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Middle EastSeptember 1 2015

The oil drain: how will banks in the Arab world cope?

As oil prices remain in the doldrums, the spending plans of hydrocarbon-dependent economies within the Arab world appear to be taking a hit. James King looks at how this new environment will affect the region's banks. 
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The news that Saudi Arabia has returned to the bond market, with a plan to raise $27bn by the end of 2015, is a good indicator of the financial strains facing the Gulf Co-operation Council (GCC) countries. Between May and August this year, the price of Brent crude fell by 26%, as fears over a slowing global economy as well as increased Organisation of the Petroleum Exporting Countries (OPEC) and non-OPEC production weighed on market sentiment. For the ruling dynasties across the Arabian peninsula, this new price environment is bringing an end to years of oil money abundance. 

It is also likely to bring new challenges to the region’s banking sector. “We expect to see a gradual change in terms of both loan growth and non-performing loans across the GCC region, though there won’t be any major shift in asset quality indicators over the short term,” says Mohamed Damak, director and global head of Islamic finance at Standard & Poor’s.

Government spending 

Across the GCC region, hydrocarbon-dependent economies have largely relied on government spending to drive domestic growth. This has worked well over the past decade, when oil prices were high. But regional banks’ exposure to the public sector is now likely to force most lenders to adjust to a new normal, particularly in terms of their key indicators, such as profit and loan growth, as well as their liquidity ratios, after a period of plenty. 

Mohamed-Damak

We expect to see a gradual change in terms of both loan growth and non-performing loans across the GCC region, though there won’t be any major shift in asset quality indicators over the short term – Mohamed Damak

“We believe the cycle of improving asset quality and declining credit losses for banks in the GCC region has come to an end, and we expect weaker oil prices to lead to gradually worsening operating conditions,” says Mr Damak. 

The common consensus, however, is that this transition process will be gradual. Most Gulf lenders are highly liquid and exceptionally well capitalised, while loan loss provisions for the region as a whole remain high. This position of strength enjoyed by Gulf banks is the product of a prudent regulatory environment, as well as a banking culture that prioritises long-term, sustainable growth. 

Moreover, much will depend on the spending policies of regional governments. For now, it seems that most are forging ahead with existing spending programmes despite the slump in oil prices. This means that the region’s banks are unlikely to be adversely affected by reduced public spending in the short term. 

Indeed, most of the region’s largest lenders are continuing to enjoy strong growth in profits. Emirates NBD, the United Arab Emirates' largest lender by Tier 1 capital, saw net profits jump by 41% in the first half of 2015. Similarly, Qatar National Bank enjoyed a 10.2% increase in net profits for the first six months of the year. Meanwhile, research from Albilad Capital, the investment banking arm of Bank Albilad, notes that the aggregate income of listed Saudi banks rose by 5.1% in the first quarter of 2015 when compared with 2014.

Budget deficits 

Non-performing loans for GCC banks

But this strategy of continued government spending will come at a cost. The International Monetary Fund (IMF) expects the Gulf region to lose about $380bn in export revenues this year as a result of the slide in oil prices. The Saudi economy is now facing an expected budget deficit of 20% of gross domestic product – equivalent to $150bn – this year, according to the IMF. In addition, the country has burned through $65bn of its reserves since oil prices began to fall to meet government spending plans. 

“The lower oil price environment has impacted some GCC sovereigns by increasing budget deficits in some cases, and diminishing long-standing surpluses in others,” says Elias Bikhazi, chief economist with the National Bank of Kuwait. 

With the price of oil expected to remain depressed for some time – Standard & Poor’s projects $65 a barrel in 2016 – the outlook for current spending patterns is unsustainable. “Most GCC sovereigns, with the exception of Qatar and Kuwait, will be running fiscal deficits soon because their fiscal breakeven point is typically high,” says Jubin Jose, an investment advisor with the Qatar Investment Fund. 

“We expect to see a lot of non-core investment projects across the region face cancellation or delay. Qatari banks will be more insulated from this trend, however, because there is more certainty around government spending moving forward,” says Mr Jose. 

This is where things will get more difficult for regional lenders. In such an environment, deposit inflows from government and government-related entities will start to diminish. As this happens, regional banks are expected to look to the private sector to bolster their deposit base, a trend that will generate additional performance pressure through increased competition. Adding to these problems is the fact that the region’s private sector is itself almost wholly dependent on government spending. 

“About 30 to 40% of the funding profile of the GCC’s banking system stems from national governments. We have already seen visible signs of weakness in deposit growth. We believe that banks in the region will have to be more careful when they underwrite longer term funding financing exposures,” says Mr Damak.

Liquidity pressures 

Evidence of these nascent liquidity pressures are beginning to appear in various regional markets. According to research from Reuters, the three-month interbank offered rate in the UAE climbed to a 17-month high of 0.79% in August this year, while rates in Qatar, Kuwait and Bahrain have also increased. 

In addition, longer term liquidity concerns have been the cause of emerging turbulence in the Saudi Arabian money markets. Following the country's issuance of SR20bn ($5.3bn) of bonds to domestic commercial banks in early August, the cost of the two-year interbank offered rate subsequently jumped to 1.53%, up from 1.05% just over a month previously. In addition, one-year US dollar/Saudi riyal forwards surged to 290 points in early August, marking it out as the highest figure in the past 12 years. 

These movements have emerged as concerns begin to crystallise over the capacity of Saudi Arabia’s banks to absorb future bond issuances. According to a number of international and local press reports, high-level banking sources in the country have been told that no more than 40% of the deficit will be financed through bond issuances. What remains unclear, however, is the extent and duration of the country’s future borrowing requirements. Similarly, a bond issuance calendar for the country has not been released. 

This situation has heightened uncertainty over the banking sector’s future bond purchasing requirements which, while providing lenders with highly rated assets, may begin to tighten system liquidity over the long term. For now, however, Saudi Arabian banks are in a good position to absorb these bond sales in light of their cash-rich balance sheets. 

Elsewhere, similar situations are emerging in Oman and Bahrain, where the budget deficits are expected to reach 13.2% and 11.2%, respectively, this year. “We believe the most vulnerable banking systems [in the GCC] are in Bahrain and Oman, whose economies are highly dependent on oil and the budget breakeven price is significant. On a positive note, we think both countries will benefit from disbursements from the GCC Development Fund providing $10bn to each country over a 10-year period, which would offset any capital expenditure cuts and act as a key growth contributor,” says Mr Damak. 

As such, exposure to the oil and gas sector, as well each country’s budget breakeven oil price, will be a strong predictor of future spending cuts. However, evaluating energy sector exposure has its difficulties in some economies. “There are some underestimated risks in the region. If you look at the Qatari banking system, a large chunk of oil-related activity will fall under the umbrella of government-related files. On paper, this means the total exposure of the oil industry looks much lower than it actually is,” says Mr Damak.

Rationalised spending 

Moving forward, most Gulf countries will be forced to rationalise their infrastructure and project spending, while cutting back on their lavish subsidy systems. The UAE boldly forged ahead with the elimination of fuel subsidies, worth about $7bn annually, in August, while both Oman and Bahrain have raised the tariff for industrial users of natural gas. 

“If public spending drops in the future or there is a postponement of projects on a selected basis, the banks will be more careful in their assessment of lending. It is worth noting, however, that most GCC lenders are typically prudent in this regard,” says Nassib Ghobril, chief economist with Lebanon’s Byblos Bank. 

GCC’s highest movers - changes in Tier 1 capital 2014-15

To date, policy-makers in the region have been relatively conservative in this regard. Action has largely come in the form of project postponements and delays rather than outright cancellations. Moreover, much of this response has been targeted at the oil and gas sector in countries with higher production costs. 

In some cases, spending has actually increased. Governments with less reliance on oil or with lower costs of production, including Qatar and Kuwait, have ramped up project spending. In particular, this has come as the government in Doha pushes ahead with preparations for 2022 World Cup, while the green light was given for the construction of the massive Al Zour refinery in Kuwait.

Projects postponed 

Yet, on the whole, most analysts expect a significant dip in project spending in 2016 and beyond. If this occurs, there may be longer term implications around specific sectors’ asset quality. “In terms of regional asset quality, the most stressed sectors will be real estate and contracting. If governments reduce spending over the medium term, this may lower contracting activity and make it harder for contractors to hit their payment targets. On the real estate side, there is less risk. Nevertheless, any government spending slowdown will be gradual. It will be a soft landing rather than a meltdown,” says Mr Jose. 

Indeed, while these challenges are mounting and the region’s banking sector braces itself for the changes of a new global energy environment, GCC banks are at least in excellent health. “For the time being, the region’s asset quality will remain at good levels. In addition, capitalisation will remain solid and the banks will continue to have acceptable non-performing loan ratios,” says Mr Ghobril. 

According to data from Standard & Poor’s, the loan loss provision coverage for the entire region stands at 137%. In addition, the percentage of non-performing loans to gross loans is favourable. In Saudi Arabia, this sits at 1.2%, while Qatar and the UAE are at 2% and 3.1%, respectively. 

It is a similar story in terms of GCC lenders’ Tier 1 capital. According to The Banker’s Top 1000 World Banks ranking for 2015, every Saudi, Qatari and Emirati bank that featured this year, amounting to 30 banks in total, recorded positive increases to their Tier 1 capital base. This trend is mirrored in the Middle East region’s share of global Tier 1 bank capital. In this year’s Top 1000 ranking, Middle Eastern lenders, dominated by GCC banks, accounted for 3.88% of the total, compared with 3.77% in the 2014 ranking. In addition, the Middle East region’s capital assets ratio also jumped over the same review period, hitting 10.83% from 9.93% last year. 

“Our overall opinion is that GCC banks are facing this tougher environment from a good position. Their capitalisation and liquidity levels have been strengthening in recent years,” says Mr Damak.

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