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Gulf States: Region well set to weather Dubai crisis

15 April 2010
(An Oxford Analytica In-depth Analysis) Subject: The outlook for the Gulf states after the Dubai crisis.

Significance: The debt and real estate crisis in Dubai has spooked international investors and put a question mark over Gulf financial and property markets. However, actual contagion from Dubai within the region has generally been limited, with Abu Dhabi the major exception. Credit markets and business growth remain under a pall, but mostly due to other, local or international, factors. In several other Gulf states, large private businesses have created their own, less publicised crises.

Analysis: The international economic crisis and the Dubai debt crisis have affected Gulf Cooperation Council (GCC) economies to quite different degrees. While the price of credit default swaps -- insurance against sovereign default -- temporarily shot up in all six, it did so more markedly in Dubai and Bahrain. The impact on Abu Dhabi was less than in these two economies, but it was still higher than in Saudi Arabia and Qatar.

Differential impact. Different degrees of international trust in the GCC economies have much to do with the fiscal cushions different governments control.

Dubai and Bahrain have small overseas reserves that could be depleted quickly in the case of declining government income. The more oil-rich regimes have built up considerable cushions during the recent oil boom: Qatar's savings would be enough to continue 2009 spending levels for more than two years, while Saudi Arabia could go on for about three, Kuwait for more than four, and the United Arab Emirates (UAE) for more than five years.

These cushions instil investor confidence, even when many private banks and businesses are paralysed by the global credit crisis. That confidence in Abu Dhabi is somewhat lower than in Qatar and Saudi Arabia is mostly due to its closer interdependence with Dubai.

Saudi Arabia. Riyadh seems to have come out of the crisis in the best shape. In post-crisis scenarios, investors focus on fundamentals, and these appear to be very sound in the Saudi case, in terms of market size, fiscal resources, private sector depth and sophistication, but also regulatory and crisis management capacity.

Although the Saudi bureaucracy is fairly heavy and fragmented, the government also contains a number of trustworthy, conservative regulatory institutions that inspire more trust than their counterparts in neighbouring states. The most important of these are the bank regulator, the Saudi Arabian Monetary Authority (SAMA) , and the Capital Markets Authority , which has grown teeth during the last few years.

Due to the size of the national population, Saudi Arabia's natural weight is coming to bear on real estate and consumer demand. This is less cyclical in the kingdom than in most neighbours, which rely more strongly on fickle expatriate demand, a factor which plays a large role even in otherwise solid Qatar.

The Saudi private sector is the most experienced and capital-rich in the region and has been diversifying into new manufacturing, finance and utility activities. For the time being it remains hamstrung as the banking sectors reels from the inter-related defaults of the large Saad and Al-Gosaibi conglomerates. The latter have had a much stronger impact on Saudi Arabia than the Dubai crisis, and other large families in the steel and retail sectors have also been reported to be struggling with debt incurred during the recent boom. The private sector grew only 2.5% in 2009, compared to 3.8% growth in government services.

In a situation of general opacity, private credit remains anaemic, even more so than in other GCC markets: while it grew 3.8% in the GCC in general last year, it was essentially flat in the kingdom. However, public financing institutions such as the Public Investment Fund have stepped into the breach to finance essential large-scale infrastructure and utility projects. This spending will in turn trickle down through the Saudi contracting sector into the economy at large, and bank credit is expected to pick up in 2010.

Qatar. Doha has also survived the crisis in a remarkably good state. Although it has lost much more of its overseas investments than conservative Saudi Arabia, its oil- and gas-related income streams are so large that its fiscal capacity is not in question.

Qatar continues on a very ambitious path of infrastructure and heavy industry expansion which is almost exclusively state-driven and hence not much affected by the state of the private credit market. The product price cycle for gas and heavy industry is at a rather disadvantageous point, this does not affect industrial planning, which is oriented towards the long term.

Although it has pursued an unhealthy strategy of bailing and buying local private banks out of their liquidity problems, this does not pose an obstacle to its development path as private economic activity is mostly still ancillary to state projects and state-generated demand. Due to continuing rapid expansion of the gas and heavy industry sector, GDP growth could reach up to 18% this year.

Abu Dhabi. The fiscal position in Abu Dhabi is, in principle, even better than that of Qatar, but it has been tainted by Dubai's problems. According to Shuaa Capital, the UAE economy contracted by 3.5% in 2009, more than most other regional countries (the IMF estimates a contraction of 0.7%).

There is no serious doubt about Abu Dhabi's ability to bail Dubai out of even the most severe solvency crisis (although its willingness is a different question), and in Abu Dhabi itself, most large developments are not strongly leveraged and have been state-initiated or supported. It remains in control of about 8% of global proven oil reserves.

However, the private sector has been hit hard by Dubai's troubles, as its more dynamic neighbour has long served as an outlet for Abu Dhabi capital.

This concerns both banks and large family groups that have invested in Dubai. For instance, local UAE banks are reported to have lent some 15 billion dollars to Dubai World , and a significant share of these are located in Abu Dhabi; Abu Dhabi Commercial Bank reported losses for 2009, quite likely due to its heavy Dubai exposure.

The recent debt rescheduling proposal from Dubai World has alleviated some concern, but the planned stretching of loan maturities is more painful for local than for international banks. UAE banks are likely to have significant exposure to other Dubai entities.

The Abu Dhabi real estate market has also been affected by the collapse of speculative demand in Dubai, and one of the largest developers, Aldar Properties (in which the ruling family is involved), has recently sold its assets on Yas Island to the Abu Dhabi government. Abu Dhabi government holding Aabar is about to acquire up 70% of Dubai-based construction company Arabtec , indicating that the government is also willing to stabilise Dubai real estate through direct investment.

Moody's has recently downgraded several government-related entities in Abu Dhabi due to the absence of an explicit government guarantee of their debt. Given that Abu Dhabi could not afford the reputational loss of a default of a major public sector player, this is perhaps an over-reaction, but it does reflect the psychology of a financial market which does not separate Dubai and Abu Dhabi clearly enough.

In the long run, development in Abu Dhabi will be driven by government initiatives. Its long-term infrastructure and public industry planning has not been greatly affected by the Dubai crisis.

Kuwait. The heavy, unregulated speculation of many of its large private sector groups has created liquidity problems for many and solvency problems for at least some in Kuwait. The issue is not directly related to Dubai, but the Dubai crisis has highlighted speculation in Kuwait and has contributed to a loss of trust and liquidity.

Kuwait's small financial sector has seen the rapid growth of unregulated investment companies, with about 100 such firms reinvesting local family wealth with only scant supervision by the Ministry of Commerce. Several high-profile ones have got in trouble through imprudent international investment and many others are under duress, including Investment Dar .

While Kuwaiti banks are also under stress -- especially Gulf Bank , which Moody's downgraded to D- in early February -- they are likely to be bailed out by the government. By contrast, several of the investment companies will probably be forced to leave the market in 2010 or 2011.

It was only in January that parliament agreed to the creation of an independent capital markets regulator, raising hopes that runaway speculation and market manipulation could be curtailed in the future. The process of setting up the institution could still become politicised.

Despite a rich and experienced private sector, diversification remains hamstrung because the government has proved incapable of upgrading its regulatory and infrastructural framework, mostly due to political infighting in parliament and with organised public sector interests.

Alone in the Gulf, the government has also had problems spending its full allocated budget, which has prevented it from stimulating demand at times of a private credit crunch. A counter-cyclical development package has recently been agreed in parliament, but again, political infighting over details of implementation could lead to stalemate.

Bahrain. Among GCC countries, Bahrain is by far the most dependent on its financial sector, which accounts for about 20% of its GDP and is strongly regionally and internationally integrated. Gulf Finance House , an important Islamic investment bank, has had to write off 300 million dollars of losses in the course of its investment in the Dubailand project; it has been exposed to several other real estate ventures and was forced to ask for deferred payments on its loans in February.

More generally, the direct spillover of the Dubai crisis has been limited. However, Bahrain has come to feel the regional and global financial contraction. The Saad and Al-Gosaibi default directly involved two Bahraini banks, while others are likely to be at least to some extent exposed. Bahrain's financial sector is reasonably well regulated, but at the same time the government's fiscal reserves are much smaller than those of its neighbours, reducing its capacity to counteract business contraction through increased government spending. It is the only government in the GCC currently talking about serious domestic subsidy reductions.

Bahrain has a good labour force and financial infrastructure and its neighbours will continue to invest there. However, its regional integration also meant that it has not been able to do much to insulate itself against the GCC financial contraction. Dependent on cross-border investment, corporate earnings in Bahrain have contracted particularly harshly in 2008 and 2009.

Oman. In common with Bahrain, Oman's fiscal situation is less robust, but its economy is more balanced, and less dependent on one sector and on capital flows from its neighbours. It managed to grow 3.7% in 2009. Its diversification strategy, focused on heavy industry and high-class tourism, has been careful and methodical, which is paying off now that more speculative projects are collapsing elsewhere. This year growth has been forecast at 3.8%. The mid-term problem of declining oil revenues somewhat detracts from investor confidence.

Outlook by sector. Although in most GCC markets, the direct contagion from the Dubai crisis has been limited, it has sensitised investors to structural problems in other Gulf markets that are in some ways similar to those in Dubai, notably weak regulatory capacity, opaque corporate structures, and speculative bubbles in finance and real estate.

These problems have developed in parallel rather than because of Dubai. They have done so to different degrees, and governmental capacity to counteract them also varies.

The most important impact of the crisis might be less in overall growth prospects, but in the sectoral composition of growth: with the tourism, real estate and finance bubbles pricked, the region is likely to return to fundamentals. How painful this return will be depends on the exposure to the boom sectors. The UAE and Kuwait have been heavily exposed to real estate, which will make the reorientation more protracted.

Although the GCC financial sector has been paralysed by the crisis, its fundamentals are by and large sound, as reflected in the modest decline in aggregate net profit in 2009 of around 8.5%. At the same time, further deleveraging might have to take place in countries with high loan-to-deposit ratios, which are in turn an outcome of the real estate and consumer boom of recent years.

Limited impact. Other sectors have felt the crisis only moderately or not at all. For instance, the largest manufacturing businesses continue to be state-run, and major players here such as SABIC, Industries Qatar or Borouge continue on their expansion path. While private manufacturers still have trouble accessing finance, but this should improve this year.

In most countries, utilities and basic infrastructure have hardly been affected by the crisis, as they are again mostly state-driven and, in the more populous countries, can bank on steady growth of the local population. Where involvement of private investors was planned, governments have had to take renewed leadership due to the weakness of the project finance market.

Consumer sectors such as health care, food or telecommunications also have weathered the crisis well and can expect stable demand. To the extent that they rely on demand from the local population, they have not been affected at all, as most nationals who hold jobs are state-employed on stable salaries. Saudi Arabia is likely to be the most stable market as it has the largest domestic population.

Conclusion: The GCC is better placed to ride out the crisis than most other regions, but opacity and weak regulation have created unnecessary damage to its private sector. The crisis has drawn investor focus back to fundamentals: market depth, stability of demand, and fiscal and regulatory capacity of governments. In this context, Saudi Arabia and Qatar emerge as the most attractive players, though each with a different mix of these characteristics. In all GCC countries, the state is taking the lead to offset liquidity problems and timidity in private business, though with varying effectiveness.

© Oxford Analytica 2010