Monday, 27 March 2017

Chronicles of an Omani devaluation unforetold

What does a devaluation in 1986 tell us about the likelihood of another devaluation today?

Of all countries in the Gulf, Oman carries the highest risk of devaluing its currency. Last year, it ran a large current account deficit (roughly trade deficit plus remittances) of around 21% of GDP, a large budget deficit worth 12% of GDP, and it has the lowest reserves among its neighbours. History shows that devaluation is not impossible: Oman devalued its currency by 10% in 1986 when oil prices collapsed. Why did Oman devalue its currency then? And what does that tells us about the likelihood of devaluation today?

The fundamental reason behind the 1986 devaluation was that Oman’s foreign currency reserves were not sufficient. At the very least, a country should be able to back every unit of currency in circulation with US dollars to maintain the peg, similar to the gold standard. In 1985, just before the devaluation, Oman had $441 million dollars of reserves. And although there is no official money supply data going back to the 1980s, I estimate currency in circulation to have been also around $400 million in 1985. With the decline in oil prices in 1986, Oman had to use its reserves to finance its deficit, which meant that it was no longer able to provide dollar coverage for its currency in circulation and was therefore forced to devalue.

Does Oman have sufficient means today to avoid a similar devaluation?

·      Oman’s reserves today are enough to last the country for two years. Oman has $38 billion of reserves, which is more than enough to back the $13 billion of Omani Rial currency and deposits. Moreover, the remainder $25 billion of reserves could be used to finance two years of external deficits (trade plus remittances), estimated to have reached $13 billion in 2016.

·   Oman could also safely borrow from international markets to finance the deficit for an additional year given its low public debt ratio. Oman could still borrow around $13 billion while keeping its public debt ratio relatively moderate at 30-40% of GDP. The additional borrowing could finance its needs for one more year.

·    The recovery in oil prices and support from other Gulf countries could double the survival time of Oman. The recovery in oil prices, which have bottomed out in 2016, will shrink Oman’s deficits and financing needs. This means that the same amount of reserves and debt would last the country longer. More importantly, other Gulf countries are likely to step in to support Oman when needed to avoid the risk of contagion on their own currencies. Indeed, recent reports suggest that Oman was in talks with Kuwait, Qatar and Saudi Arabia to receive a multi-billion dollar deposit. And although Omani authorities subsequently denied the report, other Gulf authorities have not. Interestingly, Oman joined the Islamic Military Alliance, led by Saudi Arabia, around the same time of the alleged talks.

Reserves, the ability to raise debt, the expected recovery in oil prices and support from the rest of the Gulf mean Oman could maintain the value of its currency for the next 5-6 years. There might be issues such as questions about the illiquidity of reserves, the impact of a potential credit rating downgrade on Oman’s ability to raise debt or concerns about political transition (although these have abated lately). But all in all, a devaluation in Oman is unlikely in the medium term.

Friday, 17 March 2017

US rate hike highlights the region’s policy limitations

The unintended fiscal consequences of higher US interest rates.

The US central bank raised interest rates on Wednesday. The US economy is recovering: growth is picking up, unemployment is falling, inflation is rising and the long overhang from the 2008 crisis may well be behind us. This forced the central bank to raise rates to prevent the economy from overheating and inflation from rising to uncomfortable levels.

Many central banks in the region followed the US and raised rates. As their currencies are pegged to the US dollar, many countries in the region were forced to follow the US by raising rates. Absent this rate increase, capital would have flown out of these countries into the US to benefit from higher rates, creating pressure on the currencies and the peg.

Higher interest rates would lead to slower growth in the region. Higher interest rates reduce investments by increasing borrowing costs. Higher rates also lower consumption by making saving become more attractive. Both of these factors should lead to lower economic activity.

The fiscal position could exacerbate the slowdown from higher interest rates. Due to lower oil prices, many of the region’s governments are reliant on borrowing to finance their deficits. But if borrowing costs rise, some governments may decide to borrow less and cut their spending instead. Therefore, the fiscal response could propagate the slowdown interest rate increases.

Despite the recent pickup in interest rate, appetite for borrowing has not diminished. For example, Oman borrowed $5 billion from international markets on 8 March, followed by Kuwait borrowing $8 billion on 13 March.

But the situation highlights the region’s policy limitations. While the currency peg to the US dollar makes sense from an economic view, it leaves government spending as the main tool to manage the economy as interest rates are tied to their counterparts in the US. But if government spending becomes responsive to interest rates, then the region has no truly independent policy options to manage the business cycle. This unfortunate situation came about because the decline in oil prices coincided with higher growth and interest rates in the US.

Sunday, 5 March 2017

OPEC and oil: Out of ammo?

There is little more OPEC could do to increase its revenue.

The OPEC agreement to cut production has shifted oil prices to a higher level, around $55 now compared to $45 prior to the deal. But there are signs that higher oil prices are leading to a revival in US shale production. Most energy market forecasters expect increased US production in 2017 after a decline in 2016. Could OPEC do anything to fend off the re-emergence of US shale? The short answer is probably no. If OPEC decides to cut its production further, this will lead to a loss in market share without any significant gain in prices. Conversely, the benefits from flooding the market to increase OPEC’s market share are only marginal and uncertain. 

1. Further production cuts by OPEC would be counterproductive. Further cuts would only lead to temporary improvement in prices, as more and more shale companies would become profitable leading to higher US production and a return of prices to pre-cut levels. This means that OPEC would end up with lower oil revenues as it loses market share without any gains in prices.

2. Despite increasing its production aggressively in 2014-16, OPEC allowed shale an escape route. OPEC’s actions reduced spot prices (the price at which oil is traded for immediate delivery), but it did not reduce futures prices (the price at which oil is traded for delivery in the future) below shale’s cost of production. The chart below shows that a shale company with production cost of $50 per barrel was still able to make profits in 2o15 by selling its output for delivery in 12 months’ time at the price of $55 in January 2015 and $51 in October 2015. Selling oil using futures contracts allowed many shale firms to survive during the oil slump.

3. If OPEC floods the market to reduce the spot as well futures prices of oil below the cost of US shale, then the gains would be small. Although the gain in market share could more than compensate OPEC for lower prices, the benefits are likely to be marginal. Even if we assume that the new more aggressive market share strategy would be twice as painful for shale as the one pursued in 2014-16, the overall increase in OPEC’s revenues would be small, estimated to be around $12bn per year or less than 0.5% of the cartel’s GDP. Furthermore, these gains would be quite uncertain given the uncertainty about the reaction of shale and how their production costs would evolve over time.

To summarise, OPEC’s November cuts were successful because there was room for prices to rise before hitting the cost of production of US shale, estimated to be around $50-55. Now that prices are at that level, further cuts have little more to achieve. Flooding the market on the other hand might seem more sensible, but back of the envelope calculations suggest the benefits to OPEC are small and highly uncertain.

Sunday, 19 February 2017

OPEC cuts - a short-term gain for a long-term pain?

OPEC’s strategy has worked so far, but could end up being self-defeating.

OPEC surprised markets on 30 November 2016 by agreeing to cut oil production in an attempt to support prices. The cuts were meant to reduce OPEC’s production by roughly one million barrels per day (mb/d), effective from 1 January 2017. Data released in the last few days provide the first test about whether the cuts have been successfully implemented. The bottom line is that: compliance has been high helping prices to move up; the overall movement was beneficial for the finances of OPEC members; but could prove to be short lived as it gives a lifeline to US shale producers, who are likely to ramp up production and depress prices. Below I elaborate on these points.

1. OPEC members have complied with the agreed cuts. The latest data show that production fell to 32.1 mb/d, lower than the 32.5 mb/d ceiling that had been agreed on. Every single country reduced its production compared to October 2016 levels (see chart). Some have made substantial reductions as in the case of Saudi Arabia, which lowered its production by 598 kb/d.

2. The cuts have moved oil prices to a new and higher range. While oil prices hovered around $45 per barrel before the cuts, they have been fluctuating around $55 per barrel since the agreement. This represents an increase of about 22%.

3. The cuts have so far benefited OPEC finances as the gain in prices more than offset lower production. The rise in prices has far exceeded the cuts in production. For example, Saudi oil output has fallen by 6% since last October, while prices have risen by 22%. If current prices and production were to be sustained for the whole year, Saudi oil revenues would be higher by around $27bn compared to what would have happened without the deal.

4. But higher oil prices may not be sustained as US shale oil could make a comeback. Higher oil prices are making US shale oil profitable again. US production rose in December after several months of continuous decline. The International Energy Agency is reporting increased investment in US shale oil, implying more supply to come in 2017. Higher US supply would lead to lower prices, reversing the gains made by OPEC cuts.

In conclusion, OPEC successful implementation of production cuts has pushed prices higher and benefited the revenues of its members. But the strategy could be self-defeating as it is giving US shale oil producers a lifeline to increase their production and depress prices again. If this does happen, then OPEC would either be required to support prices by making further cuts or make a U-turn on its strategy.

Sunday, 9 October 2016

How much oil does Iraq produce?

Disagreements about Iraq’s oil production could derail the recently-announced OPEC deal.

OPEC surprised markets by agreeing, in principle, to limit the oil production of its members to a range between 32.5 and 33.0 million barrels per day (m b/d). The agreement is preliminary and its ratification will be discussed on 30 November. Given that OPEC produced 33.5m b/d in August, according to the International Energy Agency, the agreement would result in a cut of 0.5-1.0m b/d, if implemented. Soon after the announcement, Iraq expressed its dissatisfaction with the deal. It claimed that the OPEC’s production numbers underestimate Iraq’s true output figures by nearly 300k b/d. If Iraq is right, then the rest of OPEC will need to cut their production even deeper to remain within the newly-agreed bounds.

Why is there a discrepancy in production numbers? OPEC publishes two sets of data. The first is based on “direct communication” relying on official sources from member countries. The second is based on “secondary sources” compiled by independent companies and observers watching the movement of tankers in and out of the world’s main terminals.

The two sets of figures can be quite different. In the case of Iraq, production figures from secondary sources were higher than those based on direct communication up to the end of 2015. The average discrepancy was nearly 300k b/d. Curiously, however, the relationship has flipped since the beginning of this year – Iraqi official numbers are now reporting production that is almost 300k b/d higher than secondary sources (see chart). It is not clear to me why this has happened.


Which number should be trusted? Oil analysts have always considered the data based on secondary source more reliable. They are less likely to be manipulated by governments to show, for example, that their production is within an agreed quota or exaggerated in order to have a room for growth in case of a production freeze agreement. Even OPEC seems to trust secondary sources more. The headline OPEC production number and the recently-announced production limits are both based on secondary sources.

What does this statistical discrepancy imply for the OPEC deal? It leaves it open to three scenarios. The first involves Iraq accepting secondary sources data as a basis for the allocation of the overall production to individual countries. The second involves the rest of OPEC acknowledging Iraq’s objection and cutting their production by 0.8-1.3m b/d to remain within the agreed targets. The third scenario is that the production limit in its current form will not be implemented as disagreement over the numbers continue. As things stand, the third option seems the most likely outcome.

Sunday, 31 July 2016

What does an IMF programme mean for the Egyptian pound?

After many false dawns, Egypt is set to agree a deal with the IMF which could stabilise its battered currency.

Egypt’s currency crisis has been an important theme since the revolution of 2011. The crisis has intensified in recent months, with the price of the US dollar in the black market deviating by as much as 30-40% from the official price. But news surfaced last week about a possible loan package from the International Monetary Fund (IMF) and other lenders totalling $21 billion over three years, increasing hopes that this could stop the freefall of the Egyptian pound. The latest developments raise two questions: Will Egypt conclude an agreement with the IMF before the end of the year? And will the agreement prevent the official price of the US dollar from sharply increasing again this year, say to above 10 pounds, by the end of 2016?

Will Egypt conclude a deal with the IMF before the end of this year?

Despite some scepticism, a deal is likely to be agreed. The scepticism stems from previous false dawns (in June 2011 and November 2012), in which Egypt seemed to be on the verge of an agreement with the IMF only to pull out in the last minute.

But the potential for reaching an agreement this time is more credible for three reasons. First, there has been official statements from the minister of finance, the prime minister and even the president admitting negotiations have been taking place for three months and suggesting a deal is likely to be in the offing. Second, Egypt is in a rather desperate position now given the large deviation between the official and market exchange rates, the low level of reserves and the reduced support from the Gulf. Third, there has been progress on the implementation of some of the policies required by the IMF, including the recent approval of the civil service law (which controls spending on public sector employees) and the value-added tax (VAT), which is expected to be approved by parliament in September.

All in all, the likelihood of a deal is high, probably around 80%.

Will the official price of the dollar increase above 10 pounds by end-2016 if an agreement is reached?

Historical experience suggests not. Egypt had three programmes with the IMF in the 1990s, and none of them resulted in a devaluation of the official rate by more than 3% four months after the start of the programme. This is quite far from the 14% devaluation required to push the official exchange rate (currently at 8.88) above 10.

Furthermore, for every argument favouring sharp devaluation, there is a counterargument against it:
  • Yes, the IMF would favour a flexible exchange rate regime, which is likely to result in a depreciation of the pound closer to the market value. But inflation is high (14%) and should rise with the likely implementation of the VAT. This may convince the negotiating parties to delay the depreciation until inflation has moderated.
  • Yes, the projected $7bn of loans per year fall short of Egypt’s financing needs, forecast at $8bn in 2016 ($12bn current account deficit minus $4bn foreign direct investment). But the gap is small and could be filled with support from the Gulf, higher foreign investments or other financial flows.
  • Yes, the Egyptian authorities may devalue the currency ahead of the deal as a sign of goodwill towards the IMF. Indeed, a large devaluation had preceded the programme of 1991-93. But any devaluation should be delayed until sufficient reserves have been built up to ensure its stability. Otherwise, the official price may end up chasing its tail.

Overall, the likelihood of a sharp devaluation of the official exchange rate is low; maybe as low as 25%.

Conclusion. Egypt is likely to agree on a loan deal with the IMF. The IMF team has started a visit to Cairo on 30 July and a staff-level agreement may be concluded at the end of the two-week trip. The agreement could get formal approval from the IMF Executive Board by September/October. It is unlikely to lead to a large devaluation in Egypt’s official exchange rate before the end of the year. 

Sunday, 26 June 2016

Brexit and the Arab World

Limited economic consequences from Brexit on the Arab World.

Against the odds, rational arguments and cost-benefit analysis, the good people of the United Kingdom voted to leave the European Union in a referendum on 23 June. The news sent shockwaves throughout the world and a long period of institutional uncertainty is likely to follow. The UK economy is expected to be hit hard by the decision, with growth being flat or negative. The uncertainty could spill over to neighbouring European countries, and forecasters around the world are revising down growth projections as a result.

How does an event of such seismic proportion impact the economies of the Arab world? The short answer is: not much for now.

For the long answer, we need to consider three channels.

1. The trade channel. If Brexit leads to slower growth in the UK or a recession, then the demand for imports in the UK will fall, hurting the UK’s trade partners in the Arab world. But the impact of this channel is limited because the UK is not a large export destination for any country in the region.

Take Qatar for instance. It is the UK’s largest trade partner in the Arab world, but the value of its exports to the UK is still small relative to the size of the economy at only 1.6% of Qatari GDP. Even if UK imports drop by 12% this year (one of the most pessimistic estimates), the impact on the Qatari economy will be small at only 0.2% of GDP.

2. The financial channel. Brexit has spooked financial markets, causing investors to hold safe assets such US or German bonds and shun riskier assets like stocks or emerging market bonds. This was evident in the stock-market meltdown on Friday 24 June, following the announcement of the referendum results.

How does this affect the Arab world? Many countries in the region, especially oil exporters, are looking to borrow from global markets to finance their deficits following the decline in oil prices. Analysts expect 2016 to register record borrowing from the Middle East on global financial markets. But the appetite from global markets to absorb this might diminish as a result of Brexit. Consequently, Arab countries might find it more challenging to finance their deficits with external debt.

But even the impact from this channel is mitigated by three factors. First, some countries in the region, such as Oman, Qatar and the UAE, have already secured funding from global markets, and have little need or requirement for further borrowing. Second, some countries, especially Algeria and those in the Gulf, have significant foreign reserves which they could use to finance themselves if global conditions tighten. Third, other countries are on a programme with the International Monetary Fund (most recently Iraq, Jordan and Tunisia) and can secure their funding requirements through the IMF.

3. The investment channel. Some Arab countries have investments in global firms and real estate through their sovereign wealth funds. And return from these investments could be hit by Brexit.

But again, the impact from this channel is likely to be limited as sovereign wealth funds have long investment horizons and are less sensitive to short-term movements in the value of their assets. Indeed, even the global financial crisis of 2008 did not seem to cause lasting damage to the region’s sovereign wealth funds.

So the bottom line is that the economies of the Arab world are relatively immune from Brexit, provided that Brexit remains localised and does not trigger an outright global crisis. In the meantime, the region is far more exposed to oil prices, attempts to diversify many of its economies and security issues, which pose more immediate and serious problems than Brexit.