Skyline of Dubai, United Arab Emirates, where a real estate bubble contributed to the economy’s troubles (Jose Fuste Raga/CORBIS)
GLOBAL FINANCIAL CRISIS
In a new study on the impact of the crisis on the GCC region, Abdelhak Senhadji and May Khamis of the IMF’s Middle East and Central Asia Department find that region’s policymakers reacted swiftly and appropriately to the crisis. Despite some lingering uncertainties—such as the consequences of the Dubai World debt standstill announcement in November 2009—the study concludes that the effects of the crisis were largely contained.
In an interview, IMF Survey online spoke to Senhadji and Khamis about the region’s lessons from the crisis and why greater financial sector transparency and more rigorous regulation is essential.
IMF Survey online: What was the impact of the crisis on the GCC region?
Senhadji: The GCC countries have been hit by the decline in oil prices and production, as well as by liquidity shortages in global financial markets. Oil market developments affected government finances and external positions directly, but they also had an indirect impact on banking and corporate liquidity and funding costs as speculative capital inflows reversed and investor confidence in the GCC declined. This, together with global liquidity shortages, triggered a steep fall in asset prices and weakened financial systems’ balance sheets, prompting governments’ intervention in the financial sector. The direct impact from U.S. subprime assets, however, was limited, given a relatively low direct exposure of GCC commercial banks to these assets.
IMF Survey online: How effective was the region’s response?
Khamis: The authorities’ swift and comprehensive response definitely dampened the crisis impact. While oil GDP contracted in 2009, non-oil real GDP growth continued to be positive, at around 3 percent compared to 6 percent in 2008. In the financial sector, there were some defaults and losses in the nonbank sector, but these events did not translate into systemic consequences. To a large extent, the measures adopted by the authorities enhanced the sector’s stability and the public’s confidence in it. Banks continued to post profits throughout the crisis, and overall, the impact was moderate.
Senhadji: Although oil prices declined significantly—from a peak of $147 in mid-2008 to a low of $34 in December of that year—the authorities were able to cushion the impact of the global crisis through financial sector support measures and countercyclical fiscal policy using the foreign exchange reserves accumulated over the boom years. This was true especially in Saudi Arabia, where the stimulus package was the largest (as a share of GDP) of any G-20 country.
IMF Survey online: The GCC experienced strong growth before the global financial crisis. In retrospect, what were some of the region’s main vulnerabilities?
Khamis: The region experienced high rates of credit growth in the period preceding the crisis. As a result, the ratio of private sector credit to nonoil GDP nearly doubled during the period 2003-2008. Rates varied—the highest were in Qatar and UAE. These high credit growth rates, together with strong economic activity supported by positive investor and consumer sentiment, resulted in inflationary pressures. High demand for real estate and equities resulted, in turn, in pushing up the prices of these assets.
At the same time, banks were increasing their leverage and becoming more dependent on foreign financing to support credit growth—even if most of the credit growth in the GCC was funded by domestic deposits. Ultimately, the banking sector became more vulnerable to reversals in asset prices, to the slowdown in economic activity, and to changes in the availability and cost of foreign financing.
IMF Survey online: Most GCC countries’ currencies are pegged to the U.S. dollar. Did this constrain the authorities’ ability to manage the economy in the years leading up to the crisis?
Senhadji: The currencies of all GCC countries but Kuwait are pegged to the U.S. dollar, which has been a factor of macroeconomic stability in the region for many years. But a peg to the dollar brings macroeconomic stability only if two conditions are met: first, that there is macroeconomic stability in the U.S.; and second, that the business cycles of the U.S. and the GCC countries are synchronized. That’s because when you peg to a currency, you essentially import the monetary policy of that country.
For years, these two conditions were met—that is, until late 2006, when the business cycles started to diverge as a result of the subprime debacle. Economic activity in the United States started to slow down, but the GCC economies were still booming, even overheating, with general inflation rising from 1-2 percent to two-digit levels. Loosening monetary policy in the U.S. contributed to inflationary pressures in the GCC. Watching inflation rise, market participants wondered whether the GCC economies would change their exchange rate regime to something that provided for greater monetary policy flexibility.
The authorities stuck with the peg (except for Kuwait, which reverted to a basket of currencies in May 2007) simply because the peg had been beneficial for many years and they judged the inflationary pressures to be transitory. The facts turned out in their favor. The authorities believe that the peg is still the right exchange rate regime, at least until they achieve monetary union, when they can revisit their options.
IMF Survey online: How did the region’s banks come to grow more dependent on foreign financing, and why did this make them vulnerable when the crisis hit?
Khamis: The dependence on foreign financing was a result of increasing integration and openness of the GCC economies. Foreign financing came in two forms: the first was direct borrowing by banks in external markets to support the credit growth. The second was the inflow of “hot money” prior to the crisis. As inflation accelerated, hot money—speculative capital—started flowing into banks in anticipation of a possible revaluation of the domestic currencies. That didn’t happen as inflationary pressures started to dissipate with the onset of the global crisis. At that point, it became clear that GCC economies would not revalue, and money started flowing out of the country quickly. But banks had already used these short-term capital inflows to lend long-term and domestically, so as the money started to flow out, they became liquidity-stripped. The countries most severely affected were the U.A.E. and Bahrain.
IMF Survey online: In the future, how can the region’s countries avoid seeing credit growth spiral out of control, as we witnessed with the real estate bubble in Dubai?
Senhadji: Perhaps it’s good to cast the problem of excessive credit growth in the broader context of overheating. How can we prevent overheating of the economy? Policymakers have three main tools at their disposal—monetary policy, fiscal policy, and prudential regulation.
Monetary policy has limited effectiveness in the case of the GCC because of the peg to the U.S. dollar. The second tool is fiscal policy. The oil market boom translated into higher revenues and also into pro-cyclical fiscal policy—that is, fiscal policy was relatively loose even when economic activity was booming. It is difficult from a political economy standpoint to keep tight control on fiscal spending during periods of high oil revenue. When you have relatively high unemployment, it is difficult to sit on the cash and not share the wealth with the rest of the population. Therefore, it’s hard to avoid procyclical fiscal policy in oil-rich countries, but this would have been one way to control overheating.
Central banks can also use prudential regulation—that is, the regulation and supervision of deposit-taking institutions to limit their risk-taking, or limit their exposure to sectors such as real estate. Reserve requirements—the stipulation that banks keep a certain level of reserves as a share of total loans—is another useful prudential tool. These instruments are the main tools by which central banks of GCC countries regulate credit growth. But for these policies to be successful, they have to be more strictly enforced.
IMF Survey online: What will be the impact of the Dubai debt standstill on the rest of the GCC countries?
Senhadji: There are two main channels—trade and financial. The trade channel is relatively limited, given that Dubai represents only 10 percent of the GCC’s GDP. Intra-GCC trade is also very small, about 10 percent of total GCC trade. The impact through financial linkages has been a bit stronger. These channels involve bank balance sheet exposure to Dubai entities, especially in the property and construction markets. Assuming that the credit problem in Dubai remains contained and that some resolution is rapidly round, the regional impact should be limited.
There is some impact on neighboring countries as well as on India and Pakistan, because Dubai employs a large number of workers from these countries.
As for the advanced economies, some isolated banks were hit, but none had exposures that were systemic in nature.
IMF Survey online: What policy measures is the IMF recommending to correct financial sector weaknesses?
Khamis: The priority is to ensure that the process of cleaning up banks and nonbanks goes smoothly. When economic growth slows and prices collapse, it takes time for these losses to materialize on banks’ balance sheets, sometimes up to 2-3 years. The authorities will need to make sure that banks recognize these losses upfront and, where needed, there should be immediate recapitalization. It’s important for the authorities to be forward-looking about asset quality—stress testing is key in this regard. The authorities will have to monitor banks closely, especially those that have exposure to real estate markets or present a systemic risk. Banks will need to adhere strictly to prudential regulation and supervisory requirements, and the authorities should be able to enforce corrective action promptly.
As for the nonbanking sector, two GCC countries have systemic nonbank financial institutions—Kuwait (investment companies) and the UAE (mortgage finance companies). The authorities will need to facilitate the restructuring of the systemic and viable institutions, and then help with the exit of the nonviable ones. They should also address weaknesses in the regulatory and supervisory frameworks of these institutions. One immediate focus is to put in place a more comprehensive, explicit legal framework for government intervention in banks and other financial institutions that provides for more efficient and cost effective resolution and restructuring options.
What are the GCC’s other reform priorities?
Khamis: Over the longer term, it is essential that GCC entities increase their transparency and financial disclosure. Another lesson from the crisis, both globally and in the GCC, is that policies should take into account both macroeconomic and financial sector stability. A third priority should be the structural reform of the financial sector. Policymakers should continue to develop local and regional debt markets to diversify financing channels away from banks.
Comments on this article should be sent to imfsurvey@imf.org
