Consequences and Impact of GCC Deleveraging-Markaz Report


Saving GCC banks is probably the most important challenge policy makers are confronting in today’s crisis-ridden world according to a recent report titled “Shelter in a storm” released by Kuwait Financial Centre S.A.K “Markaz”. The authors of the report M.R.Raghu, Senior Vice President – Research and Amrith Mukkamala, Senior Analyst – Research, point out that the GCC financial sector is probably reeling under the same aftermath as that of the global mess and hence possible solutions cannot be any different. The report looks at various policy options available to GCC financial leaders and also provides an assessment of the damage this crisis is likely to wreck on the GCC banking and financial sector if these policy options were delayed.

Policy Prescriptions

1. Overt Economic Stimulus: The authors of the report argue that currently the global response to the current financial crisis has been predominantly a rescue package initiated, launched and managed directly by the government in order to rescue local banks and financial institutions. These rescue efforts are even spreading to other sectors other than banks and financial institutions. The merits and demerits of such an approach where government will become a dominant player (instead of being a referee) are debated. Government intervention should definitely be questioned under

normal circumstances. The authors state that circumstances are hardly normal and therefore instead of wasting time debating, the best course of action would be to follow the global model.

The experience in GCC has been very different. The government has been showing marginal interest in initiating and managing a direct rescue program. The only country where such efforts are in progress is Kuwait, where the government is seriously working to hammer an economic stimulus package. The proposal is yet to be approved by the parliament as of the date of this report. However, the package aims to rescue both banks and investment companies. Successful implementation of this bill will set the trend in the region. Other such actions include $20 billion bond issue by Dubai government (subscribed by the Dubai government to the tune of $10 b) in order to provide support to distressed companies in Dubai. Also, in Qatar, the Qatar Investment Authority has been acquiring between 10% to 20% in the local Qatari banks.

Given the scale of destruction in the GCC, the authors of the report strongly feel that an overt economic stimulus package is no longer a policy option but a necessity.

2. Enhanced fiscal stimulus: The second policy option prescribed in the report is to enhance the fiscal stimulus plans already announced for 2009 and to announce one if there hasn’t been any. The report states that oil revenues (which form the majority – approx 80% of the GCC government revenues) are expected to witness a significant fall in 2009. Despite this, majority of the GCC governments have already announced an increase in government expenditures to provide fiscal stimulus to their economies. Saudi Arabia has projected a 9% decline in revenues for 2009; however, government expenditure has been significantly increased by 16%. The Saudi Arabian annual budget expects this to result in a budget deficit of USD 17 Bn as compared to a budget surplus of USD 11 Bn in 2008. Dubai too has unveiled an 11% increase in government spending. The annual budget of Dubai expects this to result in a budget deficit for the first time in Dubai to an extent of 1.3% to Dubai’s GDP.

However, Kuwait posted a contraction in its budget both in revenues and expenditures. The government expenditures as detailed in the annual budget for 2009 are all set to reduce by 36% and the revenues are budgeted to reduce by 39%. Analyst expectations on Qatar is also on similar lines with expenditures expected to be same as that of 2008.

The authors believe that an enhanced fiscal stimulus is a must in the current scenario and should be approached along with monetary easing.

3. Decrease interest rates on loans: Even though this has been the most widely followed monetary measure in these testing times, the authors believe that there is a lot more room to reduce interest rates. Most of the other GCC countries have cut their interest rates inline with the fed rate cuts. However, the quantum of decline has not been matched. Saudi Arabia started 2008 with its policy rate at 5.5% and ended the year with a rate of 2.5%. The central bank of Saudi Arabia did not cut its interest rates till October 2008, by which time the Fed had already moved its benchmark rate from 4.25% to 1.5%.

4. Cut deposit rates to increase exposure to risky assets: The report notes that deposit rates in the GCC region have already been cut in almost all the countries ex-Kuwait. Kuwait is the only country in the GCC to witness an increase in deposit rate in 2008. The up move in interest rates in Kuwait can be attributed to the currency factor, wherein, the Kuwait Dinar has moved from a full peg to the USD to a basket of currencies with a strong bias towards USD.

The deposit rates have been cut across GCC mainly to deter speculators to take advantage of the differential in interest rates between US and the GCC countries. The authors note that, even though this might be true as most of the currencies in the region are pegged to the USD, the more important factor should be the transfer of money from banks to investing in various assets classes. All asset classes are currently quoting at their historic low prices, cuts in interest rates on deposits would deter investors to choose bank deposits as a preferred destination of investment.

Even though, interest rates on deposits Ex-Kuwait has been on a downward trend, it has not matched the intensity of the cuts in US. The authors expect to see some more cuts in deposit rates in the region during the year.

5. Lend to longer term projects: The report notes that a total of USD 25.4 Bn worth of projects have been cancelled or put on hold in 2008 alone in the GCC region. The reason for cancellation of these projects has been mainly due to cost escalations and liquidity issues. However, in the last two quarters the scenario has changed drastically, wherein prices of commodities for projects and other input costs have declined drastically. The authors believe that financial institutions should take advantage of such a scenario by kick starting lending to long-term projects.

6. Increase government deposit in banks: Due to the decline in interest rates in banks, attracting retail and institutional investors towards bank deposits has become a challenge. The reports states that, anecdotal evidence pointing towards a decline in lending activities by banks resulting in reluctance of banks to take in time deposits. (Higher cost than demand deposits).

The authors feel that this situation would require the governments to increase their participation in the banking sector by increasing deposits in banks. Some GCC governments have historically been active participants in a few banks e.g. Qatar National Bank, wherein, the bulk of the deposits are from the government of Qatar. The authors of the report believe that such an increase in deposits by the government would also provide greater room for banks to increase their exposure to risky assets.

Present Context - Four forces impacting the financial services sector

The report details the impact of the four main forces - Size, Intermediation, Cross Border Activity & Capital Market representation on the GCC financial services sector in the present context. The authors state that central to this role is the level of liquidity which in turn is determined by the level of oil prices. The region experienced high levels of economic activity (real GDP growing at 6.5% annualized) due to high oil prices. This had triggered a wave of liquidity that positively impacted all the four forces as mentioned earlier. However, in light of the current financial sector crisis accentuated by low oil prices, the authors evaluate the health of the four variables and their impact on the performance of GCC financial sector.

1. Cross Border Activity: Cross border activity indicates the trend in outward investments from the GCC countries. Due to high oil prices, the quantum of investments reaching foreign shores from the region grew at a CAGR rate of 23% between 2000 – 2008. The bulk of this growth has come in between 2006 – 2008 coinciding with the strong up tick in oil prices during that period. Majority of these net foreign assets in the GCC are from Saudi Arabia forming 84% of the total GCC foreign assets.

The authors feel that cross border activity as a percentage of the size of the economy provides a better perspective on relative quantum of assets which are held outside the home country. The report notes that the net foreign investments for the first time in history of GCC crossed the 50% mark in 2008. Among the GCC countries, the net foreign assets of Saudi Arabia is almost 92% to the size of its GDP. In Bahrain and UAE, the assets have witnessed a contraction of 24% and 70%, respectively, in 2008. The authors expect average for GCC to remain stable at 51% in 2009 due to an expected 15% fall in the nominal GDP.

2. Size: The size of the financial sector as measured by broad money/GDP was at an average of 54% till 2004. Post this period broad money mainly consisting of bank deposits witnessed a steep growth and reached 60% of the GDP at USD 606 Bn in 2008. The authors attribute the growth in broad money to high liquidity mainly supported by an increasing trend in the current account surpluses in the region. However, with the fall in oil prices, the authors expect broad money also to witness a decline from its peaks in 2008.

Qatar has been witnessing the highest growth rate in broad money at a CAGR of 28% between 2000 – 2008. Broad money as a percentage of GDP shot up to a high of 61% in 2007 as compared to only 48% in 2000. After clocking a near 20% growth during the last several years, the authors expect money supply growth to be at 0% for 2009 given the steep decline in oil prices. However, the authors  also note that such an assumption will still keep the ratio of money supply to GDP intact at a new high of 67% primarily due to expected contraction in the GDP. The authors expect Bahrain and UAE to clock negative growth in money supply mainly due to the presence of huge number of foreign banks and the level of influence of expatriates in shaping the deposit profile.

3. Asset Intermediation: Asset intermediation is represented as claims on private sector divided by nominal GDP. Claims on the private sector represent loans provided to the private sector. Its proportion to GDP indicates the extent of heating up in the economy due to leverage in the private sector. The report notes that leverage levels were low in the GCC economies till 2004 at 40% and were bearable till 2006 at 46%. In 2007 and 2008, the intermediation levels spiked up to historically high levels of 54%. The value of claims on the private sector grew by 34% and 29% in 2007 & 2008 to USD 447 Bn and USD 578 Bn, respectively.

The high intermediation levels of 2008, the authors believe, will lead to significant cooling off in claims against the private sector in 2009. The general macro scenario also favors such a situation as asset prices have been witnessing a steep decline, which is a major deterrent for banks to lend for real estate and investment banks. The report notes that, UAE is clearly a case of overheating as its intermediation levels reached an astounding 80% in 2008. As a base case scenario, the authors expect claims to the private sector to witness a -0.5% growth. This would still increase the claims percentage of GDP from 54% currently to 64% of GDP in 2009. The growth in terms of percentage to the GDP can be mainly attributed to a significant expected fall in the nominal GDP.

Among the GCC countries, the authors expect Qatar and UAE to clock negative growth in lending primarily due to the dominant presence of real estate, whose contraction will impact the overall lending. Loan growth assumed for the rest of GCC countries in the report, though positive, is still far lower than the average growth they have been experiencing in the recent past.

4. Capital Market Representation: The report notes that Capital market representation (Market cap/ GDP) has cooled off since its peak in 2005. This can be mainly attributed to the significant crash in markets both in 2006 and in 2008. The GCC market capitalization has been by reduced by 52% from USD 1.1 Trillion in 2005 to USD 546 Bn as at the end of 2008. This reduction has reduced the capital market representation from 184% in 2005 to 51% in 2008.  

Banking Sector summary Expectations

The report points out that net profit growth in banks peaked in 2005 when it touched 73%. Post this period, it has been a phase of steady decline in growth rates to an estimated 4% growth in net profits in 2008. The efficiency ratios also looked robust with the average RoE in the period between 2002 – 2008 at 19% and RoA of 2%. Going forward, due to the decline in most of the parameters as provided in the summary table, the authors expect overall GCC banks net income growth to decline by 24% in 2009, taking the RoE to 12%. However, RoA will not be significantly impacted due to the low growth rates in the loan book. Among the GCC countries, the authors expect Saudi Arabia to post the least decline in net income to the tune of 11%.

About Markaz

Kuwait Financial Centre 'Markaz', with total assets under management of over KD1. 12 billion as of September 30, 2008, was established in 1974 has become one of the leading asset management and investment banking institutions in the Arabian Gulf Region. Markaz was listed on the Kuwait Stock Exchange (KSE) in 1997; and was recently awarded a BBB+ corporate rating by Capital Intelligence Ltd.