MENA Nations Shift Gears

Tighter fiscal policies and oil-output cuts agreed to by the Organization of Petroleum Exporting Countries (OPEC), plus Russia, could cause economic growth in the Middle East region to slow this year. Favorable demographics will underpin long-term growth in the decades ahead, but productivity gains will be slow, economists say. Despite efforts to diversify their economies, the Arab Gulf countries will remain reliant on their oil and gas sectors for years to come.

As the swing producer in OPEC, Saudi Arabia has carried out the bulk of the oil production cuts, reducing its output by 400,000 barrels per day (bpd), and planning even deeper cuts. Meanwhile, US oil output is expected to increase by 1.8 million bpd this year. Brazil is also producing more oil, following an increase of 365,000 bpd in 2018—the largest increase in 20 years, according to the International Energy Agency.

“The increasing energy independence of the US is one factor that has prompted some commentators to question whether Saudi Arabia still has the power to influence global oil prices,” says Caroline Bain, chief commodities economist at Capital Economics.

Saudi Arabia, the world’s third-largest producer after the US and Russia, remains the world’s largest exporter of oil, Bain says. “Capacity to export is a much bigger driver of oil prices than production,” she says.

Saudi Arabia has the largest spare production capacity in the world, and the kingdom’s ability to influence the oil market is clearly evident in the latest round of OPEC cuts, according to Bain. Saudi Arabia’s action led to a 20% rally in prices and moved the futures curve into backwardation, when futures contracts trade at a price below the expected spot price at maturity.

“The US-Saudi oil relationship has been transformed by the growth in US oil supply, and the US is arguably in a stronger position in the bilateral relationship,” Bain says. “However, Saudi Arabia can still move oil prices, with implications for global GDP growth and consumer spending. As such, mutual dependence remains.”

James Reeve, chief economist at Riyadh-based Samba Financial Group, says the US-China trade dispute and China’s slower growth will have spillover effects on other economies and impact demand for oil. “We still expect the market to tighten somewhat as OPEC reductions begin to bite, and there should be some uplift in prices,” Reeve says. “However, the upside is limited, and we expect an average price for Brent this year of $65 per barrel, edging up to $67 in 2020 as a weaker dollar helps to support demand.”

Reeve says the medium-term outlook for Saudi Arabia remains positive, with structural reforms continuing. “The fiscal outlook is manageable, given multiple financing options and a low-debt stock,” he says.

S&P Global Ratings expects sovereign long-term commercial borrowing in the Middle East and North Africa to increase by 25% this year to $139 billion, after declining 38% in 2018. Moody’s says global sovereign sukuk issuance will recover in 2019 to $115 billion, due to higher deficit financing needs, as the merits of Islamic finance allow the sector to grow into new geographies.

Meanwhile, the local private sector in Saudi Arabia is gradually adapting to the withdrawal of state largesse, but the adjustment hasn’t been easy, and investment is still subdued, Samba’s Reeve says. “The departure of an estimated 1.7 million expatriates has also meant significant hits to both the demand and supply sides of the economy,” he says. “The mass departure of expatriates in the face of higher fees [for employing expat workers] and Saudization initiatives is probably the strongest headwind.” In many cases, Saudi nationals haven’t filled the gaps left by the departing foreigners.

The Saudi reform agenda, Vision 2030, seeks to restructure the economy so that productivity growth becomes the driver of income gains, rather than the simple accumulation of cheap labor and capital, Reeve says. “Naturally, such a fundamental shift will be difficult for many firms, and the government is adjusting the pace of reform accordingly,” he says.

Postponing the Aramco initial public offering (IPO) doesn’t signal that the reform effort has stalled, Reeve says. “The reform push is continuing with less eye-catching legal and business environment initiatives, which are likely to be more important in the long run than the sale of 5% of Saudi Aramco,” he says.

Labor productivity growth in Saudi Arabia has been negative since 2012, according to research by Marmore MENA Intelligence, a unit of Kuwait-based Markaz. Throughout the past decade, the Arab states have had the lowest output per worker in constant dollars among high-income countries, the study found. “One of the major impediments for private-sector growth in the Gulf Cooperation Council (GCC) countries is a lack of skilled labor,” the study says.

Better incentives for expat workers, such as access to long-term or permanent residence, could help retain productive, high-skilled migrant workers and also support the region’s push toward a knowledge-based economy, according to Marmore. In addition, labor-market reforms should aim to create jobs for nationals by increasing the incentives for them to work in the private sector, the report says.

Jason Tuvey, senior emerging-markets economist at Capital Economics, says the countries of the Gulf are in a relatively good position to withstand a decline in oil revenue as a result of production cuts and relatively low prices. Capital Economics expects the price of Brent crude, the international benchmark, to decline to $50 per barrel by the end of this year. “The region’s recovery is set to falter in 2019 and growth is likely to be weaker than most expect,” Tuvey says. “Low oil prices shouldn’t cause major strains in the Gulf, but tighter fiscal policy and oil output cuts mean growth will soften.”

In contrast to the Gulf, the rest of the region stands to benefit from low oil prices, Tuvey says. The most promising outlook is in Egypt, where the pace of austerity will slow, he says.

Meanwhile, weak domestic demand has pushed several Gulf economies into deflation, partly reflecting downturns in housing markets. Balance sheets in the Gulf are in relatively good shape, but there are pockets of vulnerability, Tuvey says. “We’ve warned for some time about fragile sovereign balance sheets in Bahrain and Oman, although their debt dynamics are more likely to be affected by swings in oil prices than deflation,” he says.

Among Gulf countries, the United Arab Emirates (UAE) may be the most resilient to lower real oil prices. “The UAE is relatively diversified and has integrated into global supply chains by establishing itself as a manufacturing and logistics hub for the region,” Tuvey says. “In contrast to the rest of the Gulf, fiscal policy should remain fairly supportive. Infrastructure spending will be ramped up as preparations for the World Expo [2020 in Dubai] gather pace.”

On a less upbeat note, the dilapidated infrastructure in Iraq and the eventual reconstruction of Syria will require the investment of hundreds of billions of dollars. As detailed in this supplement’s story on Syria, it remains unclear who is going to rebuild the war-torn nation. Its current government is working with Russia, Iran and China. Saudi Arabia and the UAE, which supported the rebels, are now seeking to re-engage with the government of Syrian President Bashar al-Assad to limit Turkey’s bid for regional supremacy.

Iraq’s $112 billion budget for 2019 is one of the largest since the fall of Saddam Hussein in 2003. The country is now OPEC’s second-largest oil producer, and violence has declined to the lowest level in six years. But despite the improvements, the country still isn’t an appropriate destination for faint-hearted investors, according to analysts. Getting a reliable supply of electricity to the population in time for the summer heat wave will be critical.

Elsewhere in the Gulf, Qatar’s international dollar diplomacy has gathered momentum since the beginning of the economic blockade by regional neighbors, including Saudi Arabia, the UAE, Bahrain and Egypt. Qatar has extended a $500 million in economic aid to Jordan and purchased $500 million of Lebanese government bonds. In Iraq, Qatar will provide $1 billion for infrastructure and construction projects.

Gas-rich Qatar has extensive investments worldwide, including in Britain and the US. It has joined Exxon-Mobil in a $10 billion investment in natural-gas exports. Qatar’s ties with Turkey also have been strengthened, as have its connections with China, Japan, Malaysia and South Korea.

The record of investment flows into the Gulf Cooperation Council (GCC) countries paints a mixed picture, according to another report in this supplement. Riyadh’s bid to attract foreign investment is clearly visible in the evolution of its capital markets. In June, MSCI is due to include Saudi Arabia in its benchmark emerging markets index following a similar move in March by FTSE Russell. These moves could attract up to $45 billion of investments from institutions this year.

Public-private partnerships are likely to feature prominently in Saudi Arabia’s bid for foreign capital for its grandiose infrastructure projects, and to carry out the goals of its Vision 2030 reforms. However, the kingdom’s erratic progress in privatization projects suggests investors will demand improvements in governance and transparency before committing their funds.

Reforms to financial and legal frameworks provide a smoother path for more foreign direct investment (FDI) in the GCC countries, but geopolitical and regional political issues are still a stumbling block. Dubai, a longstanding magnet for FDI, has become too expensive for some. Bahrain, which is struggling financially, is seeking to capitalize on its cost advantage to woo investment and reclaim business lost to its increasingly costly neighbor.

Meanwhile, Bahrain’s regulators are leading reforms to encourage innovation and entrepreneurship in fintech. Bahrain Fintech Bay was launched as a public-private partnership a year ago, and it now has more than 50 established partners, including American Express, Cisco and Microsoft. Islamic finance offers a clear opportunity for Bahrain’s emerging fintech sector.

Faced with low oil prices and rapidly changing economies, GCC banks are sticking together to remain competitive. Again this year, major lenders have announced mergers and acquisitions, and the trend is also hitting corporates, particularly in e-commerce and transportation. Merging banks are looking to scale in mass, boost profitability and reduce operating expenses amid slow growth and subdued credit demand in the region.