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Welcome to the latest edition of ICAEW’s Economic Insight: Middle East, the quarterly economic forecast prepared directly for the finance profession. Produced by Oxford Economics, ICAEW’s partner and one of the world’s foremost independent global advisory firms, it provides a unique perspective on the prospects for the Middle East as a whole and for the region’s individual countries. We focus on the Middle East as being the Gulf Cooperation Council (GCC) member countries (United Arab Emirates [UAE], Bahrain, Saudi Arabia, Oman, Qatar and Kuwait), plus Egypt, Iran, Iraq, Jordan and Lebanon, abbreviated to GCC+5. Growth in an era of weak oil demand In this issue of Economic Insight: Middle East, we discuss the fallout from the accelerated decline in oil prices in recent months, as well as the potentially transformational impact of the lifting of sanctions on the Iranian economy. In summary, we find that: • With no sign of a change in the Organisation of Petrol Exporting Countries (OPEC) oil market policy and increasing concerns over growth in China and other emerging markets, oil prices are set to remain lower for longer. Brent is seen below $70 per barrel (pb) for the rest of the decade (see figure 1). • Growth in the oil-exporting GCC region is showing increasing signs of strain as liquidity conditions tighten and governments get serious about fiscal austerity. Recession may be avoided, but non-oil growth will be its weakest this year since the early 1990s. • The lifting of sanctions on Iran following ‘implementation day’ in January promises a sharp acceleration in Iranian growth this year. However, it will also add pressure to an already oversupplied oil market and the regional implications of a resurgent Iran are extremely uncertain. • With little resolution expected to political discord and various insurgencies in the region, activity will be dampened by the needs of refugees, stifled tourism and diminished investor confidence. ICAEW Economic Insight: Middle East Quarterly briefing Q1 2016 BUSINESS WITH CONFIDENCE No sign of end to oil market weakness The drop in oil prices gathered dramatic momentum in the final stages of 2015 and in early 2016, dashing oil exporters’ hopes of a swift reversal from last year’s weakness. Having already fallen some 43% to $52 pb in the year to mid-October, the price of Brent crude then underwent an even more intense decline, plunging by a further 45% to just $28 pb in mid-January. Oil is now cheaper than financial crisis lows, leaving many observers unsure of exactly when or at what level a new bottom might be reached. icaew.com/economicinsight Figure 1: Brent crude oil prices $ per barrel 140 120 Oxford Economics forecast 100 80 60 40 Figure 2: Middle East countries’ real GDP 20 0 2005 Iraq, Libya, Syria and Yemen. In particular, low oil prices will erode existing policy buffers in oil-rich Gulf countries more rapidly, threaten to undermine long-standing currency pegs and slow economic growth further as trade, investment and capital flows fall back. Although recession should still be avoided, growth across the Middle East region is now expected at just 2.6% this year (elevated by rebounds in Iran and Iraq). In the GCC, growth will be just 2.1% – its lowest since the financial crisis (see figure 2). % y/y 5 2007 2009 2011 2013 2015 2017 2019 4 Source: Oxford Economics/Haver Analytics 3 • The nuclear deal with Iran and lifting of international sanctions in January 2016 has opened the way for an increase in sidelined Iranian oil in an already fully-supplied market, with more to come if Iranian production is ramped up over the medium term. • The start of interest rate hikes by the US Federal Reserve in December – with two further increases forecast through 2016 – has provided continued support for the US dollar. The stronger dollar raises the domestic currency of oil for the rest of the world, and as such weakens demand and dollar prices. One thing that could change the near-term outlook for oil prices would be a shift in OPEC’s year-and-a-half old policy of keeping oil production high in order to maintain its market share and squeeze higher-cost producers out of the market. Although OPEC’s December meeting confirmed major disagreements within the organisation over the current policy, with some producers arguing for production cuts to support prices, there appears to be little prospect of a change in the Saudi-led plan anytime soon. While oil prices may have fallen much further than some members would have anticipated, the strategy’s proponents may now feel that there is little alternative but to hunker down and give it more time to work. Overall, therefore, we remain bearish about the mediumterm outlook for the global oil market. Given existing stock levels, modest demand growth, relatively resilient non-OPEC supply and a continuation of current OPEC policy, we think that the oil market will return to balance at 2017 at the earliest, implying a prolonged period of price weakness. Brent crude is expected to average $32 pb this year and remain below $70 for the rest of this decade. Middle East growth faces mounting challenges Weaker oil prices present a serious challenge to the growth outlook for the Middle East, which was already facing concerns over fiscal sustainability, as well as headwinds from structural economic weaknesses including low productivity, stifling government bureaucracy and of course, rising and deepening social and military conflict in icaew.com/economicinsight oxfordeconomics.com 1 0 2012–15 2016 Iran Lebanon Kuwait Egypt Jordan Iraq Saudi Arabia Bahrain -1 Oman • Global crude and oil product stock piles have ballooned and show no sign of falling back. According to the International Energy Agency (IEA), a notional 1bn barrels of oil were added to global inventories over 2014-2015, with further increases expected in 2016. 2 Qatar • Economic data from China suggest increasing problems with overcapacity, further undermining expectations over likely resource demand growth. UAE At least four factors appear to have caused the renewed fall. 2017 Source: Oxford Economics True economic diversification remains elusive There has undoubtedly been some progress in diversification of GCC economies; however, true economic diversification away from a heavy dependence on oil exports is yet to be achieved. Strong growth in oil revenues in 2003–2014 fuelled large, signature investments in the region and rapid growth in sectors such as construction, trade, tourism, real estate and business services. Non-oil GDP growth averaged an impressive 7.2% per year through this period – which incorporates the financial crisis – and repeatedly reached double-digit levels. This pushed the non-oil sector’s share of overall GDP from 48% to 60% in real (ie, inflation-adjusted) terms. Meanwhile, governments implemented structural reforms that improved the ease of doing business (although much remains to be done) and the post-millennium boom put Dubai on the global map as a regional business hub. Although positive, these developments overstate the true extent of economic diversification in the region. Much of the growth in the non-oil sector was still fuelled by oil-financed government spending – including on infrastructure, key development projects, public sector salaries, benefits and subsidies – which was in turn recycled through the financial system, benefitting capital markets and the banking sector. With government spending now set to be cut back, these growth drivers will fade. And although oil’s contribution to GCC economic output has shrunk, it still accounts for around 80% of total budget revenues and 50% of all export receipts, implying a major deterioration in both the fiscal position and the terms of trade. In principle, lower oil prices should provide a serious boost to net oil importing countries in the Middle East region including Egypt, Jordan and Lebanon. But with these countries suffering from political instability and uncertainties of their own, we doubt that the boost to growth will be that large. Moreover, they will also be hit by a drop in cross-border trade, investments and potentially weaker remittance flows from the GCC and elsewhere. ECONOMIC INSIGHT – MIDDLE E A ST Q1 2 016 GCC governments now serious about fiscal reform The past few months have seen growing signs of governments in the Gulf giving serious consideration to fiscal consolidation. The Saudi Government’s 2016 budget announced a year-on-year (y/y) decline in planned spending for the first time in at least 14 years, as well as plans to reduce energy subsidies starting this year, capping the public wage bill, the introduction of taxes on goods including tobacco and soft drinks, more privatisation and the establishment of a new finance unit to oversee a medium-term expenditure framework. Similarly, Oman has announced a 16% cut in budgeted spending for this year, a rise in corporation tax and the removal of certain tax exemptions. Moreover, all GCC governments have committed to establishing a regionwide VAT over the medium term to lift non-oil revenues and most have already made a start on cuts to energy subsidies (particularly petrol which, nevertheless, remains inexpensive by international standards). Additionally, there is a general move to reprioritising expenditures towards key development projects. Overall, we expect government spending in the GCC region to decline by 8% this year and to rise much more slowly in future years than it has done in the past. This will leave the aggregate budget deficit at 11% of GDP in 2016: as large as 17% in Saudi Arabia and Kuwait and 16% in Bahrain, with only Qatar recording a much-reduced surplus of 4% of GDP. A gradual recovery in oil prices will narrow these balances only slowly. Though there is a risk of permanent deficits, cumulative region-wide surplus should be restored by 2022 (see figure 3). low cost or even free, putting additional pressure on bank margins at a time when demand for borrowing has also weakened. Meanwhile, to alleviate some of the pressure on domestic liquidity and to provide additional policy space, the Saudi Government has mooted the issue of international bonds in 2016 to accompany the issue of domestic bonds started last July. Existing debt levels are extremely low at an estimated 7% of GDP in 2015 and – despite a downgrade by Standard and Poor’s in October – its debt rating remains towards the upper end of investment grade. We see Saudi government debt levels rising to around 30% of GDP by the end of this decade and, although no firm announcements have yet been made, other countries in the region are likely to follow suit. A further threat to stability and the growth outlook has emerged from pressure on long-standing GCC currency pegs against the US dollar, driven by prospects for weaker growth, the deteriorating fiscal situation and declining financial reserves. This pressure has intensified in recent months. For example, 12-month Saudi riyal-dollar forward contracts – or the difference between how many riyals traders think a dollar will be able to buy a year from now and how many riyals a dollar can buy today – reached 1,000 basis points (bps) in mid-January, unprecedented in recent years (see figure 4). In other words, this is an approximate indication that markets expect a 10% depreciation in the riyal over the next year. Figure 4: SAR/US$ 12-month forward rate bps 1,000 Figure 3: GCC fiscal balance 800 600 % GDP 20 400 15 Oxford Economics forecast 10 200 0 5 -200 0 2010 2011 2012 2013 2014 2015 2016 -5 Source: Bloomberg -10 -15 2000 2003 2006 2009 2012 2015 2018 2021 Source: Haver Analytics/Oxford Economics Weak oil prices intensify liquidity pressures Sustained fiscal weakness will damage the long-term growth outlook in the region, but the near-term implications are becoming increasingly visible through tighter domestic liquidity conditions. Stock markets in GCC countries fell by between 15% and 25% last year and some fell a further 10% to 15% in January 2016; aggregate growth in broad money (used as a general estimate of the supply of money in an economy) had slowed to just 1% y/y in November and was negative in some countries; market interest rates have started to edge up from previous lows amid higher official rates following the US Fed’s decision to hike rates in December; and finally, there has been a draw down in government reserves with funds needed to cover emerging fiscal gaps. The latter has also had the effect of depriving local banks of funds placed at icaew.com/economicinsight oxfordeconomics.com This in turn forced the Saudi central bank to impose a ban on domestic banks dealing in forward contracts. We expect GCC pegs to remain under pressure through 2016, with those in Oman and Bahrain – where relatively low financial reserves provide the least defensive cover – most vulnerable. While de-pegging would generate greater government revenues by lifting the dollar oil revenues in local currency terms, it would also impose heavy costs, including rising inflation, a loss of policy credibility and additional volatility in oil revenues. We therefore think the authorities will be determined to keep currency pegs intact, including through verbal support and by increasing interest rates further this year in response to further hikes by the US Fed – but acknowledge the increasing risk of a market-enforced change. ECONOMIC INSIGHT – MIDDLE E A ST Q1 2 016 Maintain stability – but don’t forget about reforms In light of the above pressures, the near-term objective for governments in the GCC will be to maintain financial stability and avoid a deeper crisis that could push the region towards recession. Already, the headline growth outlook is weighed down by capacity constraints in the hydrocarbon sector, where growth is expected to average just 1% per year or so for the rest of this decade and expansion plans have slowed. And GCC non-hydrocarbon growth will slip to 2.9% this year, its weakest since the early 1990s. This backdrop will make the case for economic reforms in areas such as privatisation and competition policy, housing, the labour market and education, and the public sector bureaucracy even more complex on a country-bycountry basis. Governments will need to avoid jeopardising public support but at the same time boost private sector confidence and prospects for longer-term growth that could be important for accessing international capital markets. Either way, a period of skillful policymaking will be required to balance the need for both growth and stability. IRAN AND THE NUCLEAR DEAL Sanctions relief in Iran also has implications for the region and the oil market The Iranian economy has been given a potentially transformational lift, despite weak oil prices. ‘Implementation Day’ was reached in January, when it was agreed Iran had fulfilled certain nuclear-related commitments. As a result, some sanctions were lifted, bringing in from the cold a potentially vibrant emerging country to the international economy and a major regional player in the Middle East. In addition to the lifting of sanctions on the energy and banking sectors, assets put at over US$100bn were unfrozen. However, a few sanctions remain or have been introduced by the US since − for example, on the specific companies and individuals suspected of aiding the ballistic missile programme. Evidence shows that Tehran is in a strong position to increase its oil output rapidly in the first year. Oil production crept up to 2.9m barrels per day (b/d) in December, its highest level since June 2012, as storage tanks were filled up ahead of sanctions easing. A rise towards pre-sanctions capacity of some 3.6m b/d should be seen within six months (see figure 5). Reclaiming its position as OPEC’s second biggest producer and raising production in excess of more than 4m b/d will require more advanced technology and therefore foreign investment. However, international oil companies’ appetite for investment will remain dampened until a new improved version of Iran’s former buy-back investment contract is fashioned and the threat of snap-back sanctions deteriorates. Despite the continued expected weakness in oil prices (itself exacerbated by Iran’s extra expected oil supply), Iran’s growth rate should accelerate from a predicted 1.2% in 2015/16 to 4% in 2016/17. This will be driven by a 16% increase in oil production, sanctions relief in other important industries and some increased foreign investment. Meanwhile, an improving political outlook should underpin better economic policymaking and gradually improve international relations. The success of the sanctions easing should boost reformists further, although hardliners are fighting back. icaew.com/economicinsight oxfordeconomics.com Further prospects for growth come from a relatively diversified economy; indeed, taxes now being considered in the rest of the region have already been implemented in Iran. The implications for geo-political risk are uncertain. An economically emboldened Iran could simply pursue its regional ambitions with greater vigour, which may involve proxy wars in Syria, Yemen and Iraq. There is clearly a risk of the escalation of regional conflict, which could have an adverse impact on the economy. On the other hand, the US hopes that closer relations with a more moderate Iran will facilitate progress in the conflicts in Syria and Yemen and increase cooperation in Iraq in the fight against ISIS. On the economic front, the biggest regional impact of the deal is to depress oil prices and keep them lower for longer, thus adding to the need for painful fiscal adjustment programmes among the GCC countries and other oil exporters like Libya and Iraq. However, with Iran’s GDP growing more and its trade picking up, the region should also benefit – especially countries with particularly close ties, such as the UAE. Figure 5: Iranian oil production Million barrels per day 4.1 Oxford Economics forecast 3.9 3.7 3.5 3.3 3.1 2.9 2.7 2.5 2000 2003 2006 2009 2012 2015 2018 2021 Source: OPEC/Oxford Economics GCC+5 country outlook for 2016 Low oil prices in 2016 will result in governments more committed to fiscal consolidation; the budget of Saudi Arabia led the way, with its dedication to a prolonged period of subsidy cuts, public wage constraint and nonoil taxes. Alongside multi-year lows in high-frequency indicators such as private bank lending and money growth, non-oil sector expansion will slow. Capacity constraints and a less aggressive policy stance will limit increases in oil production, leading to total GDP growth of 1.2% this year. The UAE was one of the more fiscally aggressive states towards the end of 2015, removing fuel subsidies and increasing electricity tariffs. Nevertheless, its reputation as a trade hub makes it one of the most diversified gulf economies. Continued infrastructure investment in anticipation of the World Expo 2020 should lead to growth of 2.7% in 2016. The wage bill and subsidies make up two-thirds of government spending alone in Bahrain, so authorities are looking at cuts despite political sensitivity. Petrol prices increased in January for the first time in 33 years, following gas price hikes and meat subsidy removal. Oil production is expected to fall after technical problems at the Abu Saafa field, which Bahrain shares with Saudi Arabia and relies upon for 75% of its oil. The economy is expected to expand by 1.9% this year. ECONOMIC INSIGHT – MIDDLE E A ST Q1 2 016 Oman also hiked petrol prices in January and further spending cuts are expected for the ninth five-year plan 2016-20. The authorities are loath to cut capital spending given the long-term strategy to diversify into transport and logistics, manufacturing, tourism and mining. Qatar’s greater diversification of revenues, large policy buffers and immovable infrastructure requirements associated with the 2022 World Cup will mean government spending cutbacks will be modest compared to other GCC countries. These plans include a new railway, airport, seaport, roads and real estate schemes. Meanwhile, a boost from the Barzan gas-to-liquids project coming online from early 2016, and stabilisation of crude oil production will support oil sector growth and drive total GDP growth of 4.3% in 2016. Capital spending will also remain fairly robust in Kuwait, supporting expected GDP growth of 2.3% in 2016. Economic diversification will be driven by government commitment to key infrastructural projects set out in the development plan such as in transport and power generation, in spite of pledges to cut overall spending and raise non-oil revenues. Oil output will remain constrained by lack of capacity and the unresolved dispute with Saudi Arabia over the Neutral Zone. The growing needs of the many refugees and the conflicts in Iraq and Syria will dampen economic activity in Jordan. Indeed, recent data on trade, tourism and investor confidence have been weak. The government has cut current spending but is planning more fundamental reforms to petrol, electricity and water subsidies. Nevertheless, the impact of spending cuts on private consumption and net exports should be limited by low interest rates, rising infrastructure spending funded by external investment and low oil prices, as Jordan is a net oil importer. We see GDP growth at 3% in 2016. icaew.com/economicinsight oxfordeconomics.com There is little hope of political paralysis ending in Lebanon, given the ongoing Syrian civil war. The recent garbage crisis has added to widespread corruption and rickety electrical and water systems, badly in need of structural reform. The costs of supporting at least 1.5m Syrian refugees, plus the impact of weak growth and the lack of government action has put pressure on government finances. As a result, economic confidence will remain low, trade flows will continue to be disrupted and violent clashes will occur. With little imminent improvement, we anticipate growth of 1.7% in 2016. The political situation in Iraq also remains volatile and an early return to stability appears impossible. The domestic political scene is less polarised, however international efforts to combat the ISIS insurgency have not prevented the likely long period of uncertainty, violence and poor security. The resulting deterred investment combined with spending cuts will weigh on economic growth, though it is still expected to be 3.8% this year. Social instability in Egypt has deterred tourists, and we see growth in overnight tourist arrivals falling to 3.4% this year, from 8.8% in 2015. Meanwhile, forex shortages and capital constraints will restrict business activity. The new parliament elected at the end of last year could improve relations with foreign governments but also pose a governance risk. We expect the economy to expand by 2.5% in 2016. The lifting of sanctions in Iran and increasing oil production is likely to drive growth of 4% in 2016. Nevertheless, clear downside risks include a ‘snapback’ of sanctions at any time should Tehran fail to honour its nuclear commitments and the impact on structural reforms and inward FDI if the hardliners strike back. ECONOMIC INSIGHT – MIDDLE E A ST Q1 2 016 Oxford Economics Oxford Economics is one of the world’s foremost advisory firms, providing analysis on 200 countries, 100 industries and 3,000 cities. Their analytical tools provide an unparalleled ability to forecast economic trends and their economic, social and business impact. 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