"At the current fiscal stance, the region’s financial wealth could be depleted by 2034. Fiscal sustainability will require significant consolidation in the coming years." This is the stark warning for the Gulf Cooperation Council (GCC) countries in an IMF policy paper published yesterday (6 February). The time frame could be shorter with greater improvements in energy efficiency or faster introduction of carbon taxes globally.
The risks for investors in GCC assets are material in the medium-term – more so for investors in regional equities than regional government bonds, and more so in Oman and Bahrain (lower sovereign buffers and higher fiscal break-even oil prices) than, for example, Kuwait.
But these risks are not new, urgent or irreversible.
GCC equity markets are not attractive relative to our global coverage of emerging and frontier equity markets, because the combination of growth and valuation is not that compelling and the era of index weight-led re-rating has largely passed.
Charts: IMF analysis of the erosion of fiscal buffers (sovereign wealth) if no remedial action or alternative financing
January 2020: Aggregate GCC wealth depletes by 2034
October 2015: UAE, Qatar, Kuwait depletion by about 2040; Saudi Oman, Bahrain by about 2020
GCC governments' fiscal response has not kept pace with oil revenue decline
The IMF estimates the net financial wealth (international reserves plus and sovereign wealth minus government debt) of the GCC governments has declined since 2014 (ie fiscal non-oil revenue generation and austerity has not offset the decline in oil revenue) and stands at cUS$2tn currently.
GCC government real net financial wealth in decline since 2014
Fiscal sustainability is a cause for concern, not alarm
While this may make for alarmist headlines, it is worth bearing in mind a number of factors:
- This sort of calculation assumes all the entire projected fiscal deficit is financed via sovereign wealth (ie that governments do not raise finance via privatisations, like Aramco in the case of Saudi, or sovereign debt issuance);
- Concern over the sustainability of fiscal budgets and sovereign wealth buffers is not new (indeed, as we explain below, in 2015 the IMF warned that without tighter fiscal control much of the region's sovereign wealth would be wiped out by 2020);
- The appropriate policy responses are well understood (we list these below);
- The GCC countries have, in general, demonstrated responsiveness (ie a willingness to rein in fiscal deficits, engage in structural reform of subsidies for example, and provide assistance to neighbours, eg Bahrain, Dubai, Oman) at times of fiscal stress; and
- While lower long-term oil and gas revenues impact all hydrocarbon exporters, the GCC countries remain among the lowest on the global curve of cost of production and reserve depletion (ie their market share gains will mitigate some of the decline).
This should provide some comfort to holders of highly-rated sovereign and government-related enterprise bonds. But for equity investors, this is a reminder of the reliance on growth, profit margins and cash flow of the public and private sector companies listed on regional stock markets on government oil and gas revenues, and the recycling of those into domestic fiscal spend.
Fiscal control and sovereign wealth warnings from the IMF are not new
This sort of analysis from the IMF is not new. Indeed in October 2015, the IMF warning was even starker: its regional outlook report and presentation contained the comments that "apart from Kuwait, Qatar and the United Arab Emirates, under current policies, countries would run out of buffers in less than five years because of large fiscal deficits" and that "some countries have started to tighten the public purse, but credible medium-term consolidation is needed".
Prescriptions for the policy response to lower oil revenues are also not new
- Increase non-oil fiscal revenue (increases in taxes and government fees);
- Reduce and make more efficient public spending (on projects, public sector pay and welfare benefits);
- Reduce reliance on oil and gas (international investment of sovereign wealth and domestic diversification into sectors like finance, leisure, manufacturing, tourism, trade – all of which requires investment in better education, reduction in the reliance on expatriate labour, increase in the flexibility of the labour market, leveling of the competitive playing field for the private sector, less crowding out of bank lending, and, ultimately for some, more competitive FX rates); and
- Raise government finance (within prudent limits) via privatisation and debt issuance.
GCC equity markets not compelling
Overall, within our global coverage of emerging and frontier equity markets, we are not that enthusiastic about the GCC markets because the combination of growth and valuation is not that compelling (relative to Egypt in the wider region, Kazakhstan in the oil exporters, or Asia in the global small emerging market peer group).
While global growth is also anaemic, global risk aversion is nowhere near acute enough to drive portfolio allocation to the sanctuary of US$-pegged dividend yields available (at least in the short-term) in parts of the GCC.
Most of the upward re-rating related to MSCI or FTSE index weights (country EM index inclusion or higher stock-specific weights related to M&A or foreign ownership limit increases) has now passed (although this driver for Kuwait may remain in place until it nears its country inclusion into MSCI EM in May 2020).
For cheap valuation, Dubai real estate stocks and Oman banks, and for growth, Saudi consumer and cement stocks come closest.