As many may be experiencing this holiday season, budget discipline is tough.
It has been especially difficult for Gulf nations in recent years as the tumult of regional revolutions and curiously elevated oil prices have encouraged spending increases far above the rate of economic growth.
As we approach 2015, increased scrutiny is on Gulf states to see if they will wilt under the pressure of lower prices, or instead dip into savings or borrow their way through leaner times as they did in the 90s.
I have been quite sanguine on the likely market and spending impact of lower oil prices (http://bit.ly/ecstrat2) and even though they have gone through my October prediction of a floor in the $70s to JP’s long-standing target of $60 on Brent.
Regional markets have, after a recent rally, managed to hold onto positive performance for the year in an impressive manner, being at levels far above what any seasoned market watcher would have predicted if you had told them the oil price would be $60 at the end of the year.
Indeed, some elements of the current budgetary rebalancing may actually prove beneficial for these states in the long-run, odd as that may seem.
The Saudi budget announcement yesterday put spending up a dash at $229.1bn (vs $227.8), with expected revenue at $190.5bn, we can take a quick look at how this may be made up.
In 2014 the actual spending was $293bn, well over budget, versus revenue of $278.7bn
If we back out the oil receipts we can see the Saudi government receives $30.7bn from other sources (taxes and suchlike), so $247.4bn in 2014 came from oil, which given an average oil price of $98 for this year implies 6.9mbpd of “revenueable” oil (ie exports versus total production, something I touched on here: http://bit.ly/ecstrat5 and will become increasingly important).
So for 2015, the budget is for $198.4bn from oil receipts, which would breakeven at $79 per barrel (at 6.9mbpd), or under the government’s assumption of a deficit of $39bn (< 5% of GDP), implies that they have $63 as their average oil price for 2015.
Of course, the budgets aren’t quite that simple, particularly due to the odd quirk of the hydrocarbon producers of the Gulf also being the most prolific providers of energy subsidies in the world with MENA accounting for around half of the annual $500bn bill, or 9% of regional GDP.
Iran used to be the most egregious perpetrator, spending almost $100bn in 2010 on subsidies (30% of GDP), 90% of which were for energy.
Even after significant subsidy reform one can see that in 2014 the Iranian budget called for $40bn in energy receipts, but spending on subsidies was likely to be nearer to $60bn, making lower oil prices not quite as disastrous as one may at first think.
In the case of Saudi Arabia and the other Gulf states, the situation is further muddied by the significant use of implicit subsidies, wherein the national oil companies and suchlike sell their products for above cost, but below market prices, encouraging heavy energy usage (indeed, Saudi Arabia is one of the highest consumers per capita).
The IEA has done a good job in trying to aggregate these and we see in the case of Saudi Arabia that in 2013 the cost of oil subsidies alone was $48bn, with electricity accounting for another $14bn.
These types of discounted cost subsidies are tremendously non-progressive, benefiting those that need them the least.
Egypt is the prime example of this, where the top quintile take 93% of the gasoline subsidy and 71% of the diesel subsidy, versus 1% for the bottom quintile of the population.
This has led to an energy subsidy bill 3x the size of the spend on education and 7x that on healthcare in 2011, with current low prices providing a fantastic window of opportunity for additional subsidy reform to be pushed through.
This is also the case for the Gulf, where wasted energy expenditure is imperiling long-term economic viability, with wasteful and environmentally disastrous usage of crude for power production at odds with moves to increase value capture through economic and downstream diversification.
Low oil prices provide an ideal window to address some of these imbalances and may lead to stronger, more resilient economies as a result, with Kuwait in particular already discussing energy subsidy withdrawal. This is a potential negative to energy stocks, but it is likely given their position that retail subsidies would be cut first in Gulf nations, in contrast to corporate subsidies being first under the hammer in Egypt.
Filling the gap
The Saudi Arabian deficit is currently pegged to be funded by reserves, much as they have in Oman, which as we noted a few weeks ago ran into a deficit due to ramping military spending, but we wouldn’t be surprised to see increased short-term debt issuance instead, with a significant opportunity for Shariah-compliant short-term liquidity products to complement longer-term investment of reserves (I do see 2015 as a turning point in Islamic finance, more on that soon..)
Reserves are the easy way out after such a period of excess. Saudi Arabia for example has official Central Bank reserves of $241bn and total assets closer to $800bn.
The Gulf has been somewhat shy of borrowing after the experience of the 90s, when debt to GDP levels rose above 100% and the fiscal outlook looked grim, but the issuance of government debt and development of yield curves are necessary steps to developing independent monetary policy.
This is becoming increasingly important as net exports decline due to increased local refinery output and trade surpluses with the US decline, likely leading to more countries moving to the Kuwaiti currency basket model to stabilize their economies, although we are highly unlikely to see excessive currency volatility as we have recently done in Russia.
The disintermediation of the banking sector that occurred after the crash and during the Arab Spring, where governments spent directly on projects and restricted lending growth through aggressive banking regulation (look at Gulf Tier 1 ratios!) may also start to finally unwind as increased credit extension to local populaces, particularly on the mortgage side, looks to be a cheap and underutilized stimulus measure in a similar way to Turkey in recent years and most of the developed world during the naughties.
Gulf states have been exceptionally lucky over the last decade, a period of lower prices may be exactly what they needed now, with the pain quite unlike what we are seeing in the Eurozone and elsewhere where real austerity and unemployment are biting..