Tightening the purse strings

Gulf governments are easing off on their spending commitments, and preparing for budget cuts in the future. Published in The Gulf, July 2014

The statement issued by the International Monetary Fund (IMF) in mid-June following its latest review of the Bahrain economy will have held few surprises for anyone in Manama. With rising public debt and only moderate growth expected in the coming years, the economy is under pressure. According to the IMF the government needs to address its weak fiscal position by, among other things, introducing more taxes and scaling back subsidies.

This is a message the IMF has been pushing for some time for many countries in the region. For the sake of their long-term economic stability, it says, Gulf governments need to diversify their economies, develop other sources of income and keep spending under control.

These things are hard to do in the current environment, however. For as long as hydrocarbons revenues are pouring, in the incentive to develop other industries is limited, and it is difficult to convince citizens that subsidies should be scaled back. Yet over the past year there has been a clear change in approach from policymakers around the region. For several years governments have talked about the need for fiscal discipline while continuing to spend lavishly. Now the talk is turning into action and overall spending is, if not quite contracting, certainly not rising as quickly.

The Washington-based Institute of International Finance (IIF) says it expects expenditure by the Gulf Co-operation Council (GCC) governments to rise by 4.8 per cent this year, compared to an average of 8.2 per cent in the previous two years. “Government spending will not increase at the same pace as previously,” says the IIF’s deputy director Garbis Iradien.

The thing that appears to have triggered the change in approach is the relentless rise in the breakeven oil price. This is the level at which governments need to sell their oil, if they are to balance their budgets and, over recent years, it has been going up and up thanks to heavy spending on public sector jobs and subsidies.

Bahrain is the most exposed, with an estimated breakeven price of more than $126 per barrel, but all countries have been affected (see table). In most cases the breakeven price remains well below the current market price of around $114, but prices are widely expected to soften in the coming years, which is helping to concentrate minds in finance ministries.

“In Saudi Arabia spending in 2014 is budgeted to rise by just four per cent. This is the lowest for more than a decade and it is similar across the GCC,” says Paul Gamble, director of sovereigns at Fitch Ratings. “If you look at Qatar, spending is budgeted to rise by seven per cent, for Oman it is five per cent and for Kuwait it is three per cent. In absolute terms the stimulus and the impact of government spending is still very high, although it does bring us closer to the day when governments are going to have to start cutting back spending.”

When that point comes, the tricky part will be deciding where to cut and how quickly. Some areas, such as public sector wages, are probably too risky for governments wary of provoking protests, so the axe is likely to fall elsewhere.

“Current spending is hard to reverse,” says Iradien. “You could reduce some social benefits for housing and areas like that, but it is hard to cut wages. So that leaves capital spending and prioritising certain projects. There’s scope there to limit that.” That appears to be what is happening in most countries. According to Riyadh-based Jadwa Investment, the rise in budgeted spending by the Saudi government this year is entirely because of current spending, while capital spending has been cut by 13 per cent to SR248 billion ($66 billion). This is the first time since 2002 the government has planned a cut in capital expenditure and, although it usually spends far more than it budgets for, it is a clear statement of intent. In Kuwait, by contrast, the government usually misses its capital spending targets because it finds it difficult to get parliamentary approval for its plans. Nonetheless, there is a similar trend in terms of the government’s budget. The three per cent rise in the budget for this fiscal year, which began in April, is entirely due to current spending while the figure for capital spending is down 20 per cent to KD2 billion ($7 billion). This is the largest cut on record according to the local NBK Capital.

The government in Qatar also missed its capital spending target last year, seemingly because of a mix of political and fiscal issues. The appointment of a new amir, Shaikh Tamim bin Hamad bin Khalifa al Thani, in June last year was followed by a review of the government’s project pipeline. Among the more high-profile decisions was one to scale back the number of stadiums the country will build for the 2022 football World Cup, from 12 to eight. At the same time the country has been under uncomfortably close scrutiny over the treatment of its expatriate labour force, which may also have led to a slowdown in some projects.

The Bahrain government has also been struggling to hit its spending targets. According to the IMF, the fiscal deficit in Bahrain continued to rise in 2013, to 4.3 per cent of GDP, but that was less than expected because of under-spending on the capital budget. That is probably a combination of a more cautious approach by the government and the ongoing political tensions in the country, which are slowing down projects.

In the UAE meanwhile, there has been a reduction in spending on areas such as security and defence. According to the IMF, the fiscal tightening by Abu Dhabi is equivalent to almost six per cent of non-oil GDP.

While capital spending is bearing the brunt of the tighter fiscal regime in the Gulf countries, there have also been some tentative attempts to reduce elements of current spending.

Bahrain’s prime minister Prince Khalifa bin Salman al Khalifa pre-empted the IMF’s recent advice by a few months when, in March, he told the finance ministry and the central bank to develop ideas to reduce the budget deficit and control public debt. The plan, he suggested, should involve rationalising the government’s spending and reducing the size of state-owned bodies - something that would reduce its wage bill. In other countries, including Oman, Kuwait and the UAE, governments have started a public debate on the need to replace universal subsidies with more targeted financial assistance. The initial target in all three countries is likely to be fuel subsidies. It is not clear just when any cuts might be made, but the fact that government officials have been willing to speak out on the issue is itself notable.

“The public sector wage bill is currently very high as a percentage of public spending and subsidies are exhausting the state budget,” said Kuwait’s finance minister Anas al Saleh at a conference on economic development co-hosted by his ministry and the IMF in late April.

This is, of course, a difficult subject for governments to broach. The political system in the Gulf functions on the basis of an ‘authoritarian bargain’, whereby the ruling elites exercise absolute power and in return provide a cradle-to-grave welfare state. Cutting subsidies could undermine that system, so governments will be watching closely to see what impact any cuts have in the first country brave enough to do it. A second, long-term question is what impact any spending cuts will have on the economy as a whole. Given the central position of the government in all these economies, the danger is that it could lead to a slow-down in wider growth rates.

“Over the past decade the private sector in the GCC has become very reliant on high government spending and on government contracts,” says Gamble. “And it is not clear what will happen to the non-oil sector when governments have to start cutting back spending.”

The evidence from Saudi Arabia suggests the impact could be negative. According to London-based Capital Economics, activity in the non-oil sector has lacked momentum this year. The non-oil sector expanded by 3.5 per cent year-on-year in April, a drop from 3.8 per cent in the first quarter.

“Non-oil imports, a proxy for consumer and investment spending in the kingdom, have contracted in annual terms for the past ten months,” said Jason Tuvey, assistant economist at Capital Economics, in a research note published in early June. “We doubt that the non-oil sector will experience a sharp turnaround in fortunes. Fiscal policy is likely to be less supportive of growth over the next few years as the government looks to maintain long-term fiscal sustainability.”

For all the difficulties they may be slowly facing up to, things are not yet at a critical point for most Gulf governments. Most, if not all, have built up substantial reserves during the oil boom which will help them to ride out any short-term dip in oil prices. At the same time, their economic growth rates are relatively strong by global standards, with the IMF predicting growth of 4.2 per cent for the GCC this year.

That means they do not have to rush into spending cuts, but their high breakeven oil prices mean they would be badly exposed during any sustained period of low oil prices. That in turn means that spending cuts of some sort look all but inevitable in the coming years.