High Oil Prices Drive Change Across the Middle East

The Middle East is experiencing rapid growth spurred on by spiralling oil prices and good performance by regional stock markets. The six oil-rich nations around the Persian Gulf that make up the Gulf Cooperation Council (GCC) – Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates (UAE) – have benefited most from this economic environment. The GCC as a whole carried limited exposure to US sub-prime and structured investment products.

Standard & Poor’s fund services sees the macroeconomic fundamentals for the region as robust, with oil prices near US$140 a barrel. This is driving investment and infrastructure spending, which is being reflected in earnings growth. With GCC countries planning their fiscal budgets on US$55 per barrel, the ratings agency feels that there is a significant buffer should oil prices soften.

One concern S&P has identified for the region is inflation: with most GCC currencies pegged to a weak dollar, inflation has been rising to record levels, partly under the influence of commodity price rises and partly because of what is effectively imported inflation, as central banks mimic the US Federal Reserve rate cuts.

The rise in wealth accumulation in the GCC countries has also had an impact on the global economy. In January 2008, McKinsey Global Institute (MGI) estimated that exports of crude oil will earn these states US$5 trillion to US$9 trillion from 2007 to 2020 and that they will invest 30-60% of their oil windfall abroad. The price of oil and the increasing amounts that the GCC states invest domestically will determine how much of this money flows overseas. “Decisions by Gulf leaders on how to use this wealth will have global repercussions for decades,” states the report, ‘Investing the Gulf’s Oil Profits Windfall’.

Even with funds to invest, there are limits to how quickly the Gulf will be able to effectively increase domestic investment and create new jobs. As a lower estimate, the GCC nations could continue to grow domestic investments by the same rates seen since 1993 – 6.1% annually. This would imply cumulative investments of US$3.2 trillion by 2020, or US$230bn annually.

Petrodollars not invested locally will spill over into global capital markets. “If oil lingers at around US$100 a barrel and domestic investment stays at historic levels, the GCC would send US$5.1 trillion in new funds into world markets over the next 14 years, boosting these states’ total foreign wealth to US$10.5 trillion by 2020,” predicts MGI.

There are also new initiatives developing to promote investor relations, such as Middle East Investor Relations Society (ME-IR Society) formed this month. The society aims to “support the further development and practice of investor relations across the Middle East in line with the rapid growth of the region’s capital markets and increasing demand from both regional and global investors for greater disclosure and transparency.”

Arif Amiri, chairman of the ME-IR Society, said: ” Investors are seeking enhanced levels of transparency and disclosure and the ME-IR Society will aim to ensure that regional companies have access to necessary tools, resources and a network of local and international experts who can support them in their efforts to adopt and implement best practices.”

GCC Common Market and Common Currency

The introduction of the GCC Common Market January this year is “probably the most significant change of recent times,” according to Jason Turner, product manager at SmartStream Technologies. In his article, Cash Management: Changes in the Gulf Region, Turner compares what is happening in the GCC countries with the effects of the European Union (EU) common market. He also examines the GCC’s intention to move to a common currency in 2010.

He stresses the need for banks in the Middle East to have a flexible and scalable infrastructure in order to move with the times. Turner says: “The one thing that is certain in the Middle East is change. While some of the future is sketched out, for example the Gulf dinar, much still remains to be set in stone. Therefore, if financial institutions in the region, both local entities and the operations of larger global players, want to ensure future prosperity, it is essential to move with the times. While the pace of change in Middle Eastern cash management is a challenge, it also provides an opportunity to put in place solid foundations for growth.”

The common currency is expected to yield several benefits to the GCC including access to larger markets, facilitating movement of labour and capital and lower transaction costs. Surendra Bardia, cash management head for the UAE, Citi, in part two of Citi’s What Now? What Next? Series entitled Cash Management Challenges in the Gulf outlines a number of issues that still have to be solved before the GCC can successfully move to a common currency, including preparation level and rising inflation.

He points out that maybe the common currency is not at the top of the agenda at the moment because the GCC countries have a lot to contend with at the present. “They are managing economies which are growing at a very fast pace with high rates of inflation. The average inflation in the Gulf is projected at 11% for 2008, with UAE and Qatar having the highest differential above this average. With the oil price windfall continuing unabated, they have much larger foreign exchange reserves to manage. Balancing inflation and growth, while having to defend the fixed exchange rates regime, is therefore posing a major challenge.”

There is still a lot of uncertainty plaguing corporate treasurers, whether it is uncertainty around the move to a common currency or de-pegging national currencies from the US dollar, as presented by Eversheds in the article Challenges Facing Corporate Treasurers When Doing Business in the Middle East.

Kuljit Ghata-Aura, partner, corporate finance, and Mark Lisgo, associate, corporate finance, Eversheds, both based in Abu Dhabi, believe that uncertainty is the common theme across the region. “In the event that GCC currencies were to de-peg, given economic conditions in the Middle East as opposed to the US, the currencies would appreciate rapidly in the short term. It is clear to see why companies might be tempted to acquire and retain significant sums of GCC currency with a view to profiting from such appreciation,” they said.

Their article also looks specifically at the rise in Islamic finance products and whether they can serve the needs of corporate treasurers operating in the region.

Islamic Finance

Dedicated Islamic banks and investment vehicles are emerging and flourishing. In 2007, the global market for sukuk, or Islamic bonds, more than doubled to exceed US$60bn – continuing its explosive growth since 2001 when it totalled less than US$500m, according to S&P. The ratings agency believes that it is on track to top the symbolic US$100bn mark in the next few years.

“We see good potential for conventional and Shariah-compliant securitisation, once the market in the GCC becomes more familiar with securitisation techniques,” said S&P credit analyst Mohamed Damak. “Sukuk are becoming a global phenomenon, attracting more issuers from a larger pool of countries than ever before. And this type of Shariah-compliant financing is set to continue, providing issuers with non- bank alternatives to longer-term funding.”

Currently, corporates and entities involved in project finance are the main issuers, with banks coming in second. “Corporates find that sukuk provide an alternative to financing their business or their projects, and financial institutions are increasingly turning to sukuk to sustain strong lending growth with stable funding sources and to curb maturity mismatches,” said Damak.

Additional reasons for sukuk issuance taking off include the fact that regulators and governments in the Gulf and Muslim Asia support the development of Islamic finance – including the sukuk market.

But there are still obstacles to overcome. In their article, Ghata-Aura and Lisgo say: “The main challenge now lies in the development of products that are compliant with Shariah law, while at the same time offering treasurers as competitive and effective an option as non-Islamic options.”

Andrew Woods, group vice president of treasury solutions, SunGard, explores the new Islamic financial instruments that are coming to the market and the impact on treasury management systems (TMS). In his article, Islamic Banking – Focus on Treasury Management, he predicts that: “As treasury products within Islamic banking are relied upon as tools to invest and hedge with, the need for systems that can automate and support these processes while maintaining Shariah compliance will continue to grow.”

He believes that a treasury management system that meets the demands of the compliance-focused Islamic banking landscape will also cater for banks where Shariah compliance is not required. “Cash management, debt, investment and currency management are common threads, as is the need for strong audit and controls. In addition to these requirements, an Islamic treasury system should also help manage and control operational risk within defined parameters,” he explains. The main compliance challenge is the interpretive nature of Shariah law, which makes moves towards standardisation more difficult.

Payments Initiatives

Faisal Ansari, executive director, JPMorgan Chase Bank, examines the different payment systems across the GCC in his article The Evolving Payments Landscape in the Middle East, highlighting new developments, such as the innovative GCCNET network which links the ATM switches of all the six GCC countries, the rise of regional financial hubs to cater to local and international businesses, and the increase in adoption of mobile banking to respond to the needs of foreign workers remitting their wages back to their home countries.

Ansari explains: “On the retail front, the increased use of direct channels instead of bank branches, the availability of direct transfers instead of paper instruments and the spread of new technologies like mobile payments and smart debit/credit cards will significantly change consumer behaviour. Cash will be used less often and may not even be allowed in some forms of government payments. Expatriate workers will be able to deliver funds to their families in home countries within 24 hours and at minimal cost.” He adds that the GCC common currency and single payments area will be the focus of the region’s central banks.

Steve Kirrage, senior vice president and general manager Middle East at Postilion, explores the increase in credit and debit cards usage, and how banks are supporting new technologies and channels at the point of sale (POS), such as contactless cards and near field communications-enabled mobile phones. With a large unbanked population across the region, banks also see the potential to introduce pre-paid cards such as salary cards, where businesses can top-up employee accounts electronically and employees can access their money by means of a card, thereby improving security and reducing risk.

In his article, Middle East Banks Look to Add Value to the Payment Chain, Kirrage says: “Perhaps more so in the Middle East region than in other parts of the world, banks have the ability to quickly introduce new card types, transactions and delivery channels. This means that the region can benefit from faster delivery of new services in the future, as these organisations look to grow the usage of plastic and the volume of card payments.”

Conclusion

The high price of oil is driving growth across the Middle East region and increasing the rate of change in cash management, payments and treasury operations. Adapting to this change is a major challenge, whether in response to currency-related risk or inflation, or to the new financial instruments being developed specifically for the Islamic market. And there is more change still in the pipeline with the implementation of the GCC common currency. Corporate treasurers operating in the region must examine their core processes and begin implementing a plan of action to remain ahead of the curve as new products and initiatives are constantly being developed.

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