Early warning on GCC banking credit growth

The present boom in the Gulf may be oil-driven, but it is not just an oil story. The reform effort has not been dulled. And this time round, more of the windfall is being invested in the region, and more wisely.

The region's banking system has helped translate liquidity from soaring oil revenues into financing for the rest of the economy. Bank credit to the private sector grew by an average of 38 per cent across the Gulf Cooperation Council (GCC) in 2005, with growth ranging from 12 per cent in Oman to a runaway 64 per cent in Qatar. Is this a cause for concern?

The GCC economy as a whole is forecast to grow by seven per cent in real terms in 2006, only slightly down on 2005. Firm demand has pushed up inflation to its highest level for 10 years. High oil and gas prices may have laid the foundations for this strong performance, but in most countries the non-oil sector is the biggest driver of growth (Qatar, with its gas reserves, is a notable exception).

Governments, the first to benefit as oil revenues leapt, are seizing the opportunity to invest in diversifying their economies. Some have handed consumers part of the windfall in the form of bonuses or lower fuel prices. The private sector is also investing strongly, most obviously in real estate but also in infrastructure, manufacturing and services.

Of course, financial markets in the GCC are still evolving and bank lending as a share of economic output is less than half the level in the G7. Mega-projects in energy and industry tend to be funded by foreign rather than local banks, and some powerful conglomerates rely little on domestic banks for investment capital, self-financing or turning to the growing capital markets instead.

However, banks are playing a role in financing investment and household consumption. They have helped fund the boom in construction, and sometimes unwittingly backed the spectacular rise in equity markets, via personal loans to an army of individual speculators.

Economic booms tend to flatter banks' balance sheets. Banks rapidly extend new loans, boosting assets and diluting any existing bad loans on their books. Problems only show up later, if and when investment projects fail to deliver hoped-for returns or the economic cycle turns.

Fitch's Bank Systemic Risk methodology and resulting semi-annual report, first produced in July 2005, aims to give an early warning of such risks.

Banking systems where credit growth is rapidly and consistently outpacing economic growth, where the real exchange rate rises well above its long-term average, or where equity prices have risen sharply, are at greater risk of financial crises than others.

Although the Gulf has taken a sharp correction in equity markets in its stride, and the real exchange rate is less of a concern for oil exporters, credit has been growing at unprecedented rates since 2004. Measures of the banking system's financial strength are therefore all the more reassuring.

Fitch rates all the major banks in all six GCC countries. Combining their 'Individual' or standalone credit ratings into a Banking System Indicator (BSI) gives an overall picture of each country's banking system quality or strength its vulnerability to crisis and resilience to potential shocks.

Gulf banks tend to be well-capitalised, offsetting the risks from asset quality or concentration of lending. They are also keenly supervised by the region's central banks. Regulators have stepped in to cool credit growth in a number of countries, notably Bahrain, or limit personal lending.

Nevertheless, we must closely monitor the quality of the recent rapid loan growth in the light of recent stock market corrections and other asset bubbles that are becoming evident in the various banking systems.

On Fitch's scale of A (very high quality) to E (very low quality), four of the six GCC members Bahrain, Kuwait, Qatar and Saudi Arabia have banking system indicators of B, on a par with most developed country markets and certainly better than most emerging market banking systems. Oman moved up to C from D in our latest report, to join UAE, while Bahrain also improved from C to B.

Past sovereign defaults have rarely been unconnected to banking system crises, which explains why banking systems have to be followed closely.

But whatever the vulnerabilities of the GCC economies to potential oil price falls or other shocks that might trigger a downturn its banks are one of the region's strengths.

The writer is Associate Director Sovereigns, Fitch Ratings.