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Gulf States Find Oil Wealth a Thin Buffer

November 14, 2008


Saudi Arabia and its Gulf neighbors face the most challenging economic environment in some time--and have proved to be less insulated from the U.S.-spawned global economic slowdown than many expected. Three channels link the Gulf's economy to the global economy.

The most important is the most obvious: oil, and specifically the price of oil.  A global slowdown tends to put downward pressure on commodity prices.  For a while it seemed strong growth outside the United States would keep oil prices high even as demand from the world's largest oil importer faltered. But now all major oil-importing regions of the global economy are slowing. Not surprisingly, the price of oil and other commodities have tumbled.

Six years ago, the Gulf economies could--generally speaking--balance their budgets and cover their import bills if oil averaged about $20 per barrel. But after a long period when oil prices only went up, budgets (along with dreams and expectations) adjusted upward too. The Gulf now needs about $50-per-barrel oil to cover its import bill--and likely needs an even higher oil price to finance all the large construction projects on the drawing boards. Moreover, the Gulf countries have grown accustomed to a world where they could spend and invest more every year--and still have plenty left over to invest abroad. That will change.

"The large Gulf economies can only keep growing at their current pace if they dip into their foreign assets."

The second channel of globalization isn't as obvious: The Gulf's dollar peg. The link between Gulf monetary policy and that of the U.S. Federal Reserve means these countries essentially import U.S. monetary policy, and that their currencies move with the dollar. Right now that is a mixed blessing. The financial crisis has--somewhat surprisingly--produced a strong rally in the dollar. The dollar--and thus the Gulf currencies pegged to it--have appreciated against the euro, the pound, and the bank notes of a host emerging Asian economies. On one hand, a stronger dollar should make the Gulf's imports cheaper (almost all the Gulf's imports come from Asia and Europe rather than the United States) and thus help to bring down the region's high inflation. On the other hand, Dubai is no longer a cheap destination for British tourists--and that probably won't help fill all the hotels recently thrown up on the emirate's gleaming boulevards.

But the biggest impact of the dollar's rise is more indirect. Back when oil was high, the dollar was weak, U.S. interest rates were low, and Gulf inflation was high, international investors began to bet that the Gulf wouldn't be able to maintain its peg to the dollar. A lot of speculative money moved into the region. Moreover, the Gulf's own residents began to think that the Gulf might revalue against the dollar--they too brought funds home to take advantage of the expected appreciation. That propelled very rapid credit growth.

Real interest rates were negative--so borrowing was attractive. But any large boom financed with borrowed money creates risks, and some of those risks are now being realized. With lower oil prices, a higher dollar, and a more risk-averse attitude among international investors, much of the speculative money that flowed into the Gulf last winter has gone home. Even though the Fed has brought interest rates down to 1 percent, credit is a lot harder to get in the Gulf now than it was a year ago.  In that sense, the Gulf is rather like the United States.

There is a third connection between the Gulf and the rest of the world: the Gulf has a large fraction of its own assets invested abroad. The Gulf's governments--which get the lion's share of the region's oil revenue--have bought lots of U.S., European, and Asian financial assets over the past few years as the price of oil has consistently exceeded what they needed to cover their budgets.  Conversely some private actors--including "private" companies with close ties to influential families--have been large borrowers from the world's banking system. Dubai is the most obvious example: its skyline has been built in no small part with borrowed money as the emirate's oil is next door, in Abu Dhabi. That combination--a government that has been lending and investing to the rest of the world and a private sector that often has been borrowing from the world--means that the Gulf has suffered both from the slump in financial asset prices in the United States and Europe and from the reduced willingness of U.S. and European banks to lend.

The Gulf's sovereign wealth funds have seen the value of their portfolios fall, in some cases substantially. Global equity markets are down over 30 percent--and large U.S. pension funds and university endowments have seen the market value of their holdings fall by a similar amount. It would be surprising if the more aggressive Gulf funds haven't seen a similar fall in their portfolios. Work that I have done with Rachel Ziemba of RGE Monitor suggests that the fall in the market value of the existing portfolio of some of the region's big funds over the last year could have been larger than the new inflows from high oil prices. The Saudis are an important exception: the Saudi Arabian Monetary Agency seems to have held a more conservative portfolio than the region's formal sovereign wealth funds, and this year a conservative portfolio has paid off.

"The Saudi Arabian Monetary Agency seems to have held a more conservative portfolio than the region’s formal sovereign wealth funds, and this year a conservative portfolio has paid off."

Moreover, many central banks and sovereign wealth funds are being called on to help local banks and firms that are having trouble refinancing their existing debts, let alone borrowing for new projects. Kuwait's fund has intervened in the local stock market, Qatar has used its fund to recapitalize its banking system, and the United Arab Emirates (which includes Dubai, Abu Dhabi, and five other smaller sheikhdoms) has indicated it would support all the emirates banks. To keep domestic investment up and backstop their banks, many Gulf governments will need to draw on their existing assets.

The boom of the past few years is surely about to end--or least take a pause as the Gulf waits to see whether the long-term price of oil will be closer to $50 or $100. The Gulf has already increased spending and investment to a level commensurate with $50 oil--and without access to international credit, the large Gulf economies can only keep growing at their current pace if they dip into their foreign assets. The Saudis were a bit slower than the smaller Gulf economies to ramp up spending and domestic investment--the biggest boomtowns right now are Dubai and Doha rather than Riyadh and Jeddah. That, in conjunction with the Saudis' large pool of safe assets, means that they are in a good position to ride out a downturn in oil prices--though it also means that the Saudis face pressure to try to catch up with some of the faster-growing, smaller Gulf states. The Saudis have by the far the most oil in the region--but they also have by far the most people. Some of the smaller states actually have more oil relative to their indigenous population.

Yet even though the Gulf will feel the effects of lower oil prices, the Gulf remains far better positioned to weather a global slowdown than in, say, 1998 simply because all of the region's governments have more foreign assets now, and thus a bigger buffer against falling prices. The Gulf Cooperation Council (GCC) countries are certainly in a better position than many other major oil exporters; Russia has much larger foreign debts, and both Russia and Iran need a higher oil price than the GCC countries to cover their respective budgets.

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