Economics of the Gulf Cooperation Council (GCC)

Amidst growing unrest in the region and a prolonged slowdown in the US affecting the global economy could reduce oil prices and thereby slow the expansion in the Gulf. Similarly, risks could arise from rapid credit growth in the Gulf Cooperation Council (GCC) countries if financial institutions fail to manage their risks skillfully.

The Gulf Cooperation Council (GCC) was established on May 25, 1981 in Riyadh, Saudi Arabia. It is an economic and political policy-coordinating forum for the six member states of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates (UAE). Their geographic proximity, common oil resources are persuaded to form GCC. They have an agreement on issues like customs duties, intellectual property protection, adoption of free trade, and intra-country investments. Their political system is based on Islamic beliefs and thus follow common objectives in various fields such as finance, trade, mining, agriculture, tourism, legislation, administration, technical know-how in industry and animal resources, establishing research and development centers, joint ventures and encouraging cooperation of the private sector. GCC has set the target of adoption of a single currency by 2010.

Amidst economic slowdown, the global economic landscape is changing very rapidly with emerging role of emerging markets. Henceforth, Middle East economies are likely witness real growth story over the next few years though they have not been immune to the global financial crisis. According to a report by Earnest & Young (EY), Organization of the Petroleum Exporting Countries (OPEC) is targeting floor crude oil price at $50 per barrel, the GCC members will collectively earn around $4.7 trillion by 2020, which will be 2.5 times of their oil earnings over the last 14 years.1 The report predicts that, going ahead, the GCC members will have huge opportunities to buy cheap assets and able to finance local developments while the rest of the world economies stall against ongoing global recession. Even when compared to emerging economies, the growth prospects of GCC are positive. Government spending is acting as a key growth driver and is a good investment to arrest economic slowdown. As a result of the global recession, economic growth of the GCC area has slowed down, but remains positive. Compared to other regions, GCC has no financing problems, thanks to mammoth petrodollars over the past few years.

In contrast to the earlier oil booms, GCC countries have directed the bulk of their acquired wealth to domestic infrastructure and social development as well as to the diversification of their productive base in 2008. As a result, the impact of the recent oil boom on the economic and financial development of the region is likely to be more durable. At the same time, a significant portion of the oil revenue, ranging between 30% and 45% on average, is being saved and invested for the long-term to provide a source of revenue for the population when hydrocarbon resources begin to be depleted.

Today, GCC nations are better equipped to handle their oil revenue windfall than they were in the 1970s.  Their financial elite will have great opportunities to develop and diversify their economies rather than remaining dependent on one commodity like oil. There are further gearing up to invest part of their windfall profitably by acquiring some capital assets internationally.

Exposure to International Markets

The region’s petrodollars have been providing liquidity to global markets, improving access to capital to borrowers worldwide. Analysts expect that GCC is likely to continue to hold major portion of its existing wealth in the US and European assets and growing focus on emerging markets. Nevertheless, the Gulf money flooding global financial markets is causing concern in many nations, as there is still considerable confusion surrounding about the investors’ identities, their strategies and intentions. Several analysts agree that the gulf investors’ overseas-investment choices will influence interest rates, liquidity, and financial markets around the world.

A liquidity glut in the global markets may lead to asset price bubbles, increase extravagant lending, and result in poor utilization of global capital. Surging oil prices are helping the GCC governments to channel an increasing volume of revenues into reserve and wealth management funds, which will play an important role in international financial markets. However, if the dollar plunges beyond market expectations and if the US economy continues its dismal performance, underlying pressures could ultimately test the durability of the dollar peg. Recently, by shifting future oil trading from dollars to a basket of currencies yen and euro, Iran has clearly displayed its interest to diversify its assets.

Emerging economies are already feeling the pinch for investing in dollar denominated assets. If other members of the GCC were to do the same, then all oil importing nations including the US will have no other option but to buy euro and yen to get oil from the international market.

Unemployment – A Thorn in GCC Flesh

The new fortune has also brought some nagging problems along with it. Flooded with capital, the Gulf countries need labor to keep up their growth pace. So far the governments of the region have been unsuccessful in tackling unemployment among their own people. As most of the people are reluctant to work in the private sector, governments still remain the major employer. Most GCC members have initiated training programs for their citizens to join the labor market as private sector heavily depends on imported labor. In the GCC, nearly 40% of the total population of about 37 million comprises expatriates. Saudi Arabia, the largest country both in size and population, has about 6.5 million expatriates of the total 24 million.

Analysts believe that the Gulf economies’ labor market is distorted because of allowing too many expatriates to work and the public sector operates as a convenient employer for citizens, for job security and fewer working hours.

Imported Inflation – A Double-Edged Sword

Inflation is fast becoming a serious threat for the GCC against surging oil revenues, sub-prime crisis, soaring global food prices and weak US dollar. During the past two years, rising inflation is one of the serious concerns that many parts of the GCC countries are facing. In 2008-09, inflation recorded 4.4% in Saudi Arabia which was well above the target level of 1%. According to the IMF estimates, Qatar’s inflation rate will rise to more than 12% in 2009, while in the UAE, where housing costs have surged, the figure is put at 8%. In Bahrain, the rate is expected to remain at 2.9% while in Oman, it is expected to jump to 3.8%.

However, Kuwait is the only GCC member with moderate inflation which is expected to fall from 2.8% in 2008 to 2.6% in 2009. The main reason behind increasing inflation rate in parts of the GCC is inflating food and other goods and services prices which is being fuelled by a big increase in spending on infrastructure as a result of the dramatic rise in oil revenues in the recent past.

On the other hand, wage pressures are also building as GCC region is heavily dependent on imported workers from other countries. Government subsidies and high salaries are also adding to the money supply and inflation. Furthermore, Gulf investors who preferred to invest abroad in the past are flocking back to home markets, adding up to the liquidity pressure.

The liquidity glut has been a double-edged sword, propelling economic growth at the same time flaring up inflation and creating asset bubbles. The recent Merrill Lynch report observes, “the currency peg to the falling dollar is the main source of inflation. Pegging their currencies against dollar has served them relatively well and brought stability to their currencies until recently.” However, as the US economy is in doldrums and the global economy is becoming less dependent on it, the equation is now changing. The US dollar has depreciated by more than 9% since the beginning of 2007 and by 20% since 2002. The business cycles of the Gulf nations and the US are therefore no longer in sync. This means they are importing the America’s reflationary policies, at a time when they actually need to calm their own economies.

In the absence of proper monetary management, the costs of surplus can negate many of the benefits it brings. Hence, GCC is looking for the right measures to get inflation back under control. Unfortunately, the Gulf regional central banks do not have any effective policy measures available to them to ease inflation, since all are committed to a fixed exchange policy to the US dollar. The only one policy tool they are left with is to intervene in the markets and try to control prices.

Institute of International Finance (IIF) estimated that, if the prevailing exchange rate regimes are not re-configured, average inflation in the Gulf region is likely to scale to 7% in 2008.

The regional stock markets have already witnessed corrections in the range of 30% to 70% from their peak price-earning ratios. According to the latest figures released by IMF, during 2007, inflation hovered around 6% across all Gulf countries. Particularly, in Qatar and UAE inflation is most pronounced as it surged to record levels 12% and 10% respectively. Even in Saudi Arabia, where inflation had never crossed beyond 2%, has reached 6%. The UAE’s consumer loans and money supply shot up by 41% and 37% respectively in 2007. High inflation is denting the profits of local companies in the form of high input costs, while the overall cost of living has increased alarmingly.

Strike a Right Balance

Sovereign wealth funds from Gulf have become crucial and their actions are influencing the fortunes of global financial markets significantly. Hence investors are demanding the formation of disclosure standards in order to have free flow of information and efficient functioning of SWFs. GCC must strike the right balance between accumulating and spending its oil revenues. It includes exploiting the unique opportunities presented by the current set of unstable global financial environment.

Backed by strong oil revenues, GCC is in a good position to capture the substantial illiquidity premiums caused by the massive de-leveraging among global investment banks and brokerage firms. Policymakers need to adopt a common strategy to tackle the inflation problem that has gripped the region for the last two years. Inflation is a global challenge, and in the case of Gulf, it is a serious concern as the inflation is complicated by the fixed link of domestic currencies to the declining dollar. GCC Secretariat, in a statement, urged its members that “In the short term, GCC countries should maintain the present monetary policies, which peg the national currencies to the US dollar until the current global financial downturn is over and the dollar recovers.” 

Fortunately, the GCC is tackling these problems from a position of strength. GCC’s prudent decisions for continued domestic growth and rising living standards will consolidate the region’s position globally in the years to come. However, Richard Thompson, London-based editor of the Middle East Economic Digest warns, “The current building frenzy is a worry, too, as the countries compete for the financial and tourist trade. They risk creating a glut and a collapse. It will be a rough ride. But over time, following the money pays.”

N Janardhan Rao, Senior Economist.