Market Analysis: Why higher oil prices may pose a challenge to GCC
For the GCC, 2017 was a year of record primary market issuance, elevated geopolitical instability and credit rating downgrades.
Qatar, Oman and Bahrain all faced ratings downgrades, while the unexpected boycott of Qatar by its Arabian Gulf neighbours and others and heavily publicised anti-corruption measures in Saudi Arabia caused shock waves in the markets.
Last year was also one of fiscal consolidation for the GCC, with overall gross domestic product growth falling to 0.2 per cent primarily due to oil production cuts, which more than offset the recovery in non-oil GDP growth of 1.8 per cent. Oil reversed its negative trajectory halfway through 2017, trading at a two-year high by year end, and prices have remained robust throughout 2018, averaging $68 per barrel (up 12 per cent year-to-date) and proving supportive to ongoing fiscal consolidation.
While this recovery has provided some reprieve to GCC governments’ budgets, materially higher oil prices also present a major challenge to the region should reform momentum slow. Following the implementation of subsidy and spending cuts, governments are pursing various revenue-raising measures, including the introduction of VAT in January 2018.
Most GCC countries also announced planned privatisation programmes aimed at increasing the role of the private sector in the economy. While the continued implementation of these measures is expected to reduce budget deficits, which peaked in 2016, the fiscal break-even oil price for most GCC countries, with the exception of Kuwait and Qatar, remains above current levels.
The 2018 budgets that have been announced by GCC countries, particularly Saudi Arabia, are expansionary as the pace of fiscal consolidation eases, given higher oil prices and production cut agreements with Opec. Since improving oil prices may compromise the momentum of government-led reforms, sustainable growth of the region is solely dependent on its diversification efforts.
Following the oil price collapse in 2015, GCC countries have initiated several ambitious reform programmes that focus on the role of the private sector, foreign direct investment and diversification of non-hydrocarbon sectors.
Given the stabilisation in oil and improvements in fiscal deficits, our main concerns revolve around the willingness of governments to pursue diversification strategies as well as maintain a steady pace of implementation of these critical reform agendas.
Will the GCC take this as an opportunity to further improve its reform agenda or will higher oil price decrease the momentum of economic reform?
Activity in the primary market accelerated since the start of 2017 with issuances of $110 billion, the vast majority of which have been sovereign. This acceleration was necessitated by the persistent need to fund fiscal deficits because of lower oil prices and was comfortably met by non-GCC investors, who absorbed more than 75 per cent. Although the borrowing needs across the region remain large, we expect the regional sovereign primary market activity to slow down in the second half of 2018.
Issuance statistics for deals allocated in 2016-2018 have drawn the attention of international investors and tested the market’s ability to absorb a significant uptick in bond issuance.
Growth in the new investor base has increased investor understanding of the region, improved funding conditions and market liquidity, enhanced price discovery and has paved a way for GCC corporates to enter the international debt market and diversify their funding sources. Given the current macroeconomic backdrop, recent primary deals have come at a substantial concession over the outstanding debt, driving bond yields higher.
On a relative value and risk-adjusted basis, regional bond yields remain attractive compared to other emerging markets.
Oman’s 10-year bond, rated investment grade by Moody’s and Fitch, offers a yield of 6.39 per cent while Turkey, a high yield issuer, trades at 6.37 per cent.
Given the improving macro fundamentals in combination with attractive valuations, we see room for attractive returns on regional debt in the second half of this year, provided regional governments maintain their focus on structural reforms.
Usman Ahmed is Head of Investments at Emirates NBD Asset Management, a member of The Gulf Bond and Sukuk Association