Flaming tensions between Iran and Saudi Arabia this week did little to spike oil prices. 

Market Watch Blog AGSIW | Karen E. Young | Jan 7, 2016

Flaming tensions between Iran and Saudi Arabia this week did little to spike oil prices. In fact, the execution of the Shia cleric Nimr al-Nimr by Saudi Arabia may have been politically inflammatory, and especially unhelpful to regional diplomatic efforts in Syria and Yemen. However, it did function to test the conflict sensitivity of oil markets. After a brief surge early Monday, oil prices are again back to a new low of $35 a barrel in trading on January 6, a price not seen since 2004.

Continued downward pressure on oil prices emanates from declining growth in China, stockpiles of oil globally, and continued production from OPEC members (namely Saudi Arabia). Analysts have predicted that regional conflict, including outright war involving major producers, or impediments to the Strait of Hormuz, are the few possible triggers that might compel prices upwards. The testing of markets this week supports the belief that cheap oil may be with us for some time.

Eyes on China, Hopes for India

Expectations of global growth for 2016 are not high, rather hopes are for a steady course in the few places where growth remains robust, and where it might be low but steady. Conflict in the Middle East and tensions among major (and potential) oil producers continue to be marginal to forecasts. This could be premature; certainly, if we ignore the conflicts they will not go away. The battle for oil market share is well underway, as Saudi Arabia lowered its price of crude exports to Europe this week in an effort to undercut expected Iranian competition in the spring.

Instead, investors and analysts are eyeing China’s manufacturing sector, which contracted for the tenth consecutive month. The hopeful areas of “emerging market” growth are now only in India, while growth in most of the “developing economies,” as categorized by the World Bank, is expected to be slow. The BRICS mantra seems nostalgic amidst current oil prices, as Brazil and Russia are victims of a commodities slump. As the World Bank forecasted, developing economies in 2015 grew at their slowest pace since 2009, at just 4.3 percent. (According to the Financial Times, if we exclude 2009, last year’s growth was the slowest in developing economies since 2001.) 2016 is not expected to be much better. In the U.S. and UK, modest growth is expected between two and three percent, and 1.7 percent across the Eurozone for 2016.

What Governments Can Do

With these low expectations, there is increased pressure on governments to do the best they can with what they have. For Gulf Cooperation Council (GCC) economies that are struggling to diversify, these challenges will be intense.

The temptation to borrow, for governments and their related entities, will be enticing. In the Gulf, the links between governments and their related corporate entities have created market jitters in the past when debts become difficult to service. Markets also struggle to differentiate between sovereign backed debt and corporate entities that have some state ownership, but not necessarily state guarantees of their liabilities. So-called “quasi-sovereign” bonds are a large portion (as much as $100 billion) of emerging market debt. Government debt is already on the rise, with Saudi Arabia issuing its first bonds in nearly a decade.

Fiscal austerity is not a common idea in Gulf public finance, but there will be cuts to subsidies (for example, in gasoline) and consideration of taxes. These are ideas openly debated now in Gulf governments and societies. Saudi Arabia’s rather open discussion of economic reform, prompted by the public release of the government’s solicited advice from McKinsey & Co. is one example of the shift in public discourse around fiscal prudence and planning for a reduced-oil, if not post-oil, future.

Selling assets, including equities in sovereign wealth funds, will help cover budget deficits, but the withdrawals cannot be made continually, and they could affect global equity markets as well. Sovereign wealth funds exist as a mechanism for governments to grow excess savings, mostly from resource wealth, and to designate funds for times of revenue shortfalls. In many ways, now is the perfect time to put them to use. The challenge will be the pacing of sell-offs to avoid the market perception of a fire sale.

States can make decisions to invest, both in human capital and in changing the structure of their economies to create jobs. Youth employment is a huge challenge. For example, in Saudi Arabia, more than half of the citizen population is under 25. McKinsey & Co. estimates that 4.5 million new job-seekers will enter the Saudi market by 2030. The inclusion of women working in manufacturing, retail, and health care could be transformational both socially and economically for GCC states.

Investments in infrastructure may boost local construction economies, while also improving transportation and trade links. The GCC rail network is one example of the fiscal dilemmas facing Gulf states. The project will be expensive at a moment when government budgets are less ample, yet the long-term dividends could be worthwhile. Etihad Rail is in trial operations, as a joint venture with German Rail, transporting sulfur and petrochemicals over a 1,200 km network in an effort to improve industrial production in the UAE. Financing models that complement state investment will be essential to these kinds of infrastructure plans.

Privatizations and public offerings will be opportunities for Gulf states to generate revenue. Aramco could be one of the largest state-held firms ever to go public, spurring a change of the state-led and state-owned growth model intrinsic to GCC political economies. In an interview with The Economist, Prince Muhammad bin Salman agreed that Saudi Arabia’s economic reform agenda, largely under his purview, could be described as “Thatcherite”, signaling that the economic liberalization of the kingdom is well-underway. We know from privatization and liberalization schemes of the early 1990s in Eastern Europe that massive restructurings of state-led economies have many social and political ramifications, especially on populations that are most familiar with a caretaker or welfare state.

For the Gulf Arab economies, 2016 will be a year of challenges, and potential innovations. The focus is clearly on governments to take the necessary initiatives and hope that the global economy will provide support.

This article was originally published by the Arab Gulf States Institute in Washington (AGSIW) https://agsiw.org/market-watch-new-year-same-economy/

Dr Karen E Young is a former senior resident scholar at the AGSIW. She is a resident scholar at the American Enterprise Institute in Washington and a senior advisor at Castlereagh Associates.