below budget break even points for at least half of the GCC countries, and production also set to fall in line with OPEC cuts, the combined GCC fiscal balance is expected to shift from a 28 record surplus of 28.7 percent of GDP to a deficit of 4.9 percent in 29. With oil exports expected to fall by more than half, the overall GCC current account balance is also expected to move into a small deficit, despite lower import volumes and prices, and a significant net drawdown of GCC foreign assets is now expected. Office of the Chief Economist Economics Department Samba Financial Group P.O. Box 833, Riyadh Arabia ChiefEconomist@samba.com ; Ext GCC borrowers, including banks, remain vulnerable to continued deleveraging and credit retrenchment in global financial markets, and could struggle to roll over large amounts of existing external debt in the coming years. Lower capital inflows will contribute to continued liquidity constraints in local markets where annual credit growth is expected to slow sharply from around 2-5 percent, to low single digits. Until mid-28, overheating economies were fuelling record inflation rates and posing challenges to GCC policy makers, particularly given the US dollar exchange rate. However, circumstances have now changed dramatically. Average inflation is expected to fall by almost half to 6 percent in 29 as GCC economies slow, and the policy focus has now shifted to providing liquidity support. This and other publications can be Downloaded from

2 GCC Key Macro Indicators and Forecasts GCC e 28e 29f 21f Real GDP Growth (% change) Nominal GDP ($ billion) , CPI (ave. % change) Budget Balance (% GDP) Current Account Balance (% GDP) Population (million) Arabia e 28e 29f 21f Real GDP Growth (% change) Nominal GDP ($ billion) CPI (ave. % change) Budget Balance (% GDP) Current Account Balance (% GDP) Population (million) e 28e 29f 21f Real GDP Growth (% change) Nominal GDP ($ billion) CPI (ave. % change) Budget Balance (% GDP) Current Account Balance (% GDP) Population (million) e 28e 29f 21f Real GDP Growth (% change) Nominal GDP ($ billion) CPI (ave. % change) Budget Balance (% GDP) Current Account Balance (% GDP) Population (million) e 28e 29f 21f Real GDP Growth (% change) Nominal GDP ($ billion) CPI (ave. % change) Budget Balance (% GDP) Current Account Balance (% GDP) Population (million) e 28e 29f 21f Real GDP Growth (% change) Nominal GDP ($ billion) CPI (ave. % change) Budget Balance (% GDP) Current Account Balance (% GDP) Population (million) Bahrain e 28e 29f 21f Real GDP Growth (% change) Nominal GDP ($ billion) CPI (ave. % change) Budget Balance (% GDP) Current Account Balance (% GDP) Population (million)

3 March 29 Table of Contents Economic Developments: 28 4 The Financial Crisis and World Recession 5 How have the GCC Economies been affected? 6 Box 1: GCC Liquidity Measures taken by Central Banks and Governments 9 Fiscal and External positions 11 Box 2: Exchange Rate Issues and Progress towards GCC Monetary Union 13 GCC outlook 14 Box 3: Data Weaknesses Cloud the Picture 15 3

4 Economic Developments: 28 GCC: Investment Projects; $2.5 tn; Sep-8. 4% 3% 9% Bahrain 12% 47% Source: MEED 25% The boom comes to an end The long economic boom in the six countries ( Arabia,,,, Bahrain, and ) of the Gulf Cooperation Council (GCC) came to a shuddering halt during the third quarter of 28 as the global credit crunch hit home and oil prices collapsed. Capital flows, assets prices and oil revenues fell steeply, severely denting investor confidence and forcing a substantial scaling back of the large number of infrastructure and construction projects in the region. Banks have also had to rein in soaring credit growth and rebalance their books. While the positive momentum of the first nine months ensured that 28 growth rates remained strong, the outlook for the GCC has deteriorated sharply. However, while the phase of huge fiscal and current account surpluses may be coming to an end, GCC governments have saved much of the recent oil price windfall, and are thus much better placed to weather the downturn and to run countercyclical policies. Full year economic growth remained strong GCC: Nominal GDP 28: $1,37 million Arabia Bahrain Source: IIF; Samba Fuelled by record oil prices, abundant liquidity, negative real interest rates and strong population growth, the economies of the GCC continued to grow strongly during most of 28 as credit growth and spending surged. Real GDP growth is estimated to have risen to 6.5 percent from 5.6 percent in 27, pushing the GCC s combined nominal GDP up to $1 trillion. Rising private consumption and surging public and private investment were the main sources of growth, reflected in booming construction activity and a project list approaching $2.5 trillion in value. The oil and gas sectors also contributed to real growth in the region as oil production rebounded following the small contraction in 27 when Arabia, the and reduced output to support prices. In addition, LNG exports from have surged as new production trains come on stream. Inflationary pressures remained high GCC: Inflation (%) e Source: IIF; Samba Inflationary pressures persisted during 28 as strong demand continued to overwhelm supply responses, pushing the average annual inflation rate in the GCC up to an estimated 11.5 percent. Inflation has been most pronounced in the and where negative real interest rates, easy credit, and relaxations on property ownership helped stoke overheating real estate markets. Rising rents were a particularly strong driver of inflation throughout the region as rapid population growth put pressure on housing supply. Additional pressure came from higher international food prices and import costs, with the latter fuelled by the steep depreciation of GCC currencies through mid-year due to their peg to the US dollar ( switched to a basket in May 27). Inflationary pressures eased off in the latter part of the year as the US dollar strengthened, and rates are expected to drop back significantly during 29 as economic growth slows. 4

5 World Economic Outlook 27 28e 29f 21f Real GDP growth (percent, annual) World US Japan Euro area Emerging Markets Twin fiscal and current account surpluses soared With average oil prices rising by close to 4 percent in 28, oil revenues surged pushing current account and fiscal surpluses to record highs. The combined GCC fiscal surplus rose to an estimated 28.7 percent of GDP, with the larger oil producers - Arabia,, - benefiting the most. Similarly the combined GCC current account surplus is estimated to have risen to $325 billion in 28 (31.4 percent of GDP), of which Arabia accounts for a bit less than half. With the exception of (5.4 percent), all countries saw current account surpluses rise to extraordinary levels of between 2-5 percent of GDP. Official Policy Rate (end period) US Japan Euro area Crude Oil Price ($/b, period average) WTI Source: Samba estimates and forecasts Sep-7 Middle East: JP Morgan CEMBI Blended Spread Nov-7 Jan-8 Source: Bloomberg Mar-8 May-8 Jul-8 Sep-8 Nov-8 Jan-9 The Financial Crisis and World Recession Financial turmoil and a deep global recession While the headline GCC growth, current account and fiscal balances for 28 remained healthy, they mask an abrupt turnaround in economic and financial conditions during the second half of the year, and the GCC faces an extremely challenging outlook. In particular, the world has spiraled into a major recession as negative feedback loops between the real and financial sectors have intensified. Global trade and industrial activity has slumped, accentuated by a loss of confidence by investors, employers and consumers. Output in advanced economies is now expected to contract by 2.8 percent in 29. Some pick up is possible late in the year and into 21, but this will depend on a recovery in financial markets, and on the impact of large fiscal stimulus packages. The world economy will contract in 29 Growth in emerging markets is also slowing sharply, although rates should hold up better than during previous global downturns as stronger fundamentals in many economies are providing more room for policy support. Overall global GDP is projected to contract by.9 percent in 29, its worst performance since World War II, with a weak recovery to 1.9 percent growth possible in 21. Even this bleak projection is subject to considerable downside risk, particularly if financial market conditions remain strained and emerging markets prove less resilient than currently assumed. Financial conditions remain strained 115 Dow Jones Citigroup Sukuk Index Sep-7 Nov-7 Jan-8 Mar-8 May-8 Jul-8 Sep-8 Nov-8 Jan-9 Source: Bloomberg Financial conditions are expected to remain very difficult over the next 12 months. Despite wide-ranging policy measures to provide additional capital and reduce credit risks, spreads in funding markets remain high and credit flows constrained - emerging bond markets virtually shut down during the fourth quarter of 28. Advanced economies bank balance sheets are being cut back through asset sales and the retiring of maturing credits. Credit risks have risen as deteriorating economic and financial conditions have pushed up loan loses, and the IMF now estimates that potential losses on US-originated assets for banks and non-bank financial institutions balance sheets will reach $2.2 trillion. 5

6 g-8 Au Source: Bloomberg GCC: 5YR CDS Rates (bps) Sep-8 Oct-8 Nov-8 Dec-8 Arabia ADGB Jan-9 Feb-9 Dubai How have the GCC Economies been affected? The adverse impact of the current global turmoil on the GCC is principally being felt through two main channels: Financial channels: The financial crisis has led to a steep decline in capital flows and asset values, put pressure on GCC bank balance sheets, and contributed to a sharp tightening of liquidity in the region. Oil prices: Falling oil demand has caused oil prices to slump by over $1/b, prompting OPEC to agree to large production cuts, and causing GCC oil exports earnings to plummet Emerging Markets: Net Private External Capital Flows ($ blns) GCC: Foreign Currency Debt Repayments $ billion Bahrain Arabia Total Source: BOA-Merrill Lynch Source: IIF Financial Channels External funding has dried up GCC economies are feeling the effects of advanced economies financial difficulties principally through the abrupt pullback from emerging market assets and higher financing costs. Credit Default Swap (CDS) spreads for GCC sovereigns and corporates have risen sharply as investors have become increasingly risk adverse. Borrowers in the GCC remain vulnerable to continued deleveraging and credit retrenchment, and could struggle to roll over large amounts of existing debt in the coming years. Reduced access to capital markets has already pushed GCC corporates to tap local banks for short-term loans, shortening the maturity structure of their debt and further raising roll over risks. GCC refinancing needs are large Total GCC foreign currency debt repayments are estimated at around $4 billion a year during 29-1, with half the total accounted for by, and in particular Dubai ($15 billion). Already Dubai government owned entities have struggled to refinance large loans in early 29 causing the federal authorities to provide support to prevent any defaults. This took the form of a $1 billion bond subscription by the central bank, with another $1 billion planned. While the acute situation in Dubai is not indicative of the GCC as a whole, even highly creditworthy borrowers may struggle given the dire outlook for capital flows to all emerging markets. According to the Institute of International Finance (IIF), net flows for all emerging markets are projected to fall from $466 billion in 28, to just $165 billion this year. Local liquidity conditions have tightened Feb-8 Source: Bloomberg GCC: 3M Interbank Rates (%) Apr-8 Jun-8 Aug-8 Oct-8 Dec-8 SAIB3M KIBOR3M EIBO3M Reported GCC bank exposure to US subprime, the initial catalyst of the current financial crisis, has been relatively limited, and in general banks in the region have weathered the storm reasonably well, particularly in comparison with the carnage inflicted on US and European banks. However, while full year 28 results held up in the main, reported profits fell sharply in the fourth quarter as domestic liquidity conditions tightened considerably, and GCC banks now face a much more challenging operating environment. While the GCC was awash with liquidity during the first half of 28, three key factors combined to contribute to an abrupt and sharp tightening during the second half of the year: 6

7 Jan-7 GCC: Stock Market Performance; (Jan. 27 = 1) Apr-7 Source: Bloomberg Jul-7 Oct-7 Jan-8 Apr-8 (Dubai) Jul-8 Oct-8 Jan-9 Bahrain Reduced and more costly access to international capital markets has had an adverse impact on banks and corporate entities long-term funding. This has constrained banks ability to lend, while at the same time pushing corporate entities into seeking funds in the local bank markets. Another key factor in the GCC states has been the withdrawal of large amounts of speculative funds which had flowed into the region up until mid-28 betting on exchange rate revaluations. This hurt bank deposits and added to shortages of dollar funds. Third has been the continued rapid increase in loan growth (2-5 percent p.a.) which has exceeded deposit growth and contributed to elevated bank loan to deposit ratios which, in aggregate, exceed central bank prescribed limits in all GCC members. Without easy access to wholesale funds, the shortfall in deposit growth is constraining banks ability to lend. GCC: Stock Mkt Capitalization ($ bn) 5 23 GCC stock markets have crashed Arabia Source: IIF and zawya.com end-feb, 29 Bahrain The combination of these factors ensured that the GCC has suffered its own credit crunch, leading to elevated interbank rates, a tightening of bank lending conditions, and the curtailment of credit flows with adverse consequences for economic activity. Stock markets of the GCC did not escape the general collapse in share prices world wide and increased investor risk aversion. GCC indices slumped by between percent in 28, and have continued to fall in early 29. Market capitalization has more than halved as it has become clear that the GCC has not decoupled from the rest of the world, and will suffer from the collapse in oil prices. The Dubai and stock markets were worst hit in 28 declining by 72 percent and 56 percent respectively. GCC: Real Estate Prices (average 25=1) Jun-Nov Oct-7 Jun-8 Nov-8 28 (% change) Arabia Bahrain Source: In the, concerns over Dubai s higher exposure to capital markets and real estate risk were major drivers behind the poor stock market performance. However, recent federal financial support to the Dubai government and additional capital injections by Abu Dhabi into its banks has done much to restore confidence. In early March the Abu Dhabi stock market was one of a handful around the world posting a gain for the year to date, bucking a sustained bearish trend in global equities, while the Dubai market was down just 5 percent. In contrast, the stock market has fallen steeply this year - having held up best out of the GCC in 28 - as concerns have risen over banks exposure to a falling real estate market. Real estate sectors are under pressure As credit markets tightened and economies slowed the GCC s real estate sectors have also come under pressure. Projects have been delayed cancelled or scaled down, and real estate prices have weakened. This is particularly true in Dubai and where cheap credit, a relaxation on foreign ownership, and rising expatriate populations had fuelled a long property boom. A correction is now underway with prices falling back steeply. Prices have also fallen in other markets, including Arabia. However, the kingdom s supply and demand dynamics remain favourable (it is not reliant on 7

8 GCC: Central Bank Policy Rates (%) Repo Rate Repo Rate Repo Rate Central Bank Bahrain o/n Repo rate Feb-8 May-8 Aug-8 Nov-8 Feb-9 Source: Bloomberg; Central Banks expatriate demand), and the real estate sector is expected to fare better than most in the region. GCC policy response Governments and central banks in the region have been quick to respond to the evolving liquidity crunch and have shifted their focus away from containing record inflation and rapid credit growth, to providing liquidity to their banking systems. Some of the key measures introduced over the past 6 months include (see Box 1 for more details): Placing deposits in commercial banks ( Arabia, ); Making lines of funding available for the banking sector (, Arabia, ), and Buying stakes in banks to support capital growth (, Abu Dhabi) GCC: Growth in Bank Credit to the Private Sector Arabia Source: Central Banks Bahrain 28 latest available data At the same time monetary policy has been progressively eased through reductions in interest rates, accompanied in some cases by a relaxation in bank reserve requirements and loan to deposit ratios. Some central banks have also moved to boost US dollar liquidity through providing swap facilities (, ) and, in the case of, by directly providing dollar loans to banks. Some GCC governments are also using their Sovereign Wealth Funds to invest directly in bank shares, as in, and into the stock exchanges more generally in order to stabilize markets, as in and. The measures introduced so far are having a positive impact, as reflected in declining GCC interbank rates in the GCC and an easing of forward exchange rate spreads. Governments and central banks are expected to continue monitoring liquidity developments closely and step in when necessary to provide further funds. Importantly they have the resources to do this, and expansionary fiscal policies and state liquidity injections are likely to be key drivers of liquidity in the region during will be a difficult year for GCC banks The policy stance in the GCC has shifted decisively toward monetary accommodation and fiscal stimulus, and this will be helpful to the financial sector at this time. Nonetheless, banks clearly face a number of difficult challenges GCC: Bank Loan/Deposit Ratios 112% 113% 119% 93% 113% 17% Bahrain (9%) (85%) () Central Bank Limit Source: Central Banks (9%) (85%) (85%) (1%) Dec-5 Q3-8 GCC banks are, in general, well capitalized compared with US and European banks, but a sustained shortage of long term funding sources may compel many to shrink their balance sheets (deleverage). In view of the deteriorating operating environment, banks face significant risks from asset quality deterioration including on international investments - rising non performing loans (NPLs), inflated provisioning needs, and decreased credit volumes. Exposure to declining real estate sectors is a major concern for some, especially banks in Dubai where a speculative property bubble has burst and bank exposure is large. 8

9 Box 1: GCC Liquidity Measures taken by Central Banks and Governments GCC: LCU/$ 3Month Forward Spread Jun-7 Sep-7 Source: Bloomberg Dec-7 Mar-8 KWD3M AED3M QAR3M Jun-8 Sep-8 Dec-8 BHD3M SAR3M OMR3M Arabia: Interest rates have been cut, the reserve requirement has been lowered to 7 percent from 13 percent, $2-3 billion has been injected into the banking system in the form of dollar deposits, and all bank deposits have been guaranteed. SAMA is also understood to be offering unlimited US$ swap facilities, and the government extended $2.7 billion in credit to low income citizens having difficulty accessing loans. : Interest rates have been cut, the central bank has provided a $13.6 billion short term liquidity facility, allowed banks to withdraw up to 1 percent of their central bank reserves, and introduced a dollar swap facility. All bank deposits and interbank lending has been guaranteed for three years, and $19 billion provided in the form of long-term bank deposits, convertible into a loan to raise capital if necessary. The two largest mortgage finance companies have been merged and taken over by the federal government. The Abu Dhabi government has injected new capital worth $4.4 billion into five of its banks. : Interest rates have been cut, the central bank has injected funds into the banking system in the form of short-term deposits, the regulatory loan to deposit ratio has been raised from 8 to 85 percent, all bank deposits have been guaranteed, the rights issue in Gulf Bank was underwritten by the government, and the Investment Authority has pumped cash into the stock exchange to help stabilize markets. Also under consideration are draft bailout measures for the banks including a proposed central bank guarantee for around $7 billion in new credit facilities aimed at local investment firms to prevent them defaulting on bank loans. Draft legislation would also seek to guarantee for 15 years any drop in value of local bank s investment and real estate portfolios. 2% 15% 1% 5% % GCC: Real Estate Loans as a % of Deposits; *Building/real estate and construction loan. 18.% 15.5% 16.2% 6.4% 9.7% (Oct-8) (Oct-8) Source: Central Banks Arabia* * (Sep-8) Bahrain* (Dec-8).5% * (Jan-9) : Interest rates have been cut, the QIA is spending $5.3 billion on 1-2 percent of the capital of i banks listed on the Doha stock market, and is buying listed shares within the investment portfolio of local banks to bolster their books after a collapse the stock market. Bahrain: Interest rates have been cut, a new dollar swap facility introduced and the deposit guarantee scheme is to be raised to a maximum of 2, dinars ($53,) from 15, dinars. : Interest rates have been cut, the loan to deposit ratio held at 85 percent rather than cut as planned to 82.5 percent. The central bank is lending $2 billion to banks to provide dollar liquidity, and the government has created a $39 million market stabilization fund to invest in local shares. Oil Price Collapse Oil sectors still dominate GCC economy While the GCC economies have become increasingly diversified, and have been driven by rapidly expanding non-hydrocarbon sectors in recent years, they are still dominated by their hydrocarbon sectors, particularly oil. On an 9

10 Jan-7 Apr-7 Source: Bloomberg Jul-7 Oil vs. Gas Prices Oct-7 Jan-8 Apr-8 Jul-8 Oct-8 Jan WTI (USD/bbl) Henry Hub (USD/MMBtu; rhs) aggregate basis, the hydrocarbon sector in the GCC still accounts for about 45 percent of real GDP, 79 percent of total exports and 77 percent of budget revenues. GCC economies are thus particularly vulnerable to the recent sudden decline in oil prices from a high of $147/b in mid-28 to an average of around $4/b barrel in the first quarter of 29. Gas prices have posted a similar decline. Rest of World 77% Global Gas Reserves % GCC 23% Global Oil Reserves % GCC 4% GDP Growth Vs O il Demand (%) Source: BP Rest of World 6% Source: IMF; IEA; Samba mb/d GCC OPEC members' Oil Production World GDP growth Oil demand f Source: P FC Arabia -15% With collapsing world oil demand threatening to drag prices back under $3/b, OPEC has been compelled to agree record production cuts of 4.2mb/d from the September 28 level of 29.1 mb/d for the 11 members subject to quotas, These cuts came into effect in January and are aimed at trying and restore market balance and provide some support for prices. This has dealt a double blow to the GCC economies that are members of OPEC (,,, ) which have to contend with both a steep drop in oil prices and, on average, a 14 percent drop in production in 29. Oil production is likely to be down closer to 16 percent in the largest producer, Arabia, which has indicated that it will cut output to less than 8 m/bd. This combination of falling prices and production will see GCC oil earnings fall by over half in 29, with adverse implications for fiscal and current account balances. In addition, growth will be dragged lower by the drop in oil production, and to the extent that public spending is curtailed due to lower oil revenues. Short term oil market prospects are weak Projecting oil prices under current global circumstances is extremely difficult. Much will depend on how severe the global recession turns out to be, how successful OPEC is in abiding by agreed production cuts, what happens to financial and credit markets, and whether and when markets start to worry about longer-term supply constraints again. While there are considerable downside risks, this report has been prepared on the basis of an average oil price assumption of $5/b for 29, down 5 percent over the average actual price in 28, and $6/b in 21. 1

11 Bahrai Source: IIF GCC: Sectoral Shares in 27 Nominal GDP (%) % 5% 1% Hydrocarbon GDP Non Hydrocarbon GDP GCC Oil Production m/b/d f Arabia Total GCC OPEC Source: EIA, PFC Medium-term outlook is more promising GCC: Composition of Exports, 27 (%) Bahrai % 5% 1% Hydrocarbon Exports Source: IIF Non-Hydrocarbon Exports GCC: Composition of Government Revenues, 27 (%) Bahrai Despite the bleak short-term outlook the GCC, with 4 percent of proven oil reserves and 23 percent of gas reserves, is well placed to benefit from an expected recovery in energy prices in the medium term, and could see its global market share rise strongly. In particular, concerns continue to be expressed over a looming oil supply crunch due to insufficient investment in part reflecting low prices and declining rates of production in existing oil fields. In its World Energy Outlook 28 report, the International Energy Agency suggests that current low oil prices are a temporary effect of the economic crisis, and forecasts that prices will rebound quickly to $1/b as soon as the world economy recovers. Fiscal and External positions Large savings will soften the blow from lower oil prices Going into the current global crisis the financial position of the GCC is strong, having benefited from years of huge fiscal surpluses. Rising oil prices during 22-8 have been mirrored in rising fiscal and current account surpluses, and a large accumulation of foreign assets. Official foreign reserves of GCC members increased more than seven fold through 28 to reach $517 billion, the greater part of which ($44 billion) is accounted for by the foreign assets managed by the Arabian Monetary Authority (SAMA). In addition to these reserve assets are the substantial official assets which have been built up over the last few years, in some cases in Sovereign Wealth Funds (SWFs). However, a lack of official data on SWFs means that there are no reliable estimates on the value of assets held. However, drawing together from various sources 1 the overall level of GCC foreign assets (including official reserves), is thought to have been around $1.28 trillion at end-27, with the majority accounted for by SAMA, and the large SWFs of Abu Dhabi (ADIA), (KIA), and (QIA). % 5% 1% Hydrocarbon Revenues Source: IIF Non-Hydrocarbon Revenues 1 Including the Council on Foreign Relations, IIF and Sovereign Wealth Fund Institute 11

12 Official Reserves (excluding gold) $ billion e Bahrain (Sama NFA) GCC total Source: Central Banks; Samba. Little official data on the composition of SWF assets is available, but it is clear that their value will have fallen steeply during 28 in line with the global collapse in asset values. Rough estimates suggest that the overall drop in total GCC foreign assets could be around $35 billion, with ADIA, KIA and QIA suffering the heaviest declines of around 4 percent, while SAMA s lower exposure to equities is thought to have limited losses to 12 percent. Despite such losses, large new additions to official foreign assets, reflecting record oil revenues during 28, suggest that total GCC foreign assets still ended the year at around $1.2 billion. This will provide substantial funds to help offset lower capital flows, cover external debt repayments, and support public spending levels in the face of lower oil prices. This particularly applies to the Arabia,, the (ADIA support will be crucial for Dubai), and, while Bahrain and have less room for manoeuvre and face a potentially sharper fiscal adjustment Bahrain Source: UNCTAD GCC: FDI Inflows ($ mlns) a Arabia GCC Official Foreign Asset Holdings $ billion Losses as a % New Losses of 27 portfolio Inflows GCC central banks % 129 of which SAMA+ assets managed for % 162 other gov. inst. (est. market val.) Sovereign Wealth Funds % 161 of which Abu Dhabi Investment Authority % 59 Investment Authority % 57 Investment Authority % 25 GCC Total % 29 memo Norwegian Gov. Pension Fund % 64 Source: CFR, IIF, Samba External debt levels have risen but remain relatively low GCC: Gross External Debt $ billion * Arabia Bahrain GCC Source: IIF; * June Most GCC countries have no sovereign debt (including Arabia and ) and those that do have very little, mainly for benchmarking purposes. Nonetheless, there has been a sharp increases in private sector borrowing, and by government owned corporation. This has pushed overall external debt levels up sharply over the last few years. Total combined GCC gross external debt reached an estimated $358 billion in June 28 (equivalent to 34.5 percent of 28) GDP. Much of this is accounted for by the surge in borrowing by GCC banks, particularly in and the, to fund their domestic loan portfolios, and increased borrowing from state owned corporations, again in, and also Bahrain. Despite the increase, GCC debt vulnerability is low by most measures, and the GCC maintains a strong net external creditor position. However, as stressed earlier, given the dire state of global financial 12

13 markets, roll over risks have risen, particularly for the more heavily indebted emirate of Dubai. 9 USD (DXY) Index Box 2: Exchange Rate Issues and Progress towards GCC Monetary Union Oct-7 Dec-7 Feb-8 Apr-8 Jun-8 Aug-8 Source: Bloomberg Oct-8 Dec-8 While there has been considerable debate on the issue we do not expect a change in the current exchange rate peg to the dollar prior to the establishment of the GCC Monetary Union. With inflationary pressures now receding, the US dollar stronger against other major currencies, and liquidity conditions tight, the arguments for a change in the peg have abated, and GCC policy needs have converged with those of the US. In fact speculative pressure on GCC exchange rates, as reflected in forward spreads, has turned full circle. As funds previously betting on a revaluation were withdrawn and access to capital markets curtailed, spreads reversed on forward rates to levels suggesting large devaluations in late 28 before GCC governments stepped in to provide liquidity support. The 21 timetable for GCC monetary union was already optimistic and unlikely to be met for a number of reasons, including the pressing need to harmonize data, sort out technical issues, and agree on institutional frameworks. The deteriorating macroeconomic environment has further highlighted the work still to be done in developing a coordinated approach to monetary issues members have been managing monetary policy and liquidity issues using different tools and has raised additional questions over adherence to convergence criteria. In particular, some GCC members will now probably fail to meet the budget deficit criteria. A delay to the monetary union timetable thus seems inevitable, although the desire to complete the project remains strong. Fiscal deficits are likely in 29 GCC: Break-Even Oil Prices for 29 Budgets (in $s); Bahrain Arabia Source: IIF The combination of lower oil prices and likely counter-cyclical increases in fiscal spending is expected to push some GCC budgets into deficits. In Arabia, and Bahrain, projected oil prices are now below the estimated 29 budget break even prices (i.e. the oil price which will lead to a zero government deficit), implying that they will move into deficit. In contrast,, and the are expected to sustain small surpluses as they have lower break even prices. Given that GCC spending traditionally overshoots announced budgets, the break even oil price is just a rough indicator, and understates the likelihood of fiscal deficits emerging. Budget balances will be heavily dependent on how far GCC governments are prepared to sustain and/or raise spending to help support their economies. The evidence to date suggests that GCC spending levels will appropriately be sustained or raised, consistent with global call for a robust fiscal response to the current crisis. In this context, GCC governments seem content to run much lower surpluses (,, although these too are at risk) or finance deficits from savings. In particular, this includes the dominant Arabian economy which is projected to run a 13

14 deficit of around 15 percent of GDP while preserving spending levels. This will be the main driver behind a dramatic shift from an overall GCC fiscal surplus of nearly 29 percent of GDP in 28, to a projected deficit of close to 5 percent in GCC: Fiscal Balance & Oil Price 1999 Source: IIF; IMF; Samba f Fiscal balance (% GDP) Oil price (annual av. $/b) Foreign assets will be drawn down Emerging fiscal deficits will be mirrored in external current account positions, with the overall GCC balance projected to slip into a small deficit of around $2 billion. This is better than the fiscal accounts reflecting the fact that GCC import volumes are likely to contract, and imported commodity prices will mostly be lower. In addition, exports should hold up in as LNG sales under long-term price contracts increase. Nonetheless, with external borrowing scarce and expensive, GCC governments are expected to dip into their foreign savings to fund public expenditures, including any necessary further injections of liquidity into their banking systems. In this context it is noteworthy that in December and January SAMA posted small declines in net foreign assets, its first since August 27, while central bank reserves have been falling steadily since June 28 (to $35 billion in November 28) as speculative funds flowed out and external finance dried up GCC: Combined Current Account ($ bn) GCC outlook Difficult times ahead While the outlook is challenging, the GCC is better positioned to weather the storm than many other economies. GCC governments are willing and capable of smoothing the downturn by drawing down their huge savings of the last five years. Already we have seen concerted efforts to support the financial sector, and more can be expected. Injections into the banking system will be particularly important to moderate the funding shortfall resulting from the reduction in foreign finance. In addition, further use may be made of SWFs to prop up collapsing asset prices at home. GCC authorities are also expected to maintain support on the fiscal front. However, the extent of the fiscal stimulus is harder to gauge as governments will be wary of seeing their budget and current account deficits balloon, and thus the pace of spending may lag as authorities watch to see what happens to oil prices. Credit growth will slow sharply Source: IIF; IMF; Samba e 21f Despite government interventions, it is clear that credit growth in the region will slow sharply; probably falling to low single digits in most countries, compared with the rates of between 2-5 percent over the last two years. Banks are already adopting stricter lending criteria, and will be looking to maintain liquidity ratios within prudent limits, and are likely to focus on preserving asset quality in the difficult global and local environments. Construction will suffer The severity of the global crisis and the suddenness with which it hit the GCC make it particularly hard to engineer a soft landing. In a very short period of time highly liquid and rapidly expanding economies have been stopped in 14

15 Box 3: Data Weaknesses Cloud the Picture GCC - Investment Projects by Sector; $2.5 tn, Sep-8 15% 2% 7% Waste and water Power Construction 6% 3% Industry Petrochemicals Oil and gas Source: MEED 67% Analysing and projecting economic and financial developments in the GCC is made harder by the lack of timely and comprehensive data. At the country level there are no quarterly GDP estimates, little timely information on oil sectors and the balance of payments, including on foreign assets levels. The public sector financial accounts are opaque, and even banking sector data coverage can be patchy. While progress has been made in improving data weaknesses, more needs to be done. GCC governments have access to the technology, human and financial resources to make improvements and further progress would be beneficial. A lack of data transparency can be costly in the current climate of uncertainty. This can be seen in the elevated CDS spreads for the region, particularly for Dubai related entities as, in the absence of clear data and information on finances, the market continues to price in large default risks. In this context, the decision by the government not to allow publication of the IMF Article IV report on the economy is unhelpful. Without adequate and timely data, investor confidence can swing widely, being more prone to react to rumour and sentiment. The real estate sector is a case in point, where current data on the market are not available to provide investors and analysts with a clear view of recent developments. This obviously impacts the stock markets too, which need timely data and surveys to assess prospects and value companies appropriately. In its absence, markets can over react to news stories speculating on the health of the economy, be they on the number of cancelled real estate projects, extent of jobs losses and exodus of expatriate workers, or accounting procedures used by banks to book investment losses Real GDP Growth (%, annual change) their tracks, inevitably prompting some uncomfortable adjustments and retrenchment. Although governments are likely to step in to support key projects, others will be delayed or cancelled as long-term finance remains scarce, and this will contribute to slowing economic growth. According to MEEDProjects, $33 billion worth of GCC projects (about 13 percent of the total pipeline) have already been put on hold or cancelled, and this figure is likely to rise further Emerging Markets GCC Source: IIF; Samba 26 28e United States 21e Inflation will fall back Until mid-28 surging demand and higher import costs were fuelling record inflation rates and posing a serious challenge to policy makers in the GCC, particularly given the exchange rate peg to the US dollar. However, circumstances have now changed dramatically and inflationary pressures are expected to ease. Key factors working to contain inflation include: the sharp slowdown in credit growth, an easing of capacity constraints as projects are cancelled, scaled back or postponed, lower international commodity prices, the relative strengthening of the US dollar, and the general slowdown in economic activity. In addition, rents which constitute a large proportion of GCC consumer price indices, are expected to moderate and in some cases 15

16 (especially and ) decline. Overall the GCC average rate of inflation is expected to almost halve to around 6 percent in 29. GCC growth will stall, with contractions in some economies Despite government efforts, real GCC growth is projected to fall sharply from 6.5 percent in 28 to.5 percent in 29, with a pick up possible in 21 assuming the global economy and oil prices recover. Much of this will reflect the decline in dominant hydrocarbon sectors, while non-hydrocarbon sectors should continue to post positive growth. As the largest oil producer subject to the largest cuts in oil output, Arabia s economy is expected to contract by 1.8 percent. Oil dominated is also expected to see its economy shrink by 1.5 percent, with the added pressure coming from its financial sector vulnerabilities. While the is more diversified, key sectors such as real estate, tourism and the finance, are all suffering, and it will do well not to slip into negative territory too. In and Bahrain the policy focus has shifted from inflation to growth, and while both are likely to run large deficits, their economies should show positive momentum. in contrast is expected to continue to grow strongly as scheduled new LNG gas production and export facilities come on line. Lower oil prices remain the main risks At between $45-5/b the GCC should be able manage the current downturn by dipping into its large savings to support its banking sectors, and to sustain spending and growth. Unless the global recession is substantially deeper and more protracted than projected, leading to another drop in oil prices to $2-25/b, we expect that the GCC will weather the current storm reasonably well. Although currently not our baseline scenario, there remains a risk that things would look very different if oil prices were to fall to around $2/b for any length of time. This would require large fiscal adjustments with more serious implications for growth. 16

17 Howard Handy Chief Economist Keith Savard Director Economic Research James Reeve Senior Economist Andrew B. Gilmour Senior Economist Raza A. Agha Research Economist Touheed Ahmed Management Associate Disclaimer This publication is based on information generally available to the public from sources believed to be reliable and up to date at the time of publication. However, SAMBA is unable to accept any liability whatsoever for the accuracy or completeness of its contents or for the consequences of any reliance which may be place upon the information it contains. Additionally, the information and opinions contained herein: 1. Are not intended to be a complete or comprehensive study or to provide advice and should not be treated as a substitute for specific advice and due diligence concerning individual situations; 2. Are not intended to constitute any solicitation to buy or sell any instrument or engage in any trading strategy; and/or 3. Are not intended to constitute a guarantee of future performance. Accordingly, no representation or warranty is made or implied, in fact or in law, including but not limited to the implied warranties of merchantability and fitness for a particular purpose notwithstanding the form (e.g., contract, negligence or otherwise), in which any legal or equitable action may be brought against SAMBA. Samba Financial Group P.O. Box 833, Riyadh Arabia 17