Ever since Kuwait in 2007 returned to a more flexible exchange rate maintained between 1975 and 2003, pegging the dinar against a more diversified basket of currencies, speculation has been ripe about other GCC states following suit and de-pegging from the dollar.
The Omani real has been pegged to the greenback since 1986, the UAE dirham – since 1997, the Qatari and Bahrain dinar – since 2001, and the Saudi riyal since 2003.
There is certainly plenty of incentive to loosen monetary policy as most Gulf states are beginning to reach the limits of fiscal countermeasures aimed at dampening the impact of the recent economic downturn.
According to Moody’s, the fall in the oil price led to an aggregate current account deficit of -1.8% of GDP in the GCC through 2016, compared to an average surplus of close to 18% during the 2005-2014 period. Countries with high external breakeven oil prices like Oman, Bahrain and Saudi Arabia have been most affected, whilst Kuwait and the United Arab Emirates have managed to return to small surpluses.
Growth in GCC countries is projected to slow further from 1.9% in 2016 to 1.6% in 2017, reflecting the drop-in oil production resulting from the November 2016 OPEC agreement. Non-oil growth is expected to pick up to 2.4% in 2017 and 3.0% in 2018 as oil recovers and fiscal consolidation eases, an IIF report indicated.
The US Fed hiking cycle is another concern for the GGC financial authorities, putting additional upward pressure on GCC lending rates.
“The drop in oil prices has put significant pressure on GCC fiscal and external account balances,” said Mohamed El Jamal, Managing Director, Capital Markets, WCM at Waha Capital. “We have seen other oil exporting economies rebalance through a mix of devaluations – across Russia, Kazakhstan and Azerbaijan, to name a few – and fiscal policy; in the case of GCC economies, given the US dollar peg, the burden of rebalancing has been mainly on the fiscal side so far.”
El Jamal also pointed to the large gaps between different GCC economies in terms of their oil breakeven prices, trade structures and net asset positions, which means their likelihood of abandoning the peg should be treated on a case by case basis.
These sentiments are echoed by other observers of the Gulf. Moody’s analyst Mathias Angonin noted that the key factors to watch out for are the deterioration of some GCC states’ external payments and reserve positions, which are unlikely to recover quickly even if oil prices stay on the upward trajectory.
“We think Bahrain (Ba2 negative) and Oman (Baa1 stable) face the most significant challenges to sustaining the currency peg to the US dollar. The current accounts of Oman and Bahrain went from surpluses of 4.2% and 5.2% of GDP in 2014 to average deficits of 17.4% and 2.8% of GDP in 2015-16, respectively,” Angonin stated, pointing out that Oman’s reserve buffers are still greater than Bahrain’s.
Case by Case
Bahrain has been hit the hardest by the oil slump, although it is also the smallest economy in the region. The Kingdom’s deficits are financed by external and domestic borrowing roughly in equal measure, and most analysts expect it to tap the cross-border markets again this year, borrowing a further US$1-1.5bn over and above the US$2bn bond issued October 2016. As a result, according to the IIF, public debt is projected to rise to 78% of GDP in 2017, from 18% in 2008, peaking at about 83% in the next few years.
The Central Bank of Bahrain raised its key overnight deposit rate to 1% and its one month deposit rate by another 25bp to 1.50% in December, and cost of borrowing is expected to keep rising in line with the Fed’s hiking cycle.
With FX reserves low and volatile, Bahrain has a relatively weak capacity for maintaining the peg and will, as has been the case in the past, rely on Saudi Arabia and other top economies in the region for support.
Oman’s fiscal deficit was very large at 20.8% this year, but is expected to narrow to 9% of GDP in 2017; this will come from a combination of factors, including higher oil prices and fiscal consolidation, which manifested in subsidy cuts and a 30-50% increase in electricity tariffs for the corporate sector.
The government is also able to boost non-oil revenues through corporate income taxes, added fees and a new 5% VAT, which will be implemented in 2018. Finally, the authorities are planning a privatization programme, starting with the divestment of Muscat Electricity Distribution Company in 2017, which will help ease pressure on the budget.
A lot of the financing needs will be met with external borrowing via international bonds, sukuk and syndicated loans, which will raise Oman’s gross public debt to 34% of GDP, which could push lending rates for local currency debt up around 50-75bp, according to IIF.
“Oman is adjusting significantly on the fiscal side, their deficit is narrow; while Bahrain we expect to continue to get bail-outs from Saudi Arabia, as they are a relatively small economy,” explained IIF economist Garbis Iradian.
“You cannot continue cutting government spending… Now we are in a new era where economic growth will stay relatively low, around 1-3%,” he added.
With this in mind, pressure is growing on the region to hasten the economic diversification that has been on the cards for a number of years. Some, like the UAE and Qatar, have already made significant progress, while others, like the Saudi Arabia, lag behind – either due to reluctance to reform or because of the sheer size of the country.
“Oman, Bahrain and Saudi Arabia certainly have weaker balance sheets than the rest,” commented Krisjanis Krustins, Associate Director, Sovereign Group at Fitch Ratings. “However, Saudi Arabia still has very large reserve assets to finance its twin deficits and is gradually implementing major reform to reduce its deficits.”
“The political commitment to the pegs is very strong, and we believe that some sort of facility would be made available to Bahrain and Oman if that was needed to stave off devaluation,” he added.
Saudi Arabia has taken the path towards economic transformation and diversification since 2014, when King Salman assumed throne, aiming to reduce oil dependence, boost the private sector’s role in the economy, lower unemployment, and raise nonoil revenues to about 20% of GDP by 2020.
As a consequence, it narrowed the deficit, which stood at a whopping 16.8% of GDP in 2016, to 8.8% of GDP in 2017, with overall revenues projected to rise by 27%, boosted by a more optimistic oil price outlook.
Pending the oil price remaining within the US$52-60 per barrel range, the country’s fiscal reforms should allow it to lower public debt to GDP ratio to around 25% and achieve fiscal balance by 2020.
El Jamal noted that the medium-term future of the peg hinges on the successful implementation of the National Transformation Plan, which he believes to be truly transformative, as well as the fiscal rebalancing and the size of the reserves.
The current economic situation suggests that Saudi Arabia won’t address the peg issue for several years, he concluded.
All for One and One for All
One important element in the discussion about GCC currencies is the strength of solidarity between these states, which manifests in the drive towards a monetary Union. It is reflected in Saudi Arabia’s and the UAE’s willingness to provide financial backing to the weaker economies, as well as the reluctance of more diversified economies to unilaterally adjust their monetary policies.
Any decision to de-peg or adjust the exchange rate would inevitably be made through a consensus between all member states, Iradian surmised.
“The decision to de-peg or move to a different exchange rate or devalue has to be agreed by all the GCC countries. It is unlikely for one of them to go rogue, because that would put the GCC harmonisation plans in jeopardy,” explained the IIF economist, admitting that the pegs will need to be removed “eventually, as economies become more diversified.”
While all the experts who spoke to Bonds & Loans agreed that in the short-term the pegs in GCC currencies will stay put, there are differing opinions about when exactly that policy will change – and what will drive that shift.
Krustins, for example, noted that even downward pressure from the low oil price and the Fed’s hiking is leading some speculators to bet against the pegs, as many see the region’s currencies as overvalued. The way governments navigate these challenges will dictate their ability to maintain the pegs.
“The discount at which a currency trades on the forwards markets is a measure of how much pressure it is under; in early 2016 it peaked for GCC, reaching 4% for Oman, but has now come down to less than 1%,” he commented.
The Fitch analyst highlighted that with the power that governments and central banks wield in the respective financial sectors, they are able to control the damage from such trades by limiting access to the local currency. Saudi Arabia, for instance, has already banned its banks from offering certain derivative products that could be used to bet against the currency.
But such methods create discomfort for the markets and will be difficult to implement if the currently positive outlook on oil prices suddenly changes.
That is not a major concern for now, Iradian thinks. According to the economist, OPEC’s decision to abandon the strategy of increasing market share is paying off and compliance is strong among OPEC and non-OPEC members.
Main threats to the current projections include a rise in US shale and Canadian oil production, Russia’s unpredictability and Libya’s possible return to the market. If the price remains at the $50-60 per barrel level, US producers are unlikely to have a big impact on the market. Russia, Iradian believes, is already near top capacity and won’t be able to raise more – even if it were to U-turn on previously agreed cuts.
“The wildcard may be Libya, if there is more political stability there, they could double production within 6 months, which could undermine OPEC’s efforts. Keep in mind that global economy is slowly recovering, the Chinese economy is doing well, so demand will rise,” he concluded.
How to Lose a Peg?
Looking ahead into the medium-to-long term, economists expect the chances of GCC countries dropping their currency pegs will rise – perhaps as high as 60% in three years’ time. The way these countries go about “freeing” up their currencies will be crucial.
Some believe they could follow Singapore’s or Kuwait’s examples, although Angonin is sceptical of the latter, suggesting that its choice of a basket of currencies to peg to produced limited benefits to the economy.
“While it has helped Kuwait moderate inflationary pressures during the period of rising or high oil prices until mid-2014, average consumer price inflation levels were slightly higher in the past when compared to its GCC neighbours,” noted the Moody’s analyst.
Iradian is also sceptical of the “Kuwait way”, noting that its basket is still heavily skewed towards the dollar, which made the dinar largely aligned with the “greenback” for the past decade. He speculated that alternative approaches can be taken by the Gulf states.
“They could put more weight on other currencies, such as the yuan, for example. Or why not put the oil price in the basket. If oil price takes 30% of the basket, with the rest going to the dollar and euro, that would give them more flexibility on the exchange rate,” he proposed.
The key to success in this process, however, won’t be the specifics of how it is done, but setting the groundwork and the right conditions; currently, GCC states, barring the possibly the UAE, are not prepared to take this step.
“They need expertise to run an independent monetary policy, there are requirements they have to meet; they need to learn from other countries about different monetary instruments, how to cope with inflation and prevent a vicious cycle; how to avoid social unrest and so forth. And that will be a vital part of the grand economic diversification programme the region is undergoing,” Iradian concluded.
For now, though, the bulk of exports in the GCC remains in oil and oil-related products (with prices recovering); fiscal deficits are mostly manageable; and, the currency pegs also allow these states to enjoy cheap access to the Eurobond markets, cushioning depleting reserves. Unless significant risks to any of these fundamental factors arise, the pegs are staying put.
