Outdated lending practices and a structural focus on government-related enterprises are keeping banks from backing the region’s beleaguered smaller companies.
With a $2.3 trillion in assets at the end of 2019, banks in the six-member Gulf Cooperation Council (GCC) would appear to be well positioned to weather the double whammy of a precipitous fall in oil prices and a pandemic outbreak. Gulf banks can absorb up to $36 billion in extra provisions before their capital bases erode, according to S&P Global Ratings, which covers 23 GCC institutions.
What, then, are they doing to aid vulnerable businesses and help their economies weather the storm? An April survey by Capital Economics showed a majority of businesses in Dubai expect to close within a year in a number of mission-critical sectors. A snapshot compiled by KPMG at the end of 2019 suggests regional banks were not doing enough to shore up the region’s small to medium-sized enterprises (SMEs).
Dubai is the epicenter of the region’s SME ecosystem; but banks continue to keep the sector at arm’s length, as evidenced by a marked slowdown in credit growth. Bank lending to SMEs is negligible, representing less than 5% of total loans, according to Fitch Ratings, lower than the average in the Middle East and North Africa as well as other regions. That’s in spite of a massive stimulus package, approaching $69.7 billion—around 17% of GDP—from the federal government of the United Arab Emirates (UAE). Authorities are urging the private sector to switch to a digital economy, embracing 3D printing and the “Internet of Things” as the core of its strategy to rise from the Covid-19 ashes.
That is easier said than done for many SME owners, who are often heavily invested in their existing business model. The outlook looks bleak, and Dubai’s SME meltdown is in danger of spreading to other GCC states. The trouble is that the majority of GCC stimulus programs are broad monetary and macroprudential measures, not specifically directed at SME support.
Outdated Lending Practices
One problem for SMEs is that outdated legacy lending practices—notably “name lending,” where banks lend to firms based on name or reputation—are still prevalent in the Gulf countries. This appeared to work well for many years, but is now revealed to have bred flawed lending practices, much to the cost of fledgling SMEs.
One of the biggest corporate scandals to hit the UK’s benchmark FTSE 100 owed its stratospheric rise predominately to banks in the Gulf. NMC Healthcare, once a behemoth based in Abu Dhabi, amassed a $6.6 billion debt black hole. UAE banks reportedly have a greater than 10 billion Emirati dirham ($2.7 billion) exposure to the embattled group and face write-downs between 25% and 50%.
But persuading banks to alter policy and lend to SMEs is not going to be a walkover. Banks booked handsome profits—rising by 16.9% last year, according to KPMG—doing what they were doing, leading some to call on governments to impose a one-off tax on banking profits to provide soft loans to SMEs. Pressure is building, although governments are not favored to go against history or their own vested interests.
Many banks are owned in part by governments or ruling families and mirror the paternalistic structure that has held back private sector reforms and progress in corporate governance. Local banks are often significant lenders to government-related entities; and in the case of Dubai, they have piled up a large exposure to the real estate sector.
That leaves them less bandwidth to focus on SMEs, a situation likely to worsen as tightening liquidity increases competition for capital. Karen Young, resident scholar at the American Enterprise Institute, believes the state will remain the dominant actor in regional financial markets, limiting GCC governments’ inclination to drive private sector growth. “I think banks across the GCC have to serve their most prominent customers first,” she says, “and these are largely government-related enterprises.”
A rising volume of mergers is also likely to leave SMEs with fewer financing options. “Consolidation of the bank sector, already underway in 2019, [and] the trend of smaller Islamic banks merging with larger banks, are likely to continue,” Young adds. Add to this the fact that SMEs in the Gulf are substantially held or managed by foreigners or expatriates, giving GCC governments little appetite to bail out or subsidize them.
Others say that SMEs’ predicament–banks’ reluctance to lend–is more than a matter of ownership. Redmond Ramsdale, head of Middle East bank ratings at Fitch Ratings, cites factors that include a lack of credit guarantees, limited financial information and the transitory nature of expatriate-dominated SMEs, as well as untested insolvency frameworks.
“This can be attributable as well to the structure of GCC economies,” he says, “which remain dominated by large corporates, including government-related entities and large diversified family groups.”
Getting Future-Ready
Banks have their own headaches. They face existential challenges amid a rise in nonperforming loans, falling government deposits and probable forced consolidation, as digitization sweeps away outdated banking strategies.
The pandemic has also attacked the Gulf’s highly cyclical hydrocarbon-based economies, further straining the precarious relationship between banks and SMEs. Admittedly, SMEs have recovered from previous downturns; but this time seems different, coinciding with an expat exodus and diminished global demand.
Still, there are signs that governments are growing worried about the plight of SMEs. In mid-June, Saudi Arabia’s Industrial Development Fund announced a nearly $1 billion package to support more than 500 small, medium and large industrial companies. Earlier in the month, the Central Bank of the UAE urged local banks to draw from its Targeted Economic Support Scheme, which includes an AED 50 billion, interest-free economic support facility, after clarifying the fund’s SME remit.
But is it too little, too late?
Any respite provided by banks might be fleeting, as stimulus packages ebb. Resurrecting the SME sector is going to require more government intervention, as the so-called new normal emerges, notes Rafael Lemaitre, partner at management consultant firm Sia Partners. That leaves vulnerable businesses with some hard choices. “On one hand, they get the relief needed to keep the curtain open for few months,” Lemaitre says, “but on the other, they will not have enough customers to maintain business.”
The alternative may be a fundamental overhaul of the private sector, further deregulation and opening up of Gulf economies, without which several GCC states face the prospect of serious economic decline.
Lemaitre believes SME development funds could play a major role, along with an easing of restrictions that allow funding only to SMEs owned by GCC nationals. Peer-to-peer (P2P) lending and funding platforms have recently proven themselves as another alternative, but the business model may come under strain as perceived risk increases.
“Lenders will be cautious of placing funds, and the pipeline will dry,” Lemaitre says. “SMEs will default, and defaults will increase the risk of P2P.” Other financing options, such as invoice and inventory financing, have also gained momentum outside traditional banking.
Still, analysts argue that the decimation of the SME sector is yet to be fully realized. Although some GCC states have eased restrictions, the pandemic’s longevity and oil prices’ lack of resilience remain the region’s black swans.
