Global Financial Crisis Highlights GCC’s Policy Challenges
A Commentary by Masood Ahmed, Director, Middle East and Central Asia Department, International Monetary Fund
Published in International Economic Bulletin, Carnegie Endowment for International Peace, March 2010
The global financial crisis has left its mark on the Gulf Cooperation Council (GCC), comprising Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates. But vigorous countercyclical policies and financial sector support measures—made possible by reserves accumulated during the 2003–2008 oil price boom—have helped contain its impact. While the November 2009 announcement of Dubai World’s debt standstill has dampened market sentiment, the outlook for the region remains encouraging. Nevertheless, the crisis has revealed financial sector vulnerabilities in some countries that need to be addressed in order to limit future disruptions to development plans and real economic growth.
GCC Confronts Crisis From Position of Strength
Oil accounts for about 50 percent of the GCC’s GDP and 80 percent of its fiscal and export revenues. With the oil price boom came a marked strengthening of these countries’ fiscal and external balance surpluses. This windfall, in turn, freed up resources for reducing domestic and external debt and pursuing policies that encourage economic diversification and reduce unemployment.
But the uptake in oil revenues also presented some challenges. Buoyant economic activity, rising consumer and investor confidence, and abundant liquidity spurred excessive credit growth, inflation, and asset price increases. As global shocks led to a tightening of financing conditions in late 2008, these imbalances came to the fore, especially in the United Arab Emirates, Kuwait, and Bahrain, due to these countries’ close linkages with global equity and credit markets. In addition, banks’ growing dependence on foreign financing and exposure to real estate, construction lending and—to a lesser extent—the equity market, contributed to balance sheet vulnerabilities in these countries. In the corporate sector, the boom had been associated with higher leverage, particulalry in Kuwait, Qatar, and the United Arab Emirates, which increased vulnerabilities to the reduced availability, and higher costs, of financing during the crisis.
Fallout Met With Concerted Response
With the intensification of the global credit crunch and the decline in oil prices and production, the GCC witnessed a sharp drop in external and fiscal surpluses. By early 2009, stock markets had plunged, losing between 50 percent to 75 percent of their peak values in mid-2008. Real estate prices also plummeted: market estimates in Kuwait, Qatar, and the United Arab Emirates indicate corrections of 60 percent, 40 percent, and 50 percent, respectively, over the past 18 months. Credit default swap (CDS) spreads on the region’s sovereign debt widened across the board, ranging from a 230 basis point (bp) increase for Oman, up to 625 bps for Bahrain, and 830 bps for Dubai. External funding for the financial and corporate sectors tightened and, as a result, of an estimated $2.5 trillion in projects at different stages of planning and implementation at end-2008, around $575 billion had been placed on hold by end-2009.
But, on the whole, banks continued to record profits and had sufficient capacity to absorb potential losses given their high capital adequacy ratios. The crisis, however, did lead a few nonbank financial institutions and business groups to default. Nevertheless, thanks partly to the authorities’ rapid response—in the form of high levels of spending and exceptional financial measures—these defaults were isolated and did not have systemic consequences. Supportive policies not only helped support growth in the GCC; they also helped stabilize other economies in the wider Middle East and North Africa region, as well as the Indian subcontinent by contributing to workers’ remittances, foreign direct investment, and imports.
Hefty Repercussions for Dubai
Similar to developments across the world, tight global financial conditions culminated in the reversal of real estate prices across the GCC. The correction was most pronounced in Dubai, where real estate prices had risen sharply, even relative to a number of global urban centers. Pressures on Dubai’s highly leveraged, quasi-sovereign entities followed. Consequently, in November 2009, Dubai World—a Dubai-government-owned holding company—was compelled to seek a debt standstill.
Dubai Inc.—a web of commercial corporations, financial institutions, and investment arms owned directly by the government of Dubai or the ruling family under the umbrella of three major holding companies—borrowed extensively in 2004–2008 to fund a major push into commercial and residential property. Over that period, liabilities to global banks as a ratio to non-oil GDP more than doubled, as did domestic credit to non-oil GDP. Credit growth in Dubai was among the most rapid in emerging markets, with banks in the United Arab Emirates extending about $100 billion of credit in excess of the historical trend, fueling a real estate bubble and resulting in a significant increase in leverage.
The Dubai World event has temporarily renewed pressure on the region’s equity markets, and CDS spreads on the Dubai government and entities have widened, although CDS spreads for the rest of the region have been only marginally affected. Support provided by the Abu Dhabi government has helped calm markets, but uncertainties remain as the government of Dubai is still developing a strategy to put its corporate sector on a viable path.
Developments in Dubai will also have lasting effects, particularly as markets likely stop assuming implicit guarantees when pricing quasi-sovereign and private risk and ask for greater transparency on financial information and better corporate governance. These developments also have implications for the choice of the economic diversification model going forward, certainly for Dubai, but also across the region.
However, the regional impact will likely remain limited. Dubai’s economy accounts for less than 10 percent of GCC GDP, and intra-GCC trade is less than 10 percent of total GCC trade.
Although the Dubai World event has cast a shadow on the region’s short-term outlook, the overall outlook for the medium-term is positive. Developments in Dubai have temporarily disrupted the recovery in regional equity markets and the decline in CDS spreads experienced since early 2009, but external funding for nonbanks has generally shown positive signs since early 2009.
Non-oil GDP growth—the relevant measure of economic activity for employment creation— is estimated to have been about 3.0 percent in 2009, and the rebound in growth in 2010 is expected to be stronger than in advanced economies. Headline inflation is estimated to have fallen from double-digit levels in 2008 to about 3 percent in 2009. The external and fiscal surpluses weakened in 2009, but are expected to recover partially in 2010, in line with the expected increase in oil prices as global recovery begins to take hold.
Some Policy Challenges
The global crisis and the Dubai event have underscored the need for enhanced communication and transparency in both public and private sectors in the GCC. This will prove essential in easing investor uncertainty and reducing market speculation as authorities carry out the immediate priorities of cleaning up banks’ balance sheets and restructuring the nonbanking sector—most notably in Kuwait and the United Arab Emirates—including by supporting systemic and viable entities while ensuring the smooth exit of nonviable ones.
Looking further ahead, to help promote financial stability across the region, macroprudential policies should attempt to dampen the transmission of the oil cycle to the economy. Regulations should promote prudent provisioning—similar to the countercyclical provisioning policies already in place in Saudi Arabia—and capital buffers over the business cycle. To tackle any speculative inflows and overheating pressures, reserve requirements should be used actively, and prudential limits on banks strictly enforced. Policy makers could also consider a capital gains tax on property and equity transactions. Excessive corporate sector leverage should be avoided, and spillover risks from offshore financial centers monitored and addressed.
Finally, ongoing initiatives to diversify financing channels away from banks—through the development of local and regional debt markets—should be pursued. Structural reforms aimed at diversifying the real sector should focus on facilitating private sector activity.