UAE: Update Executive Summary. May Report Series

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1 Report Series UAE: Update 2016 Executive Summary While the UAE is one of the more diverse economies in the GCC it is still heavily reliant on the oil revenues, and is having to adjust to lower prices. Given the scale of oil s decline (40 percent in 2015 and another 30 percent likely this year), the authorities have looked to consolidate spending and secure new revenue sources to prevent an unsustainable rise in the fiscal deficit. Such moves will inevitably hamper growth, but large external savings and low government debt levels, mean that the UAE can follow a relatively gentle adjustment path, and spending in Dubai will remain elevated in preparation for Expo In addition, it appears that oil prices have bottomed out and will average around $40/b this year, before moving back towards $60/b in Reduced state spending and tightening liquidity will still act as a drag on growth, but available PMI data point to a positive momentum in the nonoil sector which we expect will be sustained as oil prices continue to recover. In this context, overall GDP growth is likely to slow to around 2 percent this year before picking up to 2.5 percent in As well as curbing capital spending the authorities have pressed ahead with various reforms to utility and energy subsidies, and have stated their intention of introducing VAT before Combined with the expected recovery in oil prices, this should help restore the consolidated fiscal accounts close to balance in 2017, although this year the deficit is expected to widen to 7 percent of GDP. While the UAE current account balance is expected to slip into a small deficit this year, external balances remain healthy given large state savings, and relatively easy access to capital markets. Abu Dhabi has recently issued $5 billion in bonds, while UAE banks have raised $7 billion over the last 15 months, and central bank reserves have been trending up despite lower oil exports. Economics Department Samba Financial Group P.O. Box 833, Riyadh Saudi Arabia ChiefEconomist@samba.com (London) This and other publications can be Downloaded from Bank liquidity is tightening and the operating environment deteriorating suggesting that credit growth will slow. Given the exchange rate peg, interest rates will continue to track the US Fed, putting further pressure on financing costs. Although the exchange rate has come under pressure in forward markets, the authorities remain committed to the peg and we do not expect any change. Debt levels remain a concern in Dubai where combined government and GRE debt stands at around 140 percent of GDP. Weaker real estate prices and slower growth will challenge GRE balance sheets, but we expect that Dubai will continue to be able to repay, refinance or restructure the estimated $16 billion in loans and bonds maturing this year.

2 Managing the oil price slump While the UAE is one of the more diverse economies in the GCC it is still heavily reliant on the oil sector, and is having to adjust to lower prices. Oil revenues account for percent of consolidated fiscal revenues, the spending of which (both recurrent and capital, including via GREs) is the main driver of non-oil growth. Given the scale of the decline in oil prices the authorities have been pushed into consolidating spending, and securing new revenue sources to prevent an unsustainable rise in the fiscal deficit. Such moves will inevitably hamper growth, but large external savings and low government debt levels, mean that the UAE can follow a more gentle adjustment path (see chart), such that a reasonably healthy growth momentum should be sustained, supported in part by spending on Dubai Expo The final estimated spend on this is hard to gauge, but MEED data show that the value of projects currently under execution in Dubai is near $50 billion (excluding energy/power projects), while those in the planning stage top $320 billion, of which $219 billion is slated for mixed use schemes. However, this is an ambitious schedule which will clearly not be met in the current climate of project cuts and prioritisation. Meanwhile, the pressure on external balances from lower oil prices is mitigated by the fact that the UAE has a more diverse export base, including large revenues on the services account from tourism, transportation and logistics. As a result, the current account is projected to slip only marginally into deficit this year, before returning to surplus. However, stalling/falling public sector deposits (which account for 25 percent of total including GREs) will see liquidity tightening in the banking sector, adding to the headwinds to growth. Slowing non-oil growth will drag down GDP The slump in oil prices, lower state spending, tightening liquidity, and waning confidence are all acting as a drag on growth. Timely GDP data is not available, but monthly PMI data for the non-oil private sector confirm that economic activity is slowing. The headline index stood at 52.8 in April. This is still in expansion territory (i.e. above 50), but is down from an average of 56 during 2015 and 58.2 during Companies are having to compete hard and cut prices to secure sales, and this is being reflected in an outright decline in the output price sub-index (48.3 in April). Although input costs remain subdued, the implication is that profit margins are being squeezed and new business growth is subdued. 2

3 May 2016 Nonetheless, a positive momentum is being maintained, and jobs creation remains just about positive. Given that we expect sentiment and activity to improve in the second half of the year as oil prices recover, and increasing trade and investment activity with Iran following the lifting of sanctions, overall non-oil sector growth is projected to remain positive at 2.2 percent, albeit down on the estimated 3.5 percent in With the oil sector expected to provide less of a boost this year, overall GDP growth is similarly projected to slow to just under 2 percent, before picking up to 2.5 percent in Oil production levels likely to stabilize According to Bloomberg data, UAE oil production averaged 2.879mb/d last year, up 4 percent from the 2014 average and a record high. However, with the Saudi driven market share strategy looking to carry less weight as efforts are made to freeze production, we expect that, on average, further output gains will be minimal this year. That said, investments are likely to continue in the broader hydrocarbons sector in general, ensuring that there is still a positive contribution to GDP growth. Box 1 Oil price assumptions The average price for Brent fell 42 percent last year to around $58/b and is on track to fall another 31 percent this year to $40/b. However, prices do now appear to have bottomed out and, having hit a low of under $30/b early in the year, have rebounded to trade at over $40/b. Although stock levels remain high and there has been no agreement by OPEC members and Russia to freeze output, markets are taking heart from the evident contraction in the USA, and disruptions to other non-opec supply. With oil demand holding up, this is likely to lead to the long-awaited rebalancing in the physical markets in the second half of the year, leading to a drawdown in stocks and further support for prices (with Saudi spare capacity less than 2mb/d, stocks are increasingly viewed as a buffer against possible supply disruptions). Looking further ahead, the sustained slump in oil prices, including futures prices, has led to large scale cuts in oil investment, such that future supply growth seems inadequate to meet demand growth. As a result we think that prices will trend up to $60/b in This is the price many oil industry experts see as necessary to secure the required investment in future supply. However, we expect markets will be volatile along the away with significant downside risks (for more details on our thinking about oil markets, see our October 2015 Oil Market Outlook report, and updates in our Economic Monitor). 3

4 Inflation rate falling The average inflation rate came in at just over 4 percent in 2015, driven higher largely by the increase in the housing and utilities sub-component which rose nearly 9 percent. This reflected both a hike in utility fees in Abu Dhabi as well as rising rental costs as the rent cap was removed. However, these one off increases are now falling out of the data, and the housing market has also weakened, such that the yearon-year inflation rate had fallen back to 2.5 percent in January (6 percent for housing & utilities). Inflationary pressures are likely to be muted this year as the economy slows and real estate prices dip. Global food prices are also expected to remain stable. Countering this will be the impact of reforms to energy subsidies which will push up retail gasoline prices in the second half of the year as oil prices recover, but average inflation should hold at near 2.5 percent this year and next. Fiscal consolidation underway Analysis of UAE fiscal developments is complicated by the fact that the Emirate with the largest budget (Abu Dhabi) does not publish its budget plans. The smaller Federal budget is made available, and Dubai also publishes its budget, but together these account for just 20 percent of consolidated expenditures as identified by the IMF. Thus while Dubai has notionally budgeted a 12 percent increase in spending in 2016 to $12.6 billion (with $4.4 billion set aside for development projects as Dubai prepares to host Expo 2020), and the Federal budget is projected to remain more or less unchanged at $13.2 billion, the main influence on the economy will come from the expected contraction in spending by Abu Dhabi. This will mainly reflect a reduction in capital transfers to Abu Dhabi GREs (with negative implications for project activity), and the direct cancellation of low priority projects. Our own estimate is that overall consolidated UAE spending will fall another 6.5 percent this year (having dropped near 5 percent in 2015), but with oil revenues continuing to fall in line with lower oil prices, the deficit will widen from 5 percent of GDP in 2015 to 7.1 percent. The longer term outlook is dependent on oil price movements and progress with fiscal consolidation, but our own assumptions have fiscal accounts moving back near balance in 2017, and into surplus in Financing and reforms In the meantime, deficits will be funded by drawing on savings, and both domestic and external borrowing - Abu 4

5 Dhabi has just issued $5 billion in sovereign bonds. At the same time the authorities will continue to press ahead with reforms aimed at raising non-oil revenue and curbing recurrent spending. Already they have moved to deregulate fuel prices, raise electricity and water rates, and have sought to reduce the wage bill by cutting the number of foreign ministries and outsourcing some government tasks to the private sector. The authorities have also indicated that they intend to move ahead with introducing VAT at 5 percent earlier than the current January 2019 GCC wide schedule. Other options that could yet be explored include: Broadening the coverage of corporate income tax but at a lower rate (10 percent rather than 20 percent). Introducing excises on passenger vehicles. Continuing to reduce energy and water subsidies and slowing growth in other transfers/benefits. Privatising public sector assets. Liquidity tightening and operating environment deteriorating Government deposits with banks have been on a declining path since oil revenues started to fall in 2014 (see chart). GRE deposits have been more volatile, jumping 7.5 percent y-o-y in December, before falling back again. Details are scarce but recent increases are thought to reflect some repatriation of funds from abroad. However, the outlook for GRE deposits is generally muted as profits are likely to struggle, and as the Abu Dhabi government continues to lower transfers to its GREs. Thus, the overall trend of broadly defined public sector deposits is expected to remain down. With private sector deposit growth also stalling, this will result in a continued tightening in liquidity. So far credit growth has held up as Emirate governments look to tap banks for deficit financing, and private sector credit demand remains robust. At near 8 percent year-on-year in February, gross credit growth substantially outstripped deposit growth (2.9 percent), keeping the aggregate loan/deposit ratio elevated at 102 percent. However, we would expect the rate of credit growth to slow to nearer 5 percent as lower deposits constrain growth and banks tighten lending standards amid a deteriorating operating environment. While sentiment has picked up as oil prices have found a floor, economic activity is slowing, particularly in the contracting sector, and asset prices remain depressed, with stock markets and real estate still 5

6 weak. Banks face a tougher year with rising NPLs, and profitability is likely to suffer with increased provisions, weaker loan growth, and higher funding costs. This will be offset to some extent by improvements in lending margins, and UAE banks remain relatively sound, with healthy capital adequacy ratios. In addition, we expect the authorities will look to manage liquidity to support growth, drawing on external savings as and when necessary. Dubai debt levels still a concern Including GRE obligations, total debt levels in Dubai are still a cause for concern, and are estimated at around 140 percent of GDP by the IMF. This compares with an estimated 30 percent of GDP for Abu Dhabi. Restructuring agreements have helped manage Dubai s repayment profiles, but it is notable that approximately $16 billion in loans and bonds mature this year, including $6.3 billion for Dubai Holdings and subsidiaries, $4.3 billion for the Investment Corporation of Dubai, and $1.1 billion for Nakheel. The Dubai government also needs to refinance $1.1 billion in maturing bonds and loans. As in the recent past, we expect that the government and GREs will have few problems in repaying, refinancing or restructuring, but note that roll over risks have increased as the economy slows and interest rates rise. There is also a chance that the authorities will push ahead with the development of a domestic bond market so as to reduce the reliance on banks and external funding. We could thus see a first benchmark central government domestic bond issuance sometime during Monetary policy to tighten in line with the US In line with US Fed the UAE central bank raised interest rate on its certificates of deposit by 25 bps in December and, given the exchange rate peg to the US dollar, we expect it will continue to track the Fed. Under our latest assumptions (see our March Economic Monitor for more details), this suggests a further two 25bs increases this year. Interbank rates have risen in line with the policy rate hikes and the tightening in liquidity, pushing up the cost of funding for both banks and corporates although at a slower rate than was widely expected at the end of last year. While there has been pressure on the exchange rate in the forwards market, the authorities remain firmly committed to the dollar peg and we do not expect any change. 6

7 External balances still robust Falling oil revenues have led to a sharp deterioration in the UAE s current account balance which is expected to slip into a deficit of around 1 percent of GDP this year, from a surplus of 4 percent in 2015, and double digit surpluses during However, if oil prices recover as we expect, the current account should return to surplus in 2017, and hence pressures on external balances should be muted. In addition, the various Emirates maintain large external savings, particularly in the Abu Dhabi sovereign wealth Fund (ADIA). Given the lack of public disclosed data, estimates of these external savings are not necessarily reliable and are likely overstated, but those compiled by the Sovereign Wealth Fund Institute suggest Abu Dhabi external assets are over $773 billion, or almost twice times total UAE GDP, and three times IMF estimates of total external debt. Meanwhile central bank reserves are holding up. Large inflows in December, thought to reflect repatriation of external assets, saw foreign exchange reserves jump to $92.5 billion. They have since dropped back to $83 billion in March, but this is still up on 2015 levels when they held at around $75 billion, and we expect they will hold steady before building a gain in The UAE also continues to attract healthy FDI flows. Ratings under review, CDS spreads tighten from early year highs Reflecting the underlying strength of external balances, agencies currently maintain strong sovereign ratings for Abu Dhabi (Aa2, AA, AA) and the UAE (Aa2) Dubai is not rated. However, given the sustained weakness in oil prices, Moody s has both Abu Dhabi and the UAE under negative watch. Unless it changes its oil prices assumptions ($33/b 2016, $38/b 2017), it is quite likely that it will downgrade both a notch from their current Aa2 ratings. In contrast, market risk perceptions have recently improved in line with the recovery in oil prices. CDS spreads on both Abu Dhabi and Dubai had widened sharply as oil prices slumped to under $30/b early in the year. However, they have since retraced (115 bps for Dubai, 58 bps for Abu Dhabi), suggesting markets are again reasonably comfortable with the outlook and assumed path for oil prices. Stocks recovering but real estate still weak UAE stock markets have moved in tandem with oil prices, and were down 16.5 percent and 4.9 percent in Dubai and Abu Dhabi respectively in They have since staged a strong recovery in line with oil prices, with the Dubai index 7

8 up 13.5 percent through April 20, and the Abu Dhabi index 7 percent. Both indices are still down on their 2014 highs (Dubai 33 percent, Abu Dhabi 12 percent), but the improving investor sentiment suggest that this gap can continue to be closed. However, the outlook for real estate prices still appear weak. While encouraging from a growth perspective, the continued implementation of real estate projects is likely to lead to a sustained softness in prices as new supply exceeds demand which has been hurt by the stronger dollar and slowing regional economy. Residential prices fell by about 10 percent last year in Dubai, and are likely to be down another 5-10 percent this year. Prices have been more resilient in Abu Dhabi, but will probably come under pressure this year. Main Economic Indicators e 2016f 2017f Nominal GDP ($ bn) GDP per capita ($ '000) 54,773 54,428 46,432 43,054 48,291 Real GDP (% change) Hydrocarbon GDP Non-hydrocarbon GDP Nominal GDP (% change) Hydrocarbon GDP Non-hydrocarbon GDP CPI inflation (% change) Hydrocarbon exports ($ bn) C/A balance ($ bn) (% GDP) External debt ($ bn) (% GDP) Fiscal balance ($ bn) (% GDP) International reserves ($ bn) Crude oil prod (m b/d) Crude oil price ($/b) Source: Samba, IMF, IIF, national authorities 8

9 James Reeve Deputy Chief Economist Andrew Gilmour Deputy Chief Economist Thomas Simmons Economist Disclaimer This publication is based on information generally available to the public from sources believed to be reliable and up to date at the time of publication. However, SAMBA is unable to accept any liability whatsoever for the accuracy or completeness of its contents or for the consequences of any reliance which may be place upon the information it contains. Additionally, the information and opinions contained herein: 1. Are not intended to be a complete or comprehensive study or to provide advice and should not be treated as a substitute for specific advice and due diligence concerning individual situations; 2. Are not intended to constitute any solicitation to buy or sell any instrument or engage in any trading strategy; and/or 3. Are not intended to constitute a guarantee of future performance. Accordingly, no representation or warranty is made or implied, in fact or in law, including but not limited to the implied warranties of merchantability and fitness for a particular purpose notwithstanding the form (e.g., contract, negligence or otherwise), in which any legal or equitable action may be brought against SAMBA. Samba Financial Group P.O. Box 833, Riyadh Saudi Arabia 9