It’s become something of a cliché by now that “in every crisis, there is opportunity”. Yet in light of how some governments in the Middle East are responding to the oil deflation crisis, that cliché has a compelling ring of truth.
Let’s quickly review what has been happening recently. Low oil prices are entering their second year and it is unlikely that the markets will see a recovery to the level of $100 any time soon.
Since income from oil is the major contributor to their budgets, the decline in oil prices will have a major impact on the income of the Gulf states.
Between 2013-15, revenues as a percentage of GDP declined by 23 per cent. Most of these states will face budget deficits for the first time after a decade of continuous growth. Moody’s projects that the GCC fiscal deficit will reach close to 12.5 per cent of the regional GDP in 2016.
The huge reserves that GCC countries managed to accumulate during the high oil prices will assist them in reducing the impact of the fall in oil prices. However, ultimately GCC countries will have to resort to borrowing to fund the deficit in its budgets.
Funding the deficits will lead to a rise in government debt that will have other consequences. Moody’s has already lowered the credit rating for Oman and Bahrain. Standard and Poor cut Saudi Arabia’s rating two notches to A-.
Although the huge financial reserves will act as a buffer, that buffer will erode because withdrawals from these reserves must be made to meet the increasing public expenditure. In addition to the drop in value as a result of the withdrawals, sovereign wealth funds will also see a drop in inflows as a result of low oil prices.
Yet this fiscal turmoil presents an opportunity for GCC states to implement long-awaited fiscal reforms that could relieve pressure on government balance sheets. Hence, the low oil prices could be a catalyst for meaningful structural changes in the very economic structures of the GCC states.
In particular, consider how GCC members just announced a value-added tax (VAT) to help compensate for dwindling oil revenues. Further forms of taxation may follow to provide proper funding to the states.
Consider that this move is not intended as a short-term fix to be reversed as soon as oil prices presumably reinflate in the next year or so (a dubious presumption indeed). To the contrary, the VAT announcement was presented in the longer-term context of economic diversification.
Consider too that Saudi Arabia has opened up its stock market to foreigners. In a recent interview, the Deputy Crown Prince declared in an interview with Bloomberg that Saudi Aramco would be privatised transforming the oil giant into an industrial conglomerate. The initial public offering could happen as soon as next year.
It typifies how GCC countries are moving decisively away from their traditional reliance on state subsidies, particularly of energy costs. The private sector is being encouraged to play a larger role in employment and in the economy as a whole.
All these efforts are intended to lessen dependence on oil and encourage progress towards a more diversified economy.
Consider, in turn, how all such fiscal responsibility will enhance the GCC’s stature in the global community. It’s no accident, for example, that, when UAE Minister of State for Financial Affairs Obaid Humaid Al Tayer made the VAT announcement in February, IMF director Christine Lagarde was standing by his side.
The changes underway, of which VAT is one salient example, mean that GCC economies will move away from the welfare state model to the modern economies of the developed nations. That move will carry portentous social and political implications in the long run.
The contractual relationship between the state and its subjects will undergo a structural reform inasmuch as the state would no longer be the ultimate provider of welfare.
Let’s focus a bit more on VAT as one key step among others toward this political transformation. A framework for VAT — which is set at a rate of 5 per cent beginning January 1, 2018 — will be formalised across the GCC by June of this year. That 5 per cent is relatively low, although the IMF is satisfied that it will still have an appreciable impact.
In the UAE, for one, VAT will generate revenues equivalent to about 1.5 per cent of GDP. As the UAE forecasts growth to $440 billion in 2019, VAT revenue will therefore be approximately $6.5 billion.
All GCC nations have until January 1, 2019 to fully implement. It is a reasonably flexible schedule allowing public and private sector entities sufficient time to fully comply. Certain foods as well as health care and education are exempt — an important consideration to soften the political shock waves that might otherwise register.
Politically, it is indeed a delicate balance, especially since there are such bigger, bolder plans in the works. Again, the GCC and IMF are looking beyond the current oil crisis or, put another way, they are looking to leverage the crisis to achieve longer-term objectives.
“It is time people understand that public services need to be priced,” said Lagarde. Otherwise, “Governments resort to big borrowings, which is not sustainable in the long term.”
The IMF has been pushing the GCC in this direction for some time now; thanks to the oil price crisis, the GCC has finally stopped pushing back.
How far will it go? Al Tayer said that a corporate income tax, which many view as a crippling disincentive to foreign investment, is not on the “immediate” agenda. Nor, presumably, is a personal income tax.
But Al Tayer’s use of the word “immediate” is interesting. Now that the sluice gates are open, further revenue-raising ideas may likely be discussed in the not-so-distant future.
Indeed, VAT already seems part of a larger trend, coming as it does on the heels of another important decision late last year by Saudi Arabia to cut expenditures and raise domestic fuel prices. Spending there has been reduced by a not inconsiderable 14 per cent while consumers are now suddenly paying 0.90 riyal for a litre of gasoline, up from 0.60 riyal.
As with VAT, these measures must be understood in the context of diversification beyond oil as the Saudis expect to present this year a detailed plan for just that.
These reforms prerequisite another kind of reform and that is the legislative reform. Taxes need proper legal foundation that that the GCC countries do not have today. Economical reform entail doing away with many of the out of date commercial legislation and putting in place more modern world-class legislation in the fields of bankruptcy, companies, commercial activities, arbitration and dispute resolution mechanisms.
What is needed is a real shake up which touches the deep roots of the legislative framework.
To be sure, such austerity initiatives are not without risk. The GCC is rolling the dice on investment. Expat companies, for example, first landed in this region specifically for tax reasons.
Many now fear the business growth they counted on won’t happen if they cannot pass through VAT costs to their customers. Yet the 5 per cent was shrewdly determined: large enough to make a difference in terms of revenue, but low enough to allow companies some wiggle-room.
The biggest risk is in the timing. As slowdowns continue in China and India, the new taxes may indeed disincentivize larger investments.
And, if the next recession occurs too soon, we might have a worst-case scenario as foreign investors equivocate or simply flee at a time they’re most needed.
Yet the risk is not simply worth taking. In fact, there is no choice. Nor is it simply a matter of fiscal exigency.
The downturn in oil has deprived regional governments of their economic suzerainty. It also raises questions as to how they expect to govern in the brave new world in which they now find themselves.
They have two choices. They can simply hang on as their populations are gradually impoverished by ongoing marketplace convulsions.
Or they can face a new reality that makes closer, more responsive connection to their constituents unavoidable.
The greater the economic challenge, the more important that connection becomes — and the imposition of responsible economic measures suggests that GCC countries indeed understand that. No one likes to pay taxes but those who do have an exponentially deeper stake in their countries.
Taxes will ultimately lead to more accountability, transparency, and efficiency. In that sense, VAT is a dawning moment for the GCC countries.
If captured, it will open the doors to the 22nd century.
The writer is Chairman of Baker & McKenzie Habib AlMulla.
