GCC Flinches At Debt Crisis

The latest debt crisis in the West has led to the painful realisation that the Gulf must re-open the investigation into the controversial dollar peg and its dependency on oil.

GCC governments had hoped the case file on the two biggest economic taboos had been closed. But in light of the US dollar downgrade in early August, regional central banks have faced renewed pressure to drop their dollar pegs. Plus there are fresh concerns that the peg restricts the Gulf’s ability to fight inflation by forcing it to shadow US monetary policy.

With the US Federal Reserve cutting rates to ward off a recession, regional policymakers may find it difficult to control inflation with the cost of borrowing at historic lows. Gulf central bankers faced a similar set of problems during the 2008 recession. Plus, with another serious slowdown looming, there are fears that a repeat drop in global energy demand could cut the oil income for crude producers in the region.

Dollar deja vu

In 2008, former Fed Chairman Alan Greenspan said the Gulf’s near-record inflation rates could be eased significantly by dropping the dollar peg. Rampant real estate prices and subsequently soaring housing and rental costs had led to untenable levels of inflation in the run up to the financial crisis.

Today, inflation is much lower, partly due to the massive oversupply in residential and commercial property, but there are signs that problems could spring back, with Saudi Arabia facing the biggest threat, according to analysts. Saudi residential property prices rose 60 per cent during the first half of the year, and with the vast investment pledges by various governments and handouts, inflation could escalate quickly, a report by CB Richard Ellis said recently.

US President Barack Obama has made it clear that US interest rates will remain
low until 2013, given the fragile nature of the economy. As a result, Saudi faces “short term pressure” on inflation, according to Mohamad Hawa, head of Mena equity strategy and financials research at Credit Suisse Investment banking.

Although he added: “Medium- to long-term, the construction of 500,000 new homes as announced by the King should ease this pressure, as delivery will start in a few years.”

Dollar weakness can potentially stoke GCC inflation by also pushing up costs of importing goods to the region. but central bank chiefs in the region have in recent weeks spoken in favour of retaining the peg.

“We are pegged to the dollar and will keep it. We don’t see the dollar collapse,” Mohamed Al Tamimi, the deputy executive director of the UAe Central bank Treasury department, was quoted as saying in a report by Reuters.

Meanwhile, policymakers in Riyadh have argued that floating the Saudi riyal would not be appropriate for an economy that relies on oil exports.

Euro contagion

Outside the fiscal woes in the US, there are growing concerns about the extent of the threat posed by eurozone debt problems. Given that GCC states are intimately connected to europe, there is expected to be short-term economic and market turbulence. GCC stocks have remained depressed, partly over fears of a contagion from europe as finance chiefs spent August attempting to stop Italy becoming the next victim of the sovereign debt troubles.
long term though, economists are warning that a widespread debt disaster could jeopardise trade and investment between the GCC and the eurozone.

GCC-based sovereign wealth funds and private investors, which are net exporters of capital to countries like the UK and Germany, face the risk of sustaining substantial losses across their portfolios. latest figures show the 17-nation bloc grew by just 0.2 per cent on a quarterly basis with analysts expressing concern over sluggish GdP growth in Germany, which had been driving europe’s economic recovery.

The silver lining in all this for Gulf states could be that amid the economic turmoil government around the world will likely ditch their search for alternative sources of energy, leaving the door open for strong future oil demand.

Shrikanth S, Frost & Sullivan’s industry analyst for banking and financial services, said Europe may witness a “marginal decline in demand for energy” due to the uncertainty in the region. “If the financial troubles of Europe spread, the continuation of the concessions given to the renewable energy will be debated and might also be withdrawn. That could be a positive for the Gulf States.”

Oil demand

Yet, a collapse in global energy demand and a low oil price can never be positive for the Gulf. Most worryingly, financial analysts are heavily downgrading economic growth for the US, the world’s largest oil consumer.

Deutsche Bank revised its forecasts for US 2011Q4 GdP growth from 4.3 per cent to three per cent. Meanwhile, barclays Capital reduced its demand forecast for oil for both 2011 and 2012. Oil cartel Opec and the International energy Agency have also trimmed their estimates. In general, there is concensus that given the general outlook of the macro-economy, the state of oil demand does not seem particularly healthy.

But some believe that oil prices would have to fall dramatically to threaten the budgets of GCC oil exporters. Credit Suisse’s Mohamad hawa said prices have to drop up to 30 per cent before governments “fear the risk of lower public spending”.

Either way, the current uncertainty may be forcing Gulf governments to do some soul searching, particularly over their dependence on oil. It hits to the heart of the diversification efforts in the last decade, which some say need to be accelerated.

That oil is traded in dollars will be a compelling reason to keep the peg to the greenback. Compared to 2008, GCC states are in better shape, with healthier budgets thanks to a year of high oil prices, plus banks with stronger, more liquid balance sheets. but it’s yet to be seen how much more gloomy economic news the region can expect out of europe and US later this year.