Après le déluge: Implications for the Gulf

What are the ways in which the Gulf economy as a whole may be affected by the reverberations of the global financial crisis (most obviously represented in the US and Europe)? How do you see oil prices reacting, in particular?

The economic links between the GCC and the US have a long history — the region's oil-dependent economies, dollar-pegged exchanges rates and sovereign wealth portfolios heavily invested in US Treasuries are all affected by the shifting perceptions of prospects for US and global growth, as well as US creditworthiness.

While our regional growth projections have been modestly revised downwards in light of a new, somewhat lower oil price trajectory, the most important implications of these shifts are medium term, as a greater push toward currency and asset diversification, albeit gradual, is likely to ensue.

Regional credit markets may benefit from increased demand for more diversified high-grade sovereigns and corporates, a trend that was borne out in the first few days of trading since the US downgrade.

Investor positioning for currency appreciation is unlikely to build for now, given the recent downward pressure on oil prices. It would not be surprising, however, to see speculation about exchange rate regime changes grow over time.

The effects of the European crisis have been felt for longer, already leading to some distressed prices in both equity and fixed-income markets. This has implications for Gulf investors, not only in terms of the impact on their existing exposure but also as an opportunity for those — especially sovereign wealth funds — with a long-term view. Some of the region's savvier investors and companies may well envision new M&A opportunities.

In light of recent data and weaker markets in the US and Europe, Nomura's global growth forecast — which earlier projected a soft patch for the world economy — now shows a slightly more protracted downturn.

The oil market is the main transmission channel to the GCC of this global growth weakness, and oil prices are already considerably weaker over the past few weeks. Absent further political volatility or other supply interruption (which is not necessarily a given), oil prices are expected to remain on a slightly lower path, but still relatively well underpinned, especially if you look at what futures prices are telling us.

The impact of lower oil prices late in the third quarter hasn't really changed the picture much for full-year 2011 growth. But in 2012, we have decreased our GDP growth forecast for Saudi Arabia, for example, from 4.5 per cent to 4 per cent in light of the lower oil price path.

Until the financial crisis struck, the Gulf economies had been encouraging trends towards structural diversification to alleviate dependence on oil and gas. At the same time, they were fuelled in the years to 2008 by a cyclical surge, impeding the incentive. What is your reading of the continuing efforts along these lines now?

There has been a lot of thought and effort by regional policymakers and international institutions such as the IMF and World Bank around economic diversification away from hydrocarbons — and with some success, as seen in the growth numbers for non-oil growth.

The GCC countries have made some progress in developing other industries (for instance in real estate — the recent crisis notwithstanding, financial services, tourism, logistics), though progress of course varies by country. One might quibble a bit with the fact that a lot of investment has gone in to get just a marginal amount of growth, and therefore whether it has been efficient.

The reality remains that growth is likely to be predominantly oil and gas related, especially with oil prices so high, as a matter of incentive. Even if we talk about Saudi Arabia's huge fiscal spending programme outside the hydrocarbon sector, or Qatar's infrastructure plans, they are unlikely to move the needle in terms of where the bulk of economic growth will come from.

A dominant theme of the past decade has been the rise of Asia, and especially its emerging giants China and India. What is your impression of the Gulf's attitude towards engaging with the East rather than the legacy interests of the West, such as in respect of trade deals, or any other institutional tie-ups?

We do see an increasing focus from the Gulf, a recognition of Asia now as an important global growth engine. There is a desire to invest there, even if assessing the risk and reward balance can pose a challenge for the likes of the SWFs. Trade relationships are already there, both in oil and gas exports and a fair amount of imports.

An interesting link that will continue to grow, now that the Gulf is investing more within [its own] region, is in infrastructural development. Strong companies from Asia are getting involved, notably Chinese and Korean.

For the Gulf countries one of the important things is to create employment — managing relations, yes, but particularly creating jobs as well, at the middle-management level.

One other interesting link between the Gulf and some of the countries in east Asia is in financial products, Sharia-compliant finance. The potential market for Gulf sukuk issuance there, which has already grown, is a refrain that comes from capital markets teams.

How would you summarise your medium-term outlook for the Gulf?

Broadly speaking it's positive, largely because of the medium-term prospects for oil prices, which remain strong. The regional growth picture should also be supported by the large fiscal savings that have been put aside which can cushion economies in the face of a difficult external environment.

The Gulf is one of the few regions to be able to comfortably utilise counter-cyclical fiscal policy. This can help minimise risks of economic downturn, as well as helping to address political risks. Most of the Gulf countries are relatively immune [from the political fallout elsewhere in the region] because of the economic safety net in place, with a broad underlying sense of economic well-being that is lacking in many other parts of the rest of Arab world. This, of course, does not guarantee political stability, but helps to minimise risks.

When thinking about the outlook for Gulf countries, we not surprisingly put a lot of importance on political stability, i.e. the challenges of keeping the population satisfied. It is very hard to put a measure on these things, but we would say in the case of Saudi Arabia that there are certainly important political risks, which require monitoring, and which markets are sensitive to.

There are two avenues to that. There is regime stability within itself, and transition to the next generation of leadership. The other avenue is sectarian, with reference to the example recently in Bahrain. The main oil-producing areas in Saudi Arabia are in relatively close proximity, and here there have been similar concerns about sectarian tensions for some time.

As to policymaking, do you have any expectation that the GCC will reappraise its attachment to the US dollar peg, and EMU as a template for monetary union, in light of the recent evidence? In both cases, what would your advice be?

On the exchange rate, there are two parts. As to the short term, in a world of such volatility it is not in the interests of the Gulf countries to head down a different path from the unfaltering commitment to the dollar so far. Policy stability in the current markets is paramount.

In the slightly longer term there is potential for a structurally weak dollar to have an inflationary impact — especially with the US Fed on hold till 2013, and this could influence how policymakers think about the exchange rate commitment.

While inflationary challenges don't exist for these countries today, the combination of fiscal stimulus programmes, a potentially weaker dollar, high oil prices, and limited use of monetary tools could all lead the markets at some stage to renew speculation about revaluation, or increased currency flexibility. Note that Qatar has just cut interest rates, partly to stimulate domestic credit growth, but perhaps also — just after the Fed signalled its stance — to reduce the possibility of an interest differential creating pressure for currency appreciation in the future.

As to Gulf monetary union, that was always going to be a challenge, regardless of Europe's experience. But the growing acceptance of the view that a monetary union without fiscal union will eventually face challenges could well have a deterring influence on plans for a Gulf currency union.

The Gulf countries seem very unlikely to agree to fiscal union, not least because of the transparency it would require. Moreover, when creating such an institutional set-up, it must be resilient not only in time of high oil prices but also in an environment of protracted low oil prices as well.

Without a fiscal union, markets could well test any pledge to such a monetary union, particularly under a negative oil price scenario. Gulf policymakers need to have that thought in mind.