Analysis

GCC Countries and Credit Rating Cuts - Part II

Impact of oil prices on GCC countries and sectors immune to credit ratings and oil shocks

 

In part I of the GCC countries and credit rating cuts report, we tried to provide a picture of how the credit ratings of each GCC country have behaved since 2000 and aimed to measure the stock market performance. In this section, we shall discuss the explicit and implicit impact of sovereign credit ratings on key sectors. We have segregated some sectors that are immune to these disturbances. Based on the relative valuation methodology, we have highlighted some stocks that may offer good investment opportunities.

 

GCC countries’ GDP highly co-correlated to oil prices

 

During 1H2015, oil prices averaged at USD 60/bbl. If it continues to average at a similar level for the rest of 2015, then all other GCC countries would run into deficits except Kuwait, which would still be in budget surpluses based on our preliminary estimates of the government expenditure and oil production in 2015. The UAE could post another year of deficit based on its forecasted budget expenditure. Saudi Arabia would record its second consecutive year of budget deficit since 2009, as the IMF estimated breakeven oil price for 2015 at around USD 82/bbl. Saudi Arabia would face no issue to finance the budget deficit for the next 3–4 years due to a substantial level of accumulated foreign reserves and low sovereign debt. However, there is little scope for the Kingdom to boost expenditure from the current levels. We expect growth in spending to remain stable over the next few years. With substantial requirements for further infrastructure development, we expect the current spending (wages and salaries, subsidies, transfers, etc.) to be contained, with capital spending likely to benefit from any further increase in expenditure.  We expect Bahrain and Oman to finance the budget shortfalls from savings and transfers from other GCC countries.

 

GCC countries — Fiscal breakeven oil prices for 2015

 

Given the difference in relative fiscal strength of the GCC countries, fiscal breakeven oil price varies as well. As Bahrain caries the highest risk of a fiscal imbalance, it has the highest breakeven oil price. Oman follows next, while Saudi Arabia, due to the size and scale of its economy and higher public spending initiatives, requires a relatively higher oil price to sustain its fiscal balance. However, given its substantial foreign reserves, breakeven oil price does not matter much to Saudi Arabia. Kuwait and Qatar are relatively well positioned due to the proactive austerity measures, apart from the already strong fiscal positions. We have discussed the fiscal situation separately for all GCC countries in the section below.

 

Sovereign rating impact on banking sector

 

In the international debt market, lenders largely look upon sovereigns to offer implicit or explicit payment guarantees to private borrowers. As a result, the sovereign’s financial position in local and foreign currencies plays a crucial role to determine the credit worthiness of any financial institution looking to raise debt in the international market. Furthermore, the foreign capital flow in any country is fundamentally dependent on the overall credit risk associated with the country.

 

Sovereign rating captures a broad reflection of a country’s macroeconomic situation. Thus, understanding the sovereign rating and its impact on financial institutions is synonymous to understanding the interrelationship between macroeconomic variables of any country and its banking sector’s performance. Also, it has a direct impact on the financing cost of financial institutions. Thus, it is required to have an investment-grade sovereign rating for the development of the financial sector.

 

The continued low oil price is posing challenges for the GCC countries to maintain their fiscal prudence. Consequently, the global rating agencies have become proactive in adjusting the sovereign credit outlook for the GCC countries. We believe any deterioration in the fiscal situation due to the low oil prices could impact the banking sector in two ways: 1) low government revenue would reduce deposit inflow from large government and government-related entities that would decrease the system’s liquidity and 2) austerity measures to cut public spending would impact credit growth in the economy. According to Moody’s, government-related deposits provide a substantial 10–35% of the non-equity funding of the banks. However, internally robust capital and less reliance on market funding would provide some respite to banks in the GCC countries.

 

The banking sectors in Bahrain and Oman are expected to be affected more due to the further weakening of oil prices. Both the countries have been assigned a cautious outlook on sovereign ratings from global rating agencies. Relatively weak foreign asset position and continued public spending are cited as some of the key reasons for the outlook. Saudi Arabia’s deficit is expected to widen in the coming two years; however, the scale and strength of Saudi Arabia’s domestic economy is considered to be stronger than Bahrain and Oman. Kuwait, Qatar, and the UAE will likely witness moderate to low impact of low oil prices.

 

Dom. credit to private sector by banks (% of GDP)

Dom. credit to private sector by banks (% of GDP)

 

Implicit impact of sovereign rating (investment cycle)

 

Although a country’s sovereign rating does not pose any direct threat to the performance of the sectors in the economy, the interrelationship becomes more obvious from a credit perspective. Industries that require heavy capital funding and opt for international funding routes are definitely the most vulnerable to any downgrade of their respective sovereign ratings. Furthermore, factors leading to a nation’s sovereign downgrade affect the liquidity in the economy, cost of debt, and public spending on infrastructure projects. This creates challenges for debt- or investment-driven industries such as real estate, infrastructure assets, capital goods, and private utilities. Additionally, the associated industries such as cement and steel could face a lag in demand.

 

Impact of sovereign ratings on sectors with underlying fundamentals is low

 

While all corporates positioned in the capex cycle of their business are impacted by their respective sovereign ratings, there are certain sectors where the fundamentals are driven more by the consumption cycle in the economy. Sectors that can create a cash-rich business model are particularly relevant for discussion in this section. Many companies operating in these sectors typically become cash cows and are extremely well financed to fund capex requirements (if any) through their internal cash generation. Some sectors that would be resilient to crude fundamentals are as follows:

  • Agriculture
  • Consumer staples
  • Healthcare
  • Hotels and tourism
  • Technology
  • Transportation

 

We have identified a number of stocks in the sectors mentioned above across the GCC countries. Based on relative valuation, we believe the highlighted stocks look attractive. Despite the macro issues, we believe these sectors and stocks would perform better fundamentally.

 

Agriculture

 

Consumer staples

 

Healthcare

 

Hotels and tourism

 

Technology

 

Transportation

 

Conclusion

 

The macroeconomic dynamics of oil-exporting countries in the GCC region are driven by oil prices and production outlook. Although the degree of vulnerability to oil prices varies for all six nations in the GCC, the structural fundamentals of these countries are largely dependent on oil.

 

Sovereign ratings technically capture the credit worthiness of sovereign commitments based on a broad fiscal situation. As fiscal variables are dependent on oil prices, sovereign ratings of all GCC nations are directly correlated with the outlook for oil price. Historically, since 2000, the GCC nations have not experienced too many changes in their credit ratings despite being subjected to shocks in oil price (in 2008). The reason for this being  substantial buffer from foreign reserves that these countries have accumulated over a period of time. This helped these countries offset any deficit arising from the falling crude prices. However, due to strong public spending in these countries, foreign asset reserves have deteriorated and cannot be considered as a buffer for the deficit scenario for a prolonged period of time.

 

In our view, the recent sovereign downgrades for the GCC nations could be seen as the combined effect of three simultaneous events: 1) low oil prices outlook that impacted government revenue, 2) huge spending commitments and subsidy burden in all these countries, and 3) not-so-strong foreign reserves to combat a prolonged deficit situation.

 

As per the EIA, Brent crude oil prices are likely to average USD 60/bbl in 2015 and USD 67/ bbl in 2016 compared with USD 99/bbl in 2014. We believe such estimates would further weaken the government’s finances among the GCC countries. Furthermore, Moody's assumed an oil price outlook of USD 55/bbl (Brent) for 2015 and USD 65/bbl for 2016 and accordingly based their credit opinion on the banks in the GCC nations. Although the recent rating downgrades already reflect such an oil price scenario, any further downgrade cannot be ruled out if oil prices dip again.

 

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