Flash Report - Fixed Income / Global

Kurdistan payments to oil companies at risk as KRG-Baghdad dispute reignites

  • Iraq stops budget transfers to Kurdistan as the region fails to deliver oil to the state oil marketing company
  • This makes further delays in payments to the oil companies operating in Kurdistan more likely
  • Negative sentiment for oil and gas companies in Kurdistan

Iraq and Kurdistan fall out again on federal budget transfers to the region. According to Argus Media and Kurdistan 24, the Kurdistan Region of Iraq has not fulfilled its part of the deal in 2020 and the federal government instructed the ministry of finance to stop making payments to Kurdistan as well as recover the amounts already transferred. Last year Baghdad and Erbil (Kurdistan) reached an agreement that the Iraq government would make transfers from the federal budget to Kurdistan, to pay the salaries of civil servants, including Peshmerga, the region’s military forces, among other things. In exchange, Kurdistan committed to handing over 250,000boepd of oil, roughly half of its exports, to the state oil marketing company (SOMO) controlled by the federal government. 

Kurdistan already suffering from lower oil pricesThe region, which heavily relies on oil and gas revenues, is already suffering from lower oil prices as proceeds from oil exports have dropped at least threefold since January. As a result, Kurdistan had to delayed payments for the November 2019-February 2020 shipments, at least until the end of the year, but promised to settle invoices on a monthly basis starting from March 2020. This commitment is now at risk as the Kurdistan Regional Government (KRG) has lost one more source of budget revenue and will have to reallocate its limited resources and prioritise expenses. As we've written before, Kurdistan’s ability to make timely payments to the oil and gas industry is not certain in the new oil price reality, and the recent suspension of transfers from the federal budget exacerbates those risks.

Iraq's federal government under political pressure. Iraq almost entirely depends on hydrocarbons as more than 90% of its budget revenues are generated by the oil and gas industry. With oil prices dropping at least threefold since January, the impact on the federal budget revenue is likely be of the same magnitude. Add Covid-19, the discontent of the Iraqi population with government policies and the inability of political parties to agree on several prime ministerial nominees, and the political backdrop starts to look quite challenging. With mounting financial and political pressure, the federal government is unlikely to resume payments to Kurdistan without receiving its share of the region's oil production. On the other hand, Kurdistan may be reluctant to give up 250,000boepd of oil exports at a time when both federal and regional budget revenues have fallen with no certainty that Baghdad will be able to send money.

How can the payments made to Kurdistan be recovered? We do not know what financial instruments the federal government has to recover the payments already made to Kurdistan in 2020, but for non-financial instruments, there is a recent example. In 2017, after Kurdistan voted for independence, the federal government responded by deploying armed forces to regain control of Kirkuk, a big oil producing province that was under KRG control in 2014-17. We hope the military option is not being considered, but we cannot completely rule it out since it was last exercised less than three years ago.

Negative sentiment for oil and gas companies in KurdistanThe scenario of a severe 2017-like escalation between the KRG and the federal government pose a downside risk for the sector.

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Macro Analysis / Global

Euroclear: A possible turning point for Turkey

ING Think
18 June 2020

The government’s motives for the deal

With significant improvement in financial infrastructure and adjustments in legal framework, Russia, Peru, Chile, Malaysia and Poland have achieved to have Euroclearability status in recent years, though there are a number of countries in emerging markets space including Brazil, Indonesia, India, and Philippines etc that do not sufficiently meet all the requirements to be Euroclearable. Strong client interest with the reform driven EM stories have been one of the major drivers for them to join Clearstream.

In Turkish case, key drivers according to the Treasury and Finance Minister Berat Albayrak are:

1) Further align capital market framework with the globally recognised standards: The government has always had an objective of deepening capital markets via diversification of financial instruments and raising more funds through alternative and less costly methods. In this regards, we have seen some efforts to improve capital markets including new capital markets law, new products like issuance of Islamic bonds, establishment of ETFs etc. So, the agreement is seen another step in this direction.

2) Support to the Istanbul Financial Center objective: It is widely acknowledged that an international financial centre should offer deep liquid and sophisticated capital markets and competitive regulator regimes with foreign investment and offshore business flow. So, Minister Albayrak expects contribution from the deal in this regard.

3) Wider foreign access to the local market: For the government, being able to tap into the liquidity provided by international investors through Euroclear is important for the continued development of our local debt markets. The move should also contribute to the local market outlook, as a safe place for bond investments in times of risk aversion.

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Strategy Note / Global

Trump's tougher election makes China friction worse

  • Covid-19 policy error has punctured the economic basis for Trump's re-election; hence the deflection of blame to China
  • Cold war creep was inevitable but the coincidence of Covid-19 and the US election hasten it, with more risk for EM as...
  • ...Economic policy (tariffs, currency, overseas investment, debt relief) and multilateral institutions are weaponised
Hasnain Malik @
Tellimer Research
4 May 2020

US-China relations worsen due to US Covid-19 policy and deflection of blame 

The creep towards a cold war between the US and China is inevitable, given that both are of a size that brings them into competition across trade, technology and territory, and neither has the will or resources to settle the rivalry decisively. The recent frostiness seen on multiple fronts is in line with our expectations. 

For investors in emerging markets, some of the negatives (eg increased China territorial friction with ASEAN rivals in the South China Sea, weaker China FX rate) might be offset by positives (eg another bout of US tariffs on China that accelerates both the transition of low-end manufacturing away from China to other, more geopolitically onside, low-cost locations like Vietnam, and reinvigorated implementation, from the Chinese side, of BRI projects in countries like Pakistan). 

But one area where the lack of coordination between the US and China has already played out is the global policy response to Covid-19 and the credibility of an international organisation tasked with that coordination, the WHO, that has been weakened (by both sides, arguably).

Another global policy challenge where this friction may act as an outright negative is on coordinated debt relief for poorer countries in EM (eg Ghana, Kenya, Nigeria, Tanzania, Zimbabwe in Africa or Pakistan in South Asia). 

China is a signatory of the 15 April G20 communique on the debt service suspension initiative for poorer countries; an unprecedented bilateral agreement that promises coordinated action. But the agreement is subject to well-worn implementation and compliance risks, which are more acute when two of the largest providers of bilateral debt are increasingly distrustful of each other:

1) China's lack of transparency over the full extent of its debt exposure via state-affiliated entities (an issue for Europe as much as the US) one team of academics estimate that 50% of China's lending to emerging markets is not reported to the IMF or World Bank; 

2) The lens of the Belt and Road Initiative through which China may view debt relief (which may conflict with US priorities); and

3) China's willingness to participate in a multilateral approach over which it does not exert dominance.

Context of the US election in 2020, China party congress/presidential election in 2022/23

In the context of US President Trump's re-election bid (November 2020), which has unexpectedly been imperiled by a deficient response to Covid-19, rhetoric may be matched by more more meaningful action (eg new tariffs or sanctions). The rhetoric from the Trump administration has recently included blaming China for covering up Covid-19 (both its origin and its threat), compromising global organisations like the WHO (and therefore freezing its funding, where the US provides 22% and China 12%) and engaging in predatory lending and investment practices (eg in a warning repeated most recently to Israel on the need for more thorough scrutiny of Chinese inward investment). 

China President Xi has the benefit of a longer-term mandate (courtesy of the removal of term limits and an authoritarian political apparatus) and a sooner return to domestic social and economic normalcy after Covid-19 (regardless of the credibility of official data on infections). This likely makes for at least as much action as rhetoric; since the start of the year there has been friction between China and territorial rivals around the Nine-Dash Line in the South China Sea (Indonesia, Malaysia, Philippines, Vietnam) as well naval brushes with Japan and Taiwan. 

This is not to say that President Xi is impervious to unfavourable rhetoric from the US: to the degree that it infects either domestic opinion (the renewal of Xi's terms as party leader and president are due in October 2022 and March 2023, respectively) or international relations (eg with recipients of Chinese finance currently hoping for global debt relief and assistance), we expect at least a reciprocal rhetorical response.

Related reading

G20 endorses debt service suspension initiative for poorest countries, 16 April 2020

Geopolitics after Covid-19: US-China cold war, fragmented EU and GCC, 20 April 2020

Trump impeachment or election loss: what would it mean for emerging markets, 14 October 2019

Philippines: US to China rebalance continues, not cause for alarm, 12 February 2020

China's BRI: 2nd forum to stir an old debate, 22 April 2019

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Strategy Note / Saudi Arabia

Saudi pares fiscal deficit, hits consumer, prepares for long oil war, splits GCC

  • Fiscal measures equate to 4% of GDP, shaving about a third off the 2020 deficit
  • Saudi consumer hit: 15% VAT (from 5%), end of public worker cost of living allowance, job losses, salary cuts
  • Implications: Partly addresses Russia fiscal advantage in oil war, pressures expat remittances, may split GCC further
Hasnain Malik @
Tellimer Research
11 May 2020

The fiscal cuts announced by Saudi Arabia on 11 May equate to c4% of GDP and a prior fiscal deficit of 12.6% (2020 forecast from IMF). The measures include a VAT hike (from 5% to 15%), ending a cost of living allowance for public sector workers and project spending delays. The VAT increase is, in our view, unlikely to be reversed and could equate to 4% of GDP in annual recurring fiscal revenue.

We draw the following domestic, regional and global implications.

(1) Saudi consumer – This is another blow to consumer spending growth that has already decelerated very sharply (following the oil price fall and Covid-19 disruption to retail and tourism): the hike in VAT and the removal of public sector cost of living supplemental allowance compounds the effect of job losses, and the removal of private sector salary and hours cuts (of up to 40%), and likely job losses (particularly in the expatriate labour force).

(2) Saudi income tax – The existing VAT framework (reporting requirements, auditing procedures) allowed for rapid implementation of an increase in the tax rate. Longer-term, this is another indicator that wider corporate and personal income taxes are an inevitable part of the non-oil fiscal armoury.

(3) Saudi political risk – The centralisation of power under Crown Prince Muhammad bin Salman has demonstrably dealt with dissent in the wealthier segment of society and projected a mix of nationalism, security, social reform, the liberalisation of entertainment, and targeted welfare to preserve social stability among the less affluent mass population. Of course, domestic political threats remain ever present and a much weaker economic climate increases vulnerability. But we reiterate our view that as long as the Crown Prince retains monopolistic control over the military and security apparatus and the US remains a key supporter, then the risk of social discontent turning into something which puts the succession or the regime at risk remains a very low probability.

(4) Saudi equities – The local Tadawul index is down 20% year to date, broadly in line with MSCI EM (down 18%). Banks, Cement, Chemicals, and Consumer Non-Food have, in general, under-performed Aramco, Consumer Food, Healthcare and Telecom. Trailing price/book of the index is 1.6x, merely a 7% discount to the 5-year median. We are not that enthusiastic about Saudi equities relative to alternatives in the Middle East (Egypt), oil exporters (Kazakhstan), large and liquid EM (Technology). Within the narrow peer group of the GCC, Qatar is better able to withstand the current crisis environment (with greater firepower for fiscal stimulus) but when conditions normalise (in terms of Covid-19) we see more low-hanging fruit for non-oil diversification in Saudi.

(5) Saudi US$ sovereign debt – The 2028 3.625% Saudi US$ sovereign bond, rated A1 by Moody’s and A by Fitch, currently has a mid-yield to maturity of 2.8%, broadly in line with the start of the year but down from a mid-March peak of 4.3%. The current z-spread of 229bp is over 300bp narrower than EMBI (compared to about 180bp narrower at the start of the year). Clearly, actions which rein in fiscal deficits should be positive for fixed income investors.

(6) GCC disunity and competition – A common framework for 5% VAT across the GCC was agreed in June 2016. But implementation has been very uneven with Saudi and the UAE moving ahead first in January 2018, Bahrain in January 2019, and with Kuwait, Oman and Qatar yet to implement. A differential of 15% at one end (Saudi) and zero at the other (eg Qatar) creates a substantial competitive disadvantage when it comes to cost and attractiveness of doing business. This is another example of a lack of coordination in the GCC: a strain most evident in the Qatar blockade and one that is likely to worsen for this regional bloc – as it is for others like the EU – through the Covid-19 and oil crises.

(7) Oil price – This partly addresses one of the weaknesses of Saudi in fighting with Russia over the power to set the marginal price of oil: Russia entered the oil price war with much lower fiscal break-even oil price (approximately US$40 versus US$85 for Saudi). This could be interpreted as Saudi preparing itself for lower oil prices for much longer.

(8) Remittances in oil importers (and labour exporters) – GCC remittances (of which Saudi accounts for over half) equate to a substantial portion of GDP (approximately 2% to 8%) for the likes of India, Bangladesh, Philippines, Lebanon, Sri Lanka, Pakistan, Jordan and Egypt. Pressure on overall economic growth and consumer growth in particular usually negatively impacts the expatriate community disproportionately (because they do not represent as politically important a constituency as the citizen base).

Below we present charts on Saudi consumer and corporate confidence metrics, GCC fiscal forecasts (prior to the April OPEC+ deal and most of the crisis stimulus or austerity actions), global oil exporter fiscal break-even oil prices and tax revenues, and recent performance of Saudi equities and sovereign US$ debt.

Related reading

GCC: The Gulf is not a safe haven unless (at least) oil prices recover, 1 April 2020

Oil spat turns into a splat: A reminder of the winners and losers in EM, 21 April 2020

Kuwait, GCC: The expat debate stirs again, 15 April 2020

GCC: Sovereign wealth warning from the IMF (again), 7 February 2020

If remittances drop 20% who is exposed in emerging and frontier markets?, 29 April 2020

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