Posted on May 01, 2017

Our meetings suggested improvement on the fiscal front but that a further external debt issuance is not be excluded this year. As market expectations have been guided towards no issuance this year, a large external issuance may push Kuwait EXD to trade tighter than Qatari EXD, in our view.

A strategic decision has been taken not to tap the Qatar Investment Authority (QIA) foreign assets. This is in part due to the rate of return on QIA assets being greater than the cost of borrowing and as it allows QIA's investment income to be reinvested. It may also in our view reflect the lower liquidity profile of QIA although it appears QIA is now looking at increasing exposure to passive investments. Authorities guided that they would decide in June or September whether to issue an international bond or not. It was suggested that enough external financing was raised last year to pre-finance a portion of fiscal needs this year. If an external issuance takes place, it was suggested that a large bond could be raised, in line with historical precedents. In part, this may serve in our view to alleviate domestic liquidity. The recent uptick in government deposits in the banking sector suggests that a portion of external bond proceeds were deposited locally. The 2017 budget is based on oil prices at US$45/bbl and pencils in a deficit of QAR28.3bn (US$7.8bn; 4.5% of GDP). Given the likely revenue outperformance, much will depend on spending discipline as spending is budgeted flat to last year's budget (current spending down, capex spending up).

Kuwait: Strong balance sheet but robust supply pipeline

We hold a Market weight recommendation on external debt. In our view, Kuwait has one of the strongest balance sheets in the GCC region thanks to very low leverage yet large foreign assets in the Kuwait Investment Authority (KIA). However, the fiscal deficit (excluding investment income) is among the largest in the GCC region and likely implies a repeated large issuance of international bonds. Fiscal reforms are thus necessary to reduce imbalances and support a narrowing of the risk premium going forward. Authorities have a medium-term fiscal consolidation plan and political leadership has endorsed a deficit ceiling as the target is to bring the non-oil fiscal deficit to non-oil GDP ratio from c88% to 78% over the next three years. Parliament is unlikely to allow sharp consolidation in our view and we expect continued structural tensions between Cabinet and Parliament. We expect reforms to proceed gradually and in a non-disruptive fashion overall.

UAE: Still soft-landing

Our recent meetings in Abu Dhabi and Dubai suggest that the UAE has managed a soft landing, with a less pronounced cycle than in 2008. We expect non-oil real GDP growth to have bottomed out as the fiscal drag eases and infrastructure activity picks up. The still supportive external financing backdrop and improved domestic liquidity supports refinancing of Dubai government-related entities (GREs). Aggregate Dubai public sector debt appears to have stabilized in nominal terms, although it remains at elevated levels. We remain MarketWeight EXD for Dubai and Abu Dhabi. Over time, we expect greater market differentiation for Abu Dhabi versus other GCC credits as its high-grade high-quality value is cemented. Scarcity value, the ability to post budget surpluses at US$50/bbl and the lack of external issuance going forward should support and tighten spreads, especially versus GCC peers such as Qatar.

We expect overall UAE real GDP growth of 0.9% in 2017, from 2.2% likely in 2016. The headline figure masks a likely contraction in the oil sector due to the OPEC deal, but we see non-hydrocarbon real GDP growth picking up to 2.7% in 2017, from 2.3% in 2016. Over the medium-term, we expect non-oil growth to increase to 3-3.5% on the back of greater Expo 2020 projects. After averaging 10% annual growth from 2000-10 and a slump in 2009, Dubai real GDP growth was 4.1% in 2015, slowing to 2.5% in 9m16. Growth remains broad based although the construction sector is the laggard. The fastest growing sectors are restaurants and hotels, electricity, gas & water, transport and real estate. The key sectors in real GDP are whole and retail trade (c30% of real GDP), real estate and construction (a combined c22%), transport and communication (c15%), finance (c12%) and manufacturing (c12%). In Abu Dhabi, fiscal consolidation has slowed down non-oil real GDP growth materially, but we expect the drag to fade. Abu Dhabi real GDP growth grew by 2.8% in 2016, from 5.0% in 2015. Non-oil real GDP growth slowed to just 2.8% in 2016, from 8.6% in 2014. The slowdown was broad-based, although it was most pronounced in the public administration sector which contracted by 0.7%yoy in 2016.

The Dubai government is likely to record a small budget surplus in 2016. Still, we expect the fiscal balance to shift to modest deficits (1-2% GDP) from 2017 onwards as capex associated with the new airport, new metro lines and Expo 2020 come on line. The Dubai 2017 budget projects a deficit of US$0.6bn (0.6% of GDP) but we think the presentation excludes interest payments on the ENBD loan. We thus expect external debt issuance to pick-up consequently, noting US$0.6bn sukuk rollover needs in May 2017. Authorities have suggested they could tap the market by end-1H17 depending on fiscal outturns. Dubai fiscal outturns have been outperforming expectations over the past two years on the back of prudent spending and strong revenues. Given the pencilled in higher budgeted spending levels, delivering on fiscal revenue targets will be essential as any slowdown in economic activity is likely to drive slower growth in government fee income receipts. This could lead to wider deficits and greater external borrowing.

The Abu Dhabi government could record a fiscal surplus this year at oil prices around US$50/bbl. The 2017 budget does not include the impact of OPEC-mandated cuts but is based on an oil price assumption of US$50/bbl (versus US$40/bbl in 2016). The central government now receives a portion of ADIA's investment income. This has helped to narrow the financing gap. Efforts to obtain greater dividends from GREs are continuing as dividends from ADIA, ADIC (in turn, from bank holdings), ADWEA, ADNOC and ADX were up-streamed to the sovereign. The 2015 fiscal deficit was thus revised down from AED32bn (US$8.7bn or 4.1% of GDP) to AED18bn (US$4.9bn or 2.3% of GDP). The 2016 deficit appears to have stood at AED29.1bn (US$7.9bn; 4.0% of GDP), with spending reaching AED287.9bn and revenues reaching AED258.9bn. The 2017 budget assumes a surplus of AED15bn (US$4.1bn; 1.9% of GDP) on revenue projections of AED285bn and spending targets of AED270bn. Further hikes to administered utility and energy prices (electricity, water and gas) are planned this year. The approaching completion of major infrastructure projects (airport, in particular) should help keep a lid on capex spending as it peaks over 2017-18.

Over the next five years to 2022, authorities are planning to anchor spending at a flat level of AED250bn and target revenues (including some investment income from ADIA) increasing through the passage of a VAT, crude oil production increases (as ADNOC targets capacity at 4.0mn bpd by 2022) and oil stabilizing at US$50/bbl. Expenditures have been rationalized and have dropped versus the 2014 peak. This has so far taken place principally through a reduction in subsidies and cutbacks in domestic loans and equity investments (loans and transfers to Abu Dhabi quasi-sovereign corporate entities), although the 2016 budget, drawn with a US$40/bbl assumption, suggests more emphasis on current spending rationalization. The government has been proactive in terms of fiscal consolidation and has scaled back the net equity loans and transfers it provides to its GREs. Only the Airport and Nuclear Authorities are benefiting from net equity loans and transfers now. We would expect the bulk of spending rationalization to focus on subsidies, foreign grants, net loans and grants to GREs, federal transfers and non-essential capital spending.

Authorities do not plan to return to international markets over the coming years. Issuance of domestic debt could take place this year, although the goal would be more building a domestic yield curve than for financing purposes. AED10bn is planned for issuance annually over 2017 and 2018. An initiative to improve transparency and publish budget data is being pursued.

Bahrain: Under pressure, but supported

Our meetings suggest that the USD peg continues to be under pressure but that GCC support remains firm. Still, we anticipate that over time, the GCC is likely to require greater reforms from Bahrain to restore sustainability. As the lack of a passage of a budget prevents a return to international bond markets, we anticipate that technicals will remain supportive of EXD spreads over the coming months. The risk is if authorities decide to tap again an existing bond issuance as external financing needs remain large.

Real GDP growth stood at 3.0% in 2016, marginally higher than the 2.9% rate recorded in 2015. Economic diversification has helped as the key main sectors leading economic activity have been construction, real estate and onshore financial institutions while hospitality and manufacturing slowed down. Private consumption has likely been resilient (after a minor contraction in 2015), while a third consecutive year of import contraction is likely to have boosted net exports. Major projects such as the new 400k bpd Saudi-Bahrain pipeline, the Sitra oil refinery, Aluminum Bahrain and Bahrain International Airport expansions are proceeding ahead and will support activity going forward. The disbursement of GCC development funds likely helped support project and construction activity, allowing for on-budget capex rationalization. Government fixed capital formation has been contracting since 2013.

A key catalyst going forward could be the approval of the 2017 and 2018 budgets. Authorities are currently debating the extent of fiscal consolidation with parliament. This has delayed approval. In 2015, the two-year budget was passed in early July with a six-month delay. While the dialogue continues, the usual 1/12th spending rule applies. The 2017-18 budgets are likely to be based on an oil price assumption of US$50/bbl. Domestic issuance was halted for the past 4 months, contributing to an improvement in domestic liquidity (alongside weak credit growth). Domestic debt issuance is likely to resume soon. Authorities plan to return to the international debt markets after the budget is passed. The 2028 US$0.6bn bond tap appears to have originated from a reverse enquiry. It would also serve to pre-fund the rollover of BHD260mn in local debt expiring in July, according to authorities. With government debt at BHD8.9bn, there is still room to borrow within the current debt ceiling of BHD10bn.

Publication of monetary statistics has resumed. Fx reserves dropped by US$170mn between June and November 2016 to US$2.6bn and stood in January at US$1.9bn. However, this came despite the issuance of US$2bn in international bonds in October 2016. This suggests that external headwinds remain. The government has highlighted it is implementing measures that could yield fiscal savings of cUS$1.1bn annually (c3% of GDP), but given the wide starting budget deficit position, we think government debt is unlikely to stabilize in the absence of reforms and increase in oil prices.

Our impression is that fiscal consolidation remains socially challenging. Authorities highlight that a target of bringing the fiscal accounts to balance within three budget cycles (6 years) starting from 2017. However, this medium-term plan does not appear to be well articulated. Fiscal consolidation appears broadly planned to take place through rationalization of current spending (mostly control of the wage bill through hiring freezes), capex cuts and subsidy reform. The guiding principle for the subsidy reform appears to be that further adjustments have to be accompanied by means-tested allowances for nationals while expatriates would pay services at cost. Building a safety net could take time, in our view, while fiscal consolidation needs are pressing. Furthermore, as the fiscal consolidation is to be implemented through budget laws, it will have to be debated and approved in parliament. This could cause delays or watering down of budgetary targets. An IMF program is not being considered.

The government's foreign savings remain low. Future Generations Reserve Fund (FGRF) holds US$0.5-0.6bn (with US$1/bbl deposited when oil prices are above US$40/bbl). FGRF balances are not held at the CBB and have not been tapped yet. The central government maintains general accounts at the CBB, both in local- and hard-currency. The general government further holds foreign assets through its SWF, Mumtalakat, and through the Pension Fund Authority (PFA). Assets of Nogaholding, Bahrain's holding company for oil and gas assets, and of Edamah, Bahrain's real estate investment company, appear domestic-based. However, Mumtalakat holds mostly strategic domestic assets, has no plans to distribute dividends to the government and its liquid external portfolio stands at cUS$0.3bn.

The recent Gulf tour of Bahrain's Crown Prince Salman Al Khalifa to Saudi Arabia, Qatar, Kuwait and the UAE over February-March is positive in view of securing continued support. However, Qatar financial support appears unlikely as highlighted by the fact that Bahrain is in negotiations to buy LNG from Russian producers. We understand that, in August 2016, the UAE deposited a US$1bn at the CBB. This appears to be pre-funding for GCC development fund projects and may need to be fully repaid by 2018. At present, there is no such scheme being discussed with other GCC countries. 

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