Storm clouds clearing?

The impact of Europe’s debt crisis on Gulf economies has been muted so far, but that could change if a deal struck last month to contain the problem fails to bear fruit. Published in The Gulf, November 2011

As European policymakers announced last month what they hope is a solution for Europe’s sovereign debt crisis, the world is left looking on. For most Gulf economies, the crisis looks like something they can comfortably deal with, for now at least. However, if the plan fails to provide a lasting solution and the situation deteriorates, it could start to hurt.

To date the impact of the crisis has been most apparent in financial markets and in the price of oil. The recent break-up of Franco-Belgian bank Dexia was the latest sign of frailty among European banks, but there had already been indications that some were withdrawing from the regional project finance market. Others have been cutting back on equity research teams in the Gulf, according to bankers in the region.

Oil, meanwhile, has been edging down on international markets for much of this year, from over $120 per barrel of Brent crude in April to around $100 per barrel in early October.

Alongside investor nervousness caused by the Arab Spring, such issues have kept regional financial markets muted.

“The European debt crisis has had an impact,” says Jarmo Kotilaine, chief economist at Saudi Arabia’s National Commercial Bank (NCB). “If you look at the performance of regional stock markets and the broader capital markets it is definitely one of the factors that has depressed sentiment. The stock indices have pretty consistently declined in recent weeks.

“The other area where it is having an impact is the oil price and new concerns about demand erosion. Even though I think the oil market is fundamentally quite tight you have room for short-term corrections. It’s also having an impact on broader investor mood, causing investors to be more risk averse, more cautious than they otherwise might be.”

Such issues will not cause too much concern for finance ministries in the region for now. Gulf countries, in particular, can take some comfort from the fact that their exposure to US and European Union (EU) economies has fallen over recent years as trade with Asia has increased. According to the World Bank, the proportion of non-oil merchandise exports from the Middle East and North Africa to Asia grew from 14 per cent in 1998 to 25 per cent in 2008. GCC countries sent less than 15 per cent of their non-oil exports to the EU and the US in 2008.

However, some are more insulated than others. Saudi Arabia, for example, should be able to come through the crisis with relatively little effort, according to James Reeve, assistant general manager in the economics group at local bank Samba.

“In terms of the Saudi economy I haven’t seen any impact yet,” he says. “The fundamentals are pretty good. Around 55 per cent of its exports head towards Asia, east Asia in particular, and those economies are probably the most dynamic in the world at the moment. Although they’re certainly not uncoupled [from global trends], they have their own growth dynamics which should to a large extent be self-sustaining because of their emerging middle classes.

“On the flip side, 30 per cent of Saudi imports are from the eurozone. If one assumes a contagion or a worsening eurozone crisis also leads to euro weakness, then Saudi import costs should come down. So in that sense Saudi is well buffered on both sides.”

Qatar is in an even stronger position, with vast financial reserves which are increasing as it steps up its gas exports. Kuwait too has large oil revenues which will help it ride out any storm for the time being.

Among other GCC states, however, there are some notable areas of weakness. Bahrain looks to be in the toughest position. It is still struggling to cope with the damage done to its reputation as a result of the unrest earlier this year and growth has fallen away sharply. According to the World Bank, the economy grew by 4.5 per cent last year, but is expected to manage just 0.7 per cent this year. At least one major European bank, Crédit Agricole, has already moved its regional headquarters off the island and it can ill afford to lose others from its strategically-important financial industry.

The UAE as a whole can take comfort from Abu Dhabi’s large oil reserves and the fact that an increasing amount of its trade is now done with Asia. The World Bank is predicting growth in GDP of 3.3 per cent this year, up slightly from 3.2 per cent last year. The economy of Dubai, however, looks more vulnerable to the unfolding European crisis.

“Dubai has a more diversified economy, which includes tourism from Europe and that could well be hit if the European economies slip back into recession,” says Andrew Gilmour, a senior economist at Samba. “There will perhaps be some slowdown in the trade and logistics links with Europe. It is hard to say how much of a slowdown that will generate in Dubai, but it will certainly have an effect.

“Perhaps more worrying is the potential for the crisis in Europe to tip over into another credit crunch where banks become extremely reluctant to lend and financing seizes up again. This will be an issue for Dubai because it still has to refinance large amounts of debt,” he adds.

Dubai, as with many Gulf governments, may also be affected by the falling value of investments it has made in Europe. There is thought to be relatively limited direct exposure to European sovereign debt by Gulf states, but many investors have built up shareholdings in European banks.

“In terms of foreign exchange reserves and to an extent some of the holdings of the sovereign wealth funds, these are to a significant extent, we assume, held in US-dollar denominated, high quality securities, typically Treasuries,” says Kotilaine.

“The dollar peg has always veered these Gulf investors towards US dollar-denominated assets, so they are to an extent protected. The European exposure is probably less, but there is some risk there. The exposure is much more towards European financial institutions.”

Beyond the GCC states, the countries in North Africa are far more vulnerable to a downturn in Europe, as their economic ties to the eurozone are that much more significant. Across the region, however, the picture is at least partly obscured by the spending plans that many governments have launched in response to the events of the Arab Spring. Keen to keep their populations peaceful, many have announced significant spending plans, amounting to 4.5 per cent of GDP in the case of Oman and as much as 25 per cent of GDP in both Algeria and Saudi Arabia.

The extent of these spending plans is one of the principle reasons why the World Bank in September raised its economic growth forecasts for the region to 4.1 per cent for the year, up from its previous estimate of 3.6 per cent. A further key factor is the high oil price, which will allow many Gulf governments to maintain high levels of spending, although it will also add to the pressure on the region’s oil-importing nations.

Like the World Bank, HSBC is predicting relatively healthy growth rates for the MENA region this year. In its most recent regional quarterly report, released early last month, the bank raised its GDP growth prediction to 4.5 per cent for 2011, up from 4.3 per cent previously.

It also said that the region looks better placed to deal with the economic difficulties this year than it did ahead of the 2008/09 crisis, which came at the end of a sustained boom. As the report points out, “2008 showed that the region is far from isolated from global events. Yet it is the extent of that downturn in 2009 that gives us some confidence. MENA asset prices have not been reflated: we are no longer at the top of a five-year boom.”

All predictions of growth will have to be revised, however, if the eurozone economy deteriorates more than is currently expected. Should Europe and the US fall back into recession it will dampen demand for oil in those economies, leading to further price falls on international markets.

If severe enough, the downturn could also cause problems for the economies of India and China, which would in turn hurt Gulf economies, although some governments do have sufficient reserves to overcome a downturn in both oil prices and Asian demand.

“The Saudi government has huge net foreign assets, around $500 billion worth,” says Samba’s Reeve. “If growth looks like it is really going to sag next year, if the export environment really deteriorates, the oil price comes down and people get very edgy, I think the government will step up spending again. You may have a very weak growth story if the crisis is as bad as 2009 but even then there wasn’t a recession.”

A global downturn could even have a silver lining, helping governments to keep inflation under control. “Inflationary pressures come through the import channel and I think commodity prices will come down in a global recession, so that will give the government the licence to spend as much as they want,” Reeve asserts.

However, not everyone will be able to do that. If oil prices dip sharply then Bahrain and Oman in particular will both have fiscal troubles. Already they are relying on oil prices to average around $100 and $90 per barrel respectively this year to balance their budgets. Some assistance may be forthcoming from other GCC states to help them cope with any deficits, but it will still be an uncomfortable time for them.

The European debt crisis may be ?yet to affect the region to any great extent, but if Europe’s latest efforts fall short, then some countries could be in for a rough ride.