Rating downgrades propagate the oil price shock

By reducing the funding available to oil-dependent governments, the recent rating downgrades could lead to slower growth than previously expected.

A number of oil-producing countries in the region were subjected to rating downgrades, a re-assessment of their ability to pay back loans or make timely interest payments. Saudi Arabia’s credit rating was cut by Standard and Poor’s (S&P), one of the three major rating agencies, on 17 February. Despite the downgrade, Saudi Arabia still maintains medium/high credit worthiness. The same cannot be said about Bahrain, which was assigned a junk status by both S&P and Moody’s, another major rating agency. This means that Bahrain has a high risk of failing to service its debt. The credit worthiness of Oman, another of the countries downgraded, is somewhere in between its two Gulf neighbours.

Low oil prices are the main reason behind the downgrades. They are leading to budget deficits among the region’s oil producers, increasing the risk attached to each of them.

But not all oil-producers were subjected to rating downgrades. Kuwait, Qatar and the United Arab Emirates maintained their high credit worthiness by S&P. They are assessed to have accumulated significant savings during the last oil boom, especially in relation to the size of their economies. However, they were still put on negative watch by Moody’s with a possible downgrade further down the line. Outside the Gulf, Iraq’s credit rating was also maintained by Fitch, the third major rating agency, although two caveats are in order. First, Iraq was also put on negative watch with a possible downgrade in the future. Second, it had already been assigned a junk status associated with a high risk of default.

Almost all of the region's oil-exporters intend to borrow from investors to finance their deficits, and the downgrades make this task more difficult. Saudi Arabia has plans to borrow $30bn; Oman and Qatar up to $10bn each; and Iraq $2bn. The downgrades would reduce investors’ appetite to lend to these countries. Even if they were willing to lend, investors would charge higher interest rates to compensate for the additional risk.

The recent experience of Bahrain highlights this issue. The downgrade of Bahrain by S&P happened while the country was finalising a deal to borrow $750m from international investors. The downgrade led to a change in the terms of the deal. The amount Bahrain borrowed was lowered to $600m and the interest rates increased by 0.25%. The change in rates was small suggesting that markets were partially expecting the downgrade. But further deterioration in the ratings could worsen the terms of borrowing further.

In summary, the rating downgrades are propagating the oil price shock experienced by oil-producers. Low prices are leading to budget deficits and the downgrades make these deficits harder to finance. If rating downgrades result in reduced resources for the governments to spend, then the impact on growth could be even worse than previously anticipated.

The Central Bank of Egypt’s misdiagnosis of a crisis

The dismal performance of exports, not excessive spending on imports, is behind Egypt’s currency woes.

Correct diagnosis is key to successful treatment. On 21 February, the governor of the Central Bank of Egypt, Tarek Amer, gave a TV interview outlining his diagnosis to the country’s ongoing struggle with a currency crisis, which has led to intense speculations about a possible devaluation of the Egyptian pound. Below are a few remarks on the interview.

1.  What is the central bank’s diagnosis of the problem? The governor was clear in his assessment: the excessive increase in imports over the last few years is to blame for the crisis. This has led to a large demand for the US dollar, which reduced its availability and led to pressures on the Egyptian pound.

2. Is the central bank correct in its diagnosis? No. It is natural for spending on imports to increase with the rise in income. It would only be considered excessive if its growth far exceeded that of national income, which has not been the case in Egypt. Imports grew at an annual rate of 4.7% between 2010 and 2014, lagging the 7.0% annual growth in Egypt’s nominal gross domestic product (GDP), a measure of income for the country. There is nothing excessive about this. In fact, the share of imports in GDP fell from 31% in 2010 to 28% in 2014.

3. If imports are not the root cause of Egypt’s currency crisis, what is? The answer is exports. In 2010, Egypt’s exports were valued at $49bn. In 2014, this number fell to $47bn. As a share of GDP, exports fell from 23% in 2010 to 17% in 2014. The fall in exports meant that Egypt earned fewer US dollars than it did in the past, which led to a shortage of foreign currency.

4. What explains the decline in exports? The main reason is that Egypt lost market share in its export destinations, despite the overall growth of exports to these markets. For example, Egyptian exports accounted for 1.5% of total exports to Saudi Arabia in 2010. But this share fell to 1.2% in 2014. Among the largest 43 trade partners of Egypt, the share of its exports declined in 31 countries between 2010 and 2014.

5. What could explain the dismal performance of Egyptian exports over the last few years? Potential explanations include: First, Egyptian exports may have become less appealing because they have become more expensive, either because inflation has pushed up domestic costs or because the Egyptian currency has appreciated against competitors’ currencies. Second, demand for Egyptian exports could have declined due to either security concerns (affecting tourism), the slowdown in global trade (impacting traffic in the Suez Canal) or the quality of Egyptian exports. Third, the capacity of Egypt to produce exports may have been constrained due to power cuts in factories, the shortage of foreign currency required to buy intermediate goods for production or the destruction of the gas pipeline in Sinai, which reduced exports to Jordan.

The oil production freeze is no game changer

The agreement to freeze oil production will do little to rebalance the market.

Russia, Saudi Arabia, Qatar and Venezuela agreed on 16 February to freeze oil production at January levels, if other countries join in. Despite the publicity, the move does not change the dynamics of the oil market in any significant way. Its impact is likely to be limited for three reasons:

1. The quartet alone have limited potential to increase production anyway. Annual oil production in Qatar and Venezuela is expected to decline in 2016, according to forecasts from Goldman Sachs. And while output in Russia and Saudi Arabia is expected to rise this year, some of this might have already been realised in January. Total production from the quartet is expected to increase by only 270 thousand barrels per day (k b/d), not enough to rebalance the market in a meaningful way.

2. The main growth countries (Iran and Iraq) are unlikely to join the freeze. Iran can convincingly argue that it needs to make up for the lost production during the years of economic sanctions. It currently produces around 0.7m b/d below its 2012 peak. Meanwhile, Iraq is struggling with revenue shortages and a large budget deficit and is unlikely to commit to any cap to its oil production. Indeed, the statement issued after oil ministers from the two countries met with their Qatari and Venezuelan counterparts was polite but lacked any enthusiasm to join the deal.

3. The output freeze is unlikely to be a precursor to a future production cut agreement. OPEC’s strategy to increase production, defend market share and squeeze US shale oil firms out of the market is finally bearing fruit. US oil production is expected to decline by 492k b/d this year as US oil firms are unable to recover their costs under current oil prices. A production cut from OPEC could give these firms a lifeline to come back into the market and fill the gap vacated by OPEC.

In addition, OPEC will probably face internal disagreements on how to allocate any production cut among member countries. Even if these disagreements were resolved, temptations would be high for individual countries to deviate and produce more.

So despite initial market enthusiasm, the production freeze agreement is unlikely to be a game changer.

The McKinsey blueprint for Saudi Arabia

McKinsey makes sensible high-level recommendations but falls short on the implementation details.

A few weeks ago, the deputy crown prince of Saudi Arabia, Muhammad bin Salman, gave an interview to The Economist. The interview created headlines because it outlined the young prince’s ambition to transform the Saudi economy. Bin Salman’s vision was clearly influenced by a recently-published report from McKinsey, a management consulting firm. In fact, the prince, who is an avid reader of consultants’ reports, mentioned the McKinsey report during the interview. Understanding this report therefore sheds light on the advice Saudi policymakers are getting.

What is McKinsey saying? It says that Saudi Arabia can increase the income of its citizens by developing its non-oil sectors. Some of the discussion on the potential of certain sectors to grow is insightful, as in the case of the automotive industry. McKinsey argues that Saudi Arabia has the ingredients to develop this industry given the size of its domestic market, the growth in neighbouring countries and the lack of manufacturing hubs in the region. But in other cases, the imagined potential is unrealistic. For example, McKinsey claims that Saudi Arabia can increase the number of religious tourists five-fold to 50m by 2030 by sustaining all year round the number of pilgrims seen during the Hajj season. And I want to have Christmas every day, please.

That said, the overall case for the potential of the economy to grow is convincing. The question then is how to do it. Economies grow by either increasing the number of people working, or by making working people more productive. McKinsey suggests that the former can be achieved by encouraging more Saudis to participate in the labour market. The participation of women, in particular, is very low. Only 18% of working-age Saudi women participate in the workforce compared with 51% in Indonesia, 44% in Malaysia and 29% in Turkey. McKinsey also suggests that productivity can be boosted by allowing more competition (which would push firms to perform better in order to survive), reducing restrictions on foreign labour to move between jobs, and increasing the productivity of workers through education and training.

But this is where the report falls short. It is all good recommending increased competition in the product market or more flexibility for foreign workers, but the current state of affairs is in place because there are vested interests benefiting from it. Likewise, it is easy to recommend boosting productivity through education and training but Saudi Arabia already spends a quarter of its budget on education with meagre results. Saudi students underperform their international peers in standardised tests, and the university dropout rate is close to 50%.

I would have expected more practical recommendations from a firm like McKinsey given its global reach, its work across different sectors and its “micro-to-macro” approach to economics. I would have expected them to provide insights and lessons from success and failure stories where countries tried to overcome vested interests, increase competition or boost productivity through education and training. The insights on how to achieve these objective are unfortunately lacking in the report.

So overall, the report makes all the sensible high-level recommendations but falls short when it comes to practical implementation.

Can Iran and Saudi Arabia afford their cold war?

The fall in oil prices is raising the share of military spending in the two economies above historical norms.

[1]

There is a theory which states that the fall of oil prices ended the Iran-Iraq war in 1988. Given their reliance on oil revenue, the collapse in prices meant that neither country could afford to continue financing the war (which was reaching a stalemate anyway).

[2]

Last week saw a heating up of the cold war between Iran and Saudi Arabia. The events were triggered by the execution of a Saudi cleric, Nimr al-Nimr. Things then escalated quickly: the Saudi embassy in Tehran was ransacked; Saudi Arabia cut diplomatic ties with Iran; and Iran accused the Saudi-led coalition of bombing its embassy in Sanaa.

Last week also saw a further collapse in oil prices. They are now trading at around $33 per barrel. Only 18 months ago, oil prices were above $100, but the days of triple-digit oil prices seem well behind us.

Can Iran and Saudi Arabia financially afford the escalation of their cold war in this environment?

[3]

Iran and Saudi Arabia have different appetite for military spending. Saudi Arabia spent an average of 9.6% of GDP (a measure of the size of the economy) on defence and security each year between 1992 and 2012. This was one of the highest shares in the world. Iran, meanwhile, spent an average of 2.7% of GDP on its military over the same period.

In both countries, the share of military spending in the economy has been rising in recent years. The World Bank estimates that military spending accounted for 10.8% of GDP in Saudi Arabia in 2014. US sources estimate Iran’s military spending at around $15bn in 2014, or 3.6% of GDP.

This was before the great collapse in oil prices.

[4]

The ongoing fall in oil prices mean that the Iranian and Saudi economies are shrinking in nominal terms. Saudi Arabia is more affected by this given the greater importance of the oil sector in its economy (40% share to Iran’s 20%). If oil prices stay at $33 per barrel, my own estimates suggest that the Saudi economy will be smaller by 21% in 2016 compared to 2014, while the Iranian economy will be smaller by 6%.

 [These calculations take into account the impact of the new Saudi budget and assume that Iran will increase its oil exports following the expected lifting of the sanctions early this year].

[5]

Even if military spending (in US dollars) was maintained at 2014 levels (before the war in Yemen), its share in the shrinking Iranian and Saudi economies would rise. In the case of Iran, the share would increase to 3.8% of GDP. In Saudi Arabia, it would reach 13.7%. For both countries, the numbers are higher than their respective average and are near the high points of the historical range (which included outright wars with Iraq in the 1980s and early 1990s. See chart).

Will the decline in oil prices force Iran and Saudi Arabia to reconcile in order to reduce their military spending back to historical norms? Or will the two countries discover a new appetite for allocating a higher share of their resources to the conflict? We can only wait and observe. 

Why are markets negative about the Saudi budget?

Saudi Arabia may succeed in reducing its deficit, but it will probably experience anaemic growth in 2016.

The announcement of the Saudi budget on 28 December created a contradiction. On the one hand, the announced budget deficits, while large, were much smaller than expected. The Saudis’ preliminary estimates suggest a deficit of 367bn riyal in 2015, lower than the International Monetary Fund’s (IMF) forecast of 511bn riyal. Similarly, the Saudi budget points to a deficit of “only” 326bn riyal in 2016, compared with the IMF’s expectation of 468bn. On the other hand, the market reaction to the smaller deficit numbers was negative. The Saudi stock market fell sharply after the announcement. Why is there such a contrast between the positive deficit data and the negative market reaction? I believe two reasons are behind this.

First, markets fear that the large spending cuts will lead to slower growth in 2016. The budget slashes spending by 13.8% between 2015 and 2016. This is much larger than the IMF’s expectations of cuts around 5.7%. We can adjust the IMF’s forecast for Saudi growth in 2016 by taking into account the new, smaller spending figures. The result is growth of 1.4% in 2016 instead of 2.2% previously forecast—a significant deceleration from the 3.4% growth recorded in 2015.

Second, markets interpreted the news about subsidy cuts, which accompanied the budget, rather negatively. Saudi Arabia removed some of the subsidies on water, fuel and electricity, leading to significant price increases almost overnight. There is no question that the subsidy system is inefficient and wasteful. But markets might have interpreted the measures as an act of desperation in response to low oil prices. In addition, these measures are likely to lead to even lower growth, as the resulting price inflation will leave the population with less income to spend on other items.

Are markets concerns overstated? Concerns about the ability of Saudi Arabia to run large deficits or maintain the value of the currency are exaggerated: Saudi Arabia still possesses very large reserves at its disposal. But markets concerns about the impact of spending cuts on growth are legitimate. Saudi Arabia may succeed in reducing its deficit, but it will probably experience anaemic growth in 2016.

Can Egypt’s new central bank governor solve its currency crisis?

To tackle Egypt’s currency crisis, the authorities need to address the root cause of the problem: declining exports volume.

The new governor of the Central Bank of Egypt, Tarek Amer, whose term only began on 27 November, faces an immediate currency crisis. The crisis manifests itself through downward pressures on the Egyptian pound, a shortage of foreign currency and a burgeoning black market. The government is trying to solve this problem by raising foreign currency, either through a loan from the World Bank or investments from Saudi Arabia. But this is merely a short-term fix. The authorities need to address the root cause of the crisis, which is the decline in Egyptian exports volume since 2008. Here is why.

1. The value of a country’s exports relative to imports is an important determinant of the price of its currency. More exports imply higher demand for the country’s currency, leading to an appreciation. Conversely, more imports typically lead to a depreciation.

2. Egypt has almost always imported more than it exported, but the gap in the early 2000s was small enough to be filled by the stable inflow of foreign currency remittances from Egyptians abroad. However, this gap began to widen and, since 2008, became too large to be offset by transfers from the Egyptian diaspora. Successive governments relied on different sources to finance this gap, including foreign inflows into Egypt’s stock and debt markets, withdrawing from international reserves and support from the Gulf. But none of these sources proved sustainable, which is why there is a crisis today.

3. Why has export growth lagged import growth since 2008? To identify the source of the problem, assume for the sake of argument that Egypt exported oil. Is the problem due to Egypt’s exporting fewer barrels of oil (a volume issue)? Or is it due to lower oil prices (a price shock)?

At least part of the problem is due to exports volume, which has not only failed to keep up with imports volume growth, but it has actually been declining since its peak in 2008 (see chart).

4. One way to quantify the impact of declining exports volume is through a counterfactual analysis. This is done by asking what would have happened to Egypt’s external balances if exports volume had remained at the 2010 level, but everything else (export prices, exchange rates, imports and transfers) had evolved as in the actual data.

Under the counterfactual scenario, Egypt’s current account (the sum of trade balance and transfers from foreign governments and Egyptians abroad) would have been in a surplus of 2.2% of GDP in 2014 instead of a 2.0% deficit. Even if we exclude public transfers (mainly support from the Gulf amounting to about $15bn in 2013-14), the current account would have been in a slight deficit of 0.5% of GDP.

This suggests that if Egypt had maintained its exports volume at the 2010 level, let alone succeeded at growing it, it would have probably averted its ongoing currency crisis.

5. So why did exports volume decline so much? Potential reasons include: First, slow growth in Europe—Egypt’s main export destination—which reduced demand for Egyptian exports. Second, less tourism due to the worsening security situation. Third, reduced traffic through the Suez Canal due to the slowdown in global trade.

6. In conclusion, reviving exports should be the main solution of Egypt’s currency woes. But this is a problem that cannot be readily solved by a new central bank governor or monetary policy. Certainly not on their own.