As Oman descends deeper into junk territory, other GCC countries must learn from its mistakes.
editor's pickMonday 06, May 2019
Oman is fast becoming a cautionary tale for GCC countries. When oil prices dropped, Oman raided its savings, borrowed heavily and set lofty targets to reform its economy. When oil prices rose, diversification efforts were muted; now it’s paying for its inaction.
The world has not looked favourably on how Oman has handled the fall and rise of oil prices. In April, S&P soured its outlook on the Sultanate, downgrading it to negative. This followed Moody’s and Fitch Ratings sending the Sultanate into junk territory a few months earlier.
Sadly, higher oil prices sedated Oman’s economy and the Sultanate has been slow to wake up to lower prices. Oman’s economy shuddered to a halt in 2014 when oil prices plunged, leaving deep fiscal wounds that have yet to heal.
Despite paying lip service to diversification, Oman continues to derive about 35 per cent of GDP, 60 per cent of exports, and 70 per cent of fiscal receipts from hydrocarbon products. Higher oil prices have been like a sickness and its cure together.
While providing light relief for the economy, narrowing last year’s fiscal deficit by more than five per cent of GDP according to Moody’s estimates, it also narrowed Oman’s interest in finding alternative fuel for its finances.
Stéphane Roudet from the IMF, who recently held the 2019 Article IV consultation discussions with Oman, said, “Economic activity is gradually recovering. After reaching a low of 0.5 per cent in 2017, real non-hydrocarbon GDP growth is estimated to have increased to 1.5 per cent last year, reflecting higher confidence driven by a rebound in oil prices and higher government spending.”
“Oil and gas production increases brought overall real GDP growth to 2.2 per cent. Non-hydrocarbon growth is projected to increase gradually over the medium term, reaching about four per cent, assuming efforts to diversify the economy continue.”
However, as oil prices have climbed Oman’s enthusiasm for diversification has waned. Vital reforms that would have brought fresh revenue streams have been pushed back. Planned excise taxes on alcohol, tobacco and sugary drinks, along with the five per cent value-added tax (VAT), have been delayed to no earlier than the second half of 2019 and early 2020 respectively.
Moody’s estimates that these two measures combined could raise revenues of about 1.7 per cent of GDP, a relatively small share of the government deficits when oil prices are around current levels. These two measures are the only substantive fiscal measures that are being targeted for implementation in the coming years.
The 2019 budget law that was approved by the royal decree in January 2019 contains few new measures that would arrest or reverse the fiscal deterioration if oil prices moderated. Other than some further potential revenue from state asset sales, the budget only plans additional revenue from the standardisation of municipality fees.
This is unlikely to make much of a dent in Oman’s monetary woes. “The sharp fall in oil prices over 2014-2016 and only modest recovery since then has caused a significant deterioration in Oman’s GDP per capita and its fiscal and external metrics, similar to some other large oil exporters,” S&P said.
Despite a sharp increase in average oil prices last year, Fitch expects Oman’s budget deficit to narrow only gradually to nine per cent of GDP, still one of the largest deficits among its rated sovereigns. This is indicative of weaknesses in Oman’s fiscal policy framework. Any improvement in Oman’s finances has come from cannibalising existing revenue streams rather than cultivating new ones.
Apart from heavily borrowing, Oman has been tapping its sovereign wealth funds for cash and tightening its purse strings. The 2017 fiscal deficit was financed mainly through $6.5 billion in international bonds and $1.3 billion drawdown on reserves, the World Bank said.
The current account deficit fell to 15.1 per cent of GDP in 2017, from 18.7 per cent of GDP in 2016, due to an improvement in the trade balance related to higher oil prices and nonhydrocarbon exports. Central Bank gross reserves fell to $16.1 billion in 2017 from $20.3 billion in 2016.
In 2017, the Government managed to reduce the fiscal deficit from 20.9 per cent of GDP in 2016 to 13.7 per cent, according to World Bank data. This was achieved by reducing current and capital expenditures, from 50.9 per cent of GDP in 2016 to 44.8 percent in 2017, and higher fiscal revenues from higher oil prices. However, Government spending has increased again. This is despite continued restraint on the civil service payroll and capital spending.
“In nominal terms, the deficit will be only about 10 per cent smaller than budgeted, despite oil prices averaging more than 30 per cent above the 2018 budget assumption of $50/bbl,” Fitch said. “We estimate that Oman would have needed an oil price of $96/bbl in 2018 to reach budget balance.”
Lower oil prices will give the Government little breathing space in 2019-20. “We forecast the fiscal deficit will widen to 10 per cent of GDP in 2019 under our baseline assumption that average Brent oil prices will moderate to $65/bbl,” Fitch said.
As oil prices dropped, Oman’s debts rose. S&P estimates that gross general government debt increased to 49 per cent of GDP in 2018 from less than five per cent in 2014 and expects it to rise to about 64 per cent by 2022. Fitch forecasts that Government debt will continue to rise well into the 2020s, reaching 58 per cent of GDP by 2020.
It also predicts that sovereign net foreign assets will become a negative eight per cent of GDP in 2020, from an asset position of seven per cent of GDP in 2018. This reflects government external borrowing, the drawdown of reserves and the use of the State General Reserve Fund for financing.
At the same time, S&P highlighted that the share of foreign currency denominated debt predominantly held by non-residents increased to 80 per cent of total debt in 2018, from 26 per cent in 2015. In 2018, the Government issued Eurobonds of $6.5 billion in January and Sukuk of $1.5 billion in October.
“In our view, the debt structure is vulnerable to a sharp decline in foreign investor confidence in Oman, particularly as large Eurobond maturities loom in 2021 and 2022, which could add significant pressure to foreign exchange reserves,” S&P said. “High fiscal pressures since the drop-in oil prices have eroded Oman’s once-strong asset position, and we estimate that Oman will become a net debtor in 2019.”
S&P forecasts that general government liquid assets will average about 48 per cent of GDP over 2019-2022. It projects an increase in net general Government debt to about 20 per cent in 2022 from five per cent in 2018.
“The accumulation of government external debt has been a key factor behind negative rating actions on Oman,” S&P said. “The Government has made some strides toward diversification away from hydrocarbon receipts, but the pace and scope of planned fiscal measures could continue to be insufficient to stem deterioration in the Government’s balance sheet and curb rising external debt.”
Even if Oman takes the baby steps towards diversification that it has planned, Moody’s predicts that Oman will struggle to service its debts. It forecasts that Oman’s debt metrics will continue to deteriorate in the medium term, reaching around 60 per cent of GDP and more than 170 per cent of revenues by 2021.
the government battles rising debts, Oman’s citizens battle unemployment and stagnating incomes. While Oman has relatively high GDP per capita levels, estimated at $16,400 in 2019, real GDP per capita growth lags well below other countries at similar income levels. The World Bank forecasts that the 10-year weighted-average real GDP per capita is expected to increase only by about 0.4 per cent to 2022.
Population growth has historically been high due to immigration. However, this has recently moderated due to the shrinking construction sector and the Government’s restrictions on expatriate labour in line with Omanisation efforts.
The most recent International Labour Organisation estimate of unemployment was 17 per cent in 2017, however youth unemployment is approximately 49 per cent—an urgent challenge in Oman where over 40 per cent of the population is under the age of 25. This also makes a difficult clientele for Oman’s banks. With an increasingly frugal population and a government weighed down by debts, Oman’s banks may struggle over the coming months.
Indeed, in March Moody’s downgraded seven of the country’s financial institutions. “We expect the ongoing price correction in the domestic property markets and high household debt levels will increase credit risks for Omani banks,” S&P said. “We also continue to believe that systemwide funding may deteriorate if we see a significant weakness in government deposits, which account for more than one-third of the country’s bank deposits.”
In October, Moody maintained its negative outlook for Oman’s banking system, reflecting the diminishing capacity of Oman’s Government to support the country’s banks in times of need. The negative outlook also reflects banks’ softening asset quality and relatively tight funding.
Omani banks’ high reliance on government deposits remains a risk, said Moody’s, because the Government’s ability to finance its rising debt burden is becoming increasingly vulnerable to a change in foreign investors’ risk appetite. This increases the risk of deposit withdrawals from banks should the sovereign face reduced market access. “The Government’s capacity to provide support to banks is weakening as its fiscal position deteriorates,” said Mik Kabeya, an Assistant Vice President at Moody’s.
Moody’s expects the Government to continue to show a high willingness to extend support to its banking sector in a crisis, but the rating agency points out that the authorities may become more selective in providing support to banks as the sovereign’s credit strength reduces. “We are expecting a softening in loan performance despite the upturn in the economy, as the sluggish economic growth of last year weighs on borrowers,” said Kabeya.
Bank profitability will soften as funding costs rise as higher US rates outweigh rising lending rates from banks’ loan re-pricing, Moody’s said. Loan-loss provisioning will increase as problem loans rise. On the bright side, Moody’s expects capital to remain sound, providing loss absorbency.
S&P also pointed out that banks remain well capitalised and have relatively limited reliance on external funding. “Banks benefit from high capitalisation, low non-performing loans, and strong liquidity buffers,” said Roudet. “Maintaining strong regulation and supervision will help strengthen resilience and ensure sustained growth.”
Oman does have circumstances in its favour. S&P says that Oman benefits from relatively strong fiscal buffers, with liquid government assets estimated at about 50 per cent of GDP. It also expects that timely support from neighbouring countries in the GCC would be forthcoming, if needed.
Moody’s said that the rise in the Government’s debt burden may be mitigated by planned asset sales. As the first step, late last year the government owned Oman Oil Company sold a 10 per cent stake in the Khazzan-Makarem gas field joint-venture to a foreign investor. A significant portion of the proceeds will be transferred to the Government and used to finance the 2019 budget.
Earlier this year, the Government also sold a portion of the country’s gas pipeline network to the state-owed Oman Gas Company (OGC). While OGC borrowed externally to fund this purchase, increasing the debt burden of the broader public sector, the proceeds of the sale will likely reduce the government’s direct borrowing requirement in 2019.
During 2018, increased gas production from the Khazzan field, recovery in the manufacturing sector, and higher crude oil production in the second half of the year supported real GDP growth of 3.4 per cent, following a contraction of 0.9 per cent in the previous year.
According to Fitch, there is significant potential for higher growth and government revenue from new hydrocarbon projects, which will be critical to stabilising public and external finances. In nominal terms, the hydrocarbon sector expanded by almost 37 per cent year on year in 2018, largely on the back of higher oil prices.
With a significant ramp-up in production, the gas sector’s contribution has increased to about 20 per cent of total petroleum activity, from 13 per cent in 2015.Nonetheless, the outlook for oil production, prices and the pass-through of oil revenues to the Government’s budget is highly uncertain. “We estimate that a $5/bbl change in oil prices could change the fiscal deficit by around two per cent of GDP, all else equal,” Fitch warned.
“A change in oil production of around five per cent relative to our forecast could shift the overall fiscal deficit by more than one per cent of GDP.” Despite its potential, Fitch’s calculations illustrate how precarious Oman’s financial situation is while it is reliant on limited hydrocarbon reserves. Non-oil sector growth inched up just 0.9 per cent in 2018, according to Moody’s.
Construction saw a double-digit contraction as megaprojects such as the new Muscat airport and several road projects reached their natural conclusions. However, other sectors are beginning to shine. Manufacturing and financial services both performed well last year, albeit not well enough to offset the fall in construction.
Oman is a natural beauty, and its growing tourist industry is proving to be a vital asset. “Further efforts to curtail spending and the planned introduction of VAT could reduce the deficit by another two percentage points of GDP over the next two years,” said Roudet.
“However, thereafter, assuming the IMF’s projected gradual decline in oil price and production materialises, and given the expected increase in interest payments, the fiscal deficit would increase again, pushing government and external debt up and increasing vulnerability to shocks. “Deeper fiscal consolidation is therefore important to ensure fiscal and external sustainability.
The authorities are encouraged to lay out and implement an ambitious medium-term fiscal adjustment plan, based on reforms to tackle current spending rigidities—particularly on the wage bill and subsidies—streamline public investment, and raise nonhydrocarbon revenue.
These efforts should be implemented by prioritising measures that help limit the impact of fiscal consolidation on growth and by placing more of the adjustment burden on those who can best shoulder it.” If Oman can take the IMF’s advice— and quickly—it could yet prove that one man’s junk is another man’s treasure.