Oman in focus: External financing is key: Bank of America Merrill Lynch
Oman’s continued large twin deficits imply a need for material external financing to prevent sustained erosion in foreign assets and to defend the USD peg.
Availability of foreign financing is key to avoiding a hard landing near term. Still, further borrowing is likely to pressure external debt, especially if a downgrade to non-investment grade removes a source of technical support as debt levels increase further. In the absence of material fiscal consolidation, debt dynamics remain adverse and unanchored, despite the low starting level for government debt.
The potential GCC (Gulf Corporation Council) support to Oman would be credit-positive, if it were to materialise, although it may not alter credit fundamentals. Bank of America Merrill Lynch suspects Oman may have benefited from official support in 2015, although details remain unclear. Nonetheless, Bank of America Merrill Lynch is sceptical that any potential ongoing support talks could be concluded near-term in the absence of political concessions.
Fiscal accounts under pressure
The sharp drop in oil prices last year and spending slippage have led to a large widening in the fiscal deficit in 2016. The consolidated government fiscal balance recorded a deficit of OMR 5.2 billion ($13.5 billion, 22.6 per cent of GDP) in 2016, widening from OMR 4.2 billion ($10.8 billion, 16.9 per cent of GDP) in 2015. On the revenue side, this was due to a substantial fall in hydrocarbon revenues, only partially offset by an increase in non-oil revenues. The latter was mostly due to an increase in investment income and miscellaneous revenues including fees and asset sales, which suggests the increase may not be recurrent.
Revenues from corporate tax collection disappointed, but an increase in the corporate tax rate to 15 per cent from 12 per cent may have delayed to 2017. Total expenditures dropped by just four per cent yoy, and came 6.4 per cent above the budgeted target.
The full breakdown of spending between current and capital spending is not yet finalised. The spending rigidities and fiscal slippage reflect reform challenges. Bank of America Merrill Lynch has discussed here and here the political outlook and its impact on reform implementation.
Bank of America Merrill Lynch expects the fiscal deficit to narrow this year on higher oil prices, but hover around 2015 levels. The 2017 budget targets narrowing of the fiscal deficit (excluding net grants) to OMR 3 billion ($7.8 billion and 11.9 per cent of GDP), based on an oil price assumption of $45/bbl. Spending is targeted 7.5 per cent yoy lower, with lower defence spending offsetting potentially higher current spending. GCC-wide sin taxes are likely to be implemented in 2Q17, and, while yet unbudgeted for, are unlikely to bring in material proceeds.
External borrowing is primary financing avenue
Authorities plan to cover the 2017 fiscal gap with an OMR 0.5 billion ($1.3 billion) drawdown from reserve assets, OMR 2.1 billion ($5.5 billion) in external borrowing, and OMR 0.4 billion ($1.0 billion) in domestic borrowing. The MoF appears to be maintaining overdrafts at the Central Bank of Oman (CBO) of OMR 0.7 billion in December 2016 ($1.8bn or 3.0 per cent of GDP), but financing from this avenue is limited as overdrafts at the CBO cannot exceed 10 per cent of annual revenues. Drawing down on all of the government deposits in the banking sector (OMR 5.9 billion or $15.3 billion; 23.3 per cent of GDP) would increase fiscal buffers by a year.
However, Bank of America Merrill Lynch expects authorities to be reluctant to materially draw down on these deposits to avoid tightening domestic liquidity in the banking sector (as government deposits represent 30 per cent of total deposits).
Government debt has increased materially, albeit from a low base. Total government debt stood at $19.7 billion (32.6 per cent of GDP) in 2016, from 4.9 per cent of GDP in 2014. The largest increase has come from external debt, which stood at 22 per cent of GDP ($13.4 billion).
Large current deficit pressures USD peg
The sharp drop in oil prices last year has led to a large widening in the current account deficit in 2016 despite continued import contraction (20 per cent yoy). 3Q16 current account deficit data annualises at $12.8 billion (21.4 per cent of GDP), versus a deficit of $10.8 billion (16.9 per cent of GDP). Net errors and omissions show a further annual outflow of $1 billion. External borrowing has supported CBO FX reserves, including through the issuance of a $4.5 billion international bond, a $4 billion PDO pre-export facility, a $1 billion syndicated loan and $1 billion bilateral short-term loan with China (expiring in May 2017). The external public sector medium-term debt repayment profile suggests in addition $1.5 billion in annual average redemptions over 2017-2020.
Large external borrowing and potential support from non-resident entities have prevented a more rapid erosion of gross foreign assets than implied by external imbalances. Total gross foreign assets, including CBO, the State General Reserve Fund (SGRF), the Petroleum Reserve Fund (PRF), the Infrastructure Project Finance Account (IPT), and Oman Investment Fund (OIF), have declined to $38.8 billion (64.9 per cent of GDP) at end-2016, from a peak of $51.5 billion (66 per cent of GDP) in 2013. The PRF, IPT and OIF foreign asset balances are now near-exhausted and hold $0.6 billion versus $11.5 billion in 2013. SGRF foreign assets declined by $6.1 billion in 2016 to $18 billion in 2016 (30 per cent of Emerging Insight | 27 February 2017 3 GDP), but Bank of America Merrill Lynch assumes liquid assets are closer to $13 billion (22 per cent of GDP). Boosted by external debt proceeds and non-resident deposits, CBO foreign assets stood at $20.3 billion in 2016 (33.9 per cent of GDP). As such, liquid foreign assets likely represent 2.5 years of external financing needs, providing near-term cushion. The previous cycle’s bottom in CBO FX reserves stood at 10 per cent of GDP, prior to the 1986 devaluation.
Potential bailout talks unlikely to be conclusive for now
Bank of America Merrill Lynch is sceptical of the near-term success of bailout talks in the absence of political concessions. Press reports suggested in early January that Oman was in the early stage of talks with Kuwait, Qatar and Saudi Arabia to obtain a multi-billion dollar deposit. This was subsequently denied by the Omani authorities, but not by other GCC authorities.
Nevertheless, Oman has started to somewhat align its foreign and oil policy to that of Saudi Arabia by joining the Islamic Military Alliance Against Terrorism and by participating in the OPEC/non-OPEC production cut agreement. Still, Bank of America Merrill Lynch thinks a greater rapprochement with the GCC is likely to be necessary for material support.
It would be in the interest of the GCC to support Oman in maintaining its USD peg to prevent contagion risk. However, Bank of America Merrill Lynch thinks that the market distinguishes between Oman and Bahrain in terms of political/financial links to the rest of the GCC. As such, Oman’s contagion risk could likely be exaggerated, particularly if oil prices remain supported.
However, Saudi Arabia and the rest of the GCC may decide to make available, under the appropriate circumstances, financial support to counterinfluence Iranian links to Oman and influence the process of political transition and the direction of policy thereafter.
The curious case of financial support in 2015
Bank of America Merrill Lynch suspects Oman benefited from foreign support over 2015. This likely took the form of credit/deposits from non-resident banks to the conventional non-Islamic banking sector. In terms of BoP dynamics, this is likely captured by the OMR 2 billion ($5.3 billion) entry in the currency and deposits liabilities in the 2015 financial account. These deposits were subsequently moved from the banking sector in August 2016 to the CBO balance sheet. This is reflected in the $5.5 billion jump in CBO’s foreign liabilities to $5.7 billion in August and the simultaneous drop in the banking sector foreign liabilities.
The deposit move to the CBO boosts gross reserve assets but not net reserve assets. In terms of other forms of GCC support, Oman suggests that only $1.5 billion in grants from the $10 billion GCC Development Fund has been allocated. This is likely reflected in the annual OMR0.2bn revenue item recorded as grants from other countries in 2015-16.
Investment grade rating at risk over medium-term
Bank of America Merrill Lynch sees risks that Oman’s average sovereign rating could approach or fall to noninvestment grade over the next 24 months. The low starting level for government debt provides a source of support to ratings, albeit a gradually eroding one. At the current pace of build-up of government debt, Oman’s public sector debt level may no longer compare much favourably to BBB peers in two years’ time.
The next ratings reviews are scheduled for 17 March (Moody’s) and 12 May (S&P). Oman is currently rated Baa1 with stable outlook by Moody’s, BBB- with negative outlook by S&P, and BBB with stable outlook by Fitch. Some macro forecasts of rating agencies appear relatively optimistic in light of fiscal slippage and realisations in 2016.
In S&P’s case, it suggested it could downgrade to non-investment grade if the political succession leads to instability or if the external position deteriorates more than anticipated. Its rating already captures an assumption of GCC backstop support.
Oman’s investment grade rating is a key anchor for foreign investors. Bank of America Merrill Lynch believes the bulk of the holders of sovereign debt are indexed investors or ratings-sensitive investors. A downgrade to non-investment grade could thus remove a source of technical support, especially as external debt supply continues to increase further. For instance, Bahrain’s 10-yr bond (Ba2/BB-/BB+) trades at a z-spread of 375bp despite a Saudi support assumption, versus a z-spread of 280bp for Oman’s existing 10-yr bond.