09 June 2008 The projected GCC economic growth forecast for 2008-09 has been revised upwards by Merrill Lynch from five to more than six per cent due to the increase in oil prices and high growth in non-oil sectors.The financial management and advisory firm says in its first quarterly report on the GCC the expected average oil price will be $130 per barrel during 2008-09 – and accordingly it has increased the expected economic growth rate in the region to 6.4 per cent.
“The high oil price bumps up external and budget surpluses and liquidity keeps flowing,” the report said. “The recent spike in prices confirms that the risk is on the upside. We now expect the GCC current account surplus to reach 36.2 per cent of GDP this year.”
The report predicts that the oil windfall will boost infrastructure spending and highlights the increasing prospects of the non-oil sectors as growth becomes less of an oil story. But inflation is expected to continue rising, representing the key macro challenge for the GCC.
“The current spike in oil prices benefits the growth prospects of the GCC, with a $10 increase in oil price adding $50 billion to revenues. Larger external and fiscal surpluses allow governments to press ahead with more diversification.”
Merrill Lynch says the hydrocarbon sector will grow by three per cent this year, accounting to 33 per cent of the GCC economy, while growth in non-oil sectors will reach 7.5 per cent.
“The main drivers of strong non-oil growth are loose monetary and fiscal policies, infrastructure investments and favourable demographics. GCC countries have eased their monetary policies substantially since November 2007.
“Fiscal policy has become more expansionary as governments try to compensate for higher living costs. Real estate and construction remained a key driver with the planned projects estimated at $1.9 trillion in April 2008. Rapid population growth not only expands the domestic market but keeps the real estate market undersupplied.”
Merrill Lynch expects the GCC equity markets to remain bullish during the rest of 2008 as the macro outlook remains buoyant with 6.4 per cent real GDP growth and limited downside risk given the petrodollar spending on investment projects.
“There is no shortage of cash in the GCC with a current account surplus equal to 36.2 per cent of GDP and corporations still flush with cash. Our bullish house view on the local currencies is positive for stocks. GCC stocks are trading at only a slight premium to emerging peers.”
Global emerging markets have fallen 1.9 per cent since the beginning of the year, while developed markets lost 3.4 per cent. “Performance has been robust in light of strong last quarter of 2007 GCC returns and treacherous global conditions this year.”
The report says Kuwait and the UAE are the most preferred markets as they are trading at discounts to emerging markets as a whole with much stronger current account positions.
Merrill Lynch says the financial sector is the obvious leveraged play in the GCC with strong macro fundamentals and low downside risk. The banking sector is financing key infrastructure and real estate spending.
“The positive demographic conditions a young and fast-growing population also support their long-term outlook. Banks are geared to capital market development through their investment banking units.”
The report shows that the positive outlook for the GCC is based on two main factors, one of which is the strong loan growth, which has reached 28 per cent in the UAE and 46 per cent in Qatar this year. The other key issue is the solid fee income growth through a combination of credit expansion and capital market activities.
It highlights the UAE’s banking industry as the most attractive sector in the region. “Our most expensive buy-rated bank, NBAD, is the privileged sovereign bank of Abu Dhabi with a low risk profile and estimated return on equity of 26 per cent this year.”
Turning to Islamic finance, Merrill Lynch says the confirmed issuance of sukuk to date during the second quarter of 2008 stands at $2.24bn, compared to $2.3bn during the first quarter.
Sukuk issuance declined by 43 per cent during the first quarter this year compared with 2007, which Merrill Lynch attributes to the fall-out from the financial and liquidity crunch, leading to the postponement of at least $8bn of supply and the uncertainty over depegging in the GCC. “However, we see these factors as exogenous, rather than fundamental, and as these shocks are subsiding we expect the issuance level to rise. “We believe that strong growth is set to continue for the rest of 2008 and beyond as many Muslim countries have benefited from record-high oil and gas prices, which are both creating demand for Islamic investment products and generating an infrastructure boom.”
However, Merrill Lynch says the liquidity constraint is limiting further inflow of funds to Islamic banks. Liquidity to trade out of positions, at short notice, is almost non-existent in the region. This not only hampers the growth and potential demand for Sukuk but also affects the profitability of Islamic financial institutions.
“We estimate total assets in major Middle Eastern Islamic banks are $84.9bn, which translates into liquid assets of about $25.5bn. The limitations on the productive use of assets call for the development of a Shariah-compliant inter-bank market and other short-term liquidity facilities. This would not only push up profitability but would also create a secondary market for Sukuk.”
GCC inflation to hit 10.4% Merrill Lynch has revised its forecast for the average GCC inflation rates in 2008/09 to 10.4 per cent, increasing its previous forecast by 4.2 percentage points.
“Inflation is on the rise in the GCC and remains the main macro challenge to the boom. GCC inflation has risen from 0.1 per cent year-on-year in 2000 to 6.4 per cent in 2007 and continues to touch multi-year highs into 2008.
“Saudi inflation stood at 10.7 per cent in April 2008, up from an average of 4.1 per cent in 2007, Kuwaiti was 9.5 per cent in January 2008, averaging 5.5 per cent in 2007, and Qatar continued to lead the inflation league, ending 2007 at 13.7 per cent.
“While food and rental prices stick out as key drivers, inflation is broader-based in the fast-growing UAE and Qatar,” it said in the report.
“The popular view is still that inflation in the GCC is mainly driven by supply bottlenecks. We find this incomplete. Rapid economic growth and population expansion exacerbate the supply bottlenecks. The surge in food prices also adds to the problem. But one cannot ignore the huge negative real interest rates and surging oil windfall in the region. We believe that the core of the problem is too much and too cheap money chasing too few goods and services,” the report added.
It predicted that the GCC governments, except Kuwait, will continue unorthodox policies to face increasing inflation such as public sector wage hikes, subsidy increases, rent caps and increases in social welfare payments.
However, Merrill Lynch considered these measures would turn to be inflationary and also aggravate the problem.
“In the medium term, inflationary pressures are cumulative – and the longer the delay in addressing them, the stickier inflation gets and the more inflated the asset bubbles become.
“This poses the biggest risk to the GCC business model, which rests on expansion of human and physical capital in the region. With 75 per cent of planned projects not yet at construction stage, cost escalation becomes a real problem and shortages and labour issues are already evident.”
Merrill Lynch said that the threat of inflation at the global level was real, stemming from emerging markets and with risks to the upside. “Many emerging markets’ central banks have started to act to curb higher inflation via higher policy rates, stronger currencies or both, taking a step away from simply blaming the supply-side shocks introduced by food and energy prices.”
In the GCC, the popular view remains that inflation is a temporary phenomenon driven by supply bottlenecks.
“We expect GCC real growth to reach 6.4 per cent in 2008, and it is likely that supply shortages, demographics and strong demand will continue to push real asset prices higher.”
