If you are in the construction business and a Gulf government is your client, be sure to be paid in advance.

Market Watch Blog AGSIW | Karen E. Young | Feb 9, 2018

If you are in the construction business and a Gulf government is your client, be sure to be paid in advance.

The collapse of a major international construction and contracting firm, with many projects in the Gulf Arab states, has rattled the industry. Carillion, the British construction firm, failed to secure financing to continue its operations. Like the Bin Laden Group and Saudi Oger, Carillion has proved that the construction of megaprojects in the Gulf, however lucrative and central to state-led development plans, is full of pitfalls.

Carillion had troubles in delivering its contracts with the National Health Service in the United Kingdom, but it also faced problems in collecting unpaid bills from government clients in the Gulf states. The company was a sprawling giant in construction, infrastructure (including power distribution), service provision in health care, and facilities management in the U.K. and Canada, and across the Middle East. Late in the summer of 2017, Carillion sought to exit a series of joint ventures in the Gulf. Its regional partnerships have included: Al-Futtaim Carillion in the United Arab Emirates, Carillion Saudi Arabia, Carillion Qatar LLC, and Carillion Alawi in Oman.

Just before its forced liquidation and insolvency as a publicly listed company in the U.K. on January 15, the company employed more than 43,000 workers worldwide. Reports that Carillion’s efforts to recover more than $276 million in unpaid bills from construction projects for the World Cup in Qatar failed may have been the straw that broke the proverbial camel’s back. Months of chasing down receivables and hiring former management explicitly for the purpose of calling on Gulf governments to make good on promised payments did not save the company. According to the former CEO, Richard Howson, he “felt like a bailiff, just to try and collect cash.”

However, the billing difficulties in Qatar point to a larger issue in cyclical oil-based spending and contracting practices pervasive in the Gulf states. Bills are very frequently paid late, and often governments try to renegotiate terms of contracts (and even designs and materials) after work has been completed. This is partly the art of the negotiation in Gulf business, but it is also a very disruptive practice to local economies. Moreover, difficulties in the construction sector point to challenges in government diversification efforts across the Gulf states to grow the private sector and encourage competition among firms, including foreign-owned firms in engineering and construction.

The slowdown in economic activity, particularly in government contracting since 2015, has created a flat line in new projects, which has debilitated numerous contractors in the region.

Gulf Projects Index

In effect, because oil revenue continues to be the driving force of government expenditure, the unwinding of reduced spending is still reverberating across Gulf economies. In 2016, project awards, both government and private funded, fell 32 percent from the previous year, and further declined by 8 percent in 2017, according to MEED. The value of Gulf Cooperation Council contract awards in 2017 was $108 billion, with as much as 40 percent of awards in construction, followed by transport, power, oil, and gas.

These are largely state-led and state-financed infrastructure and real estate projects, the mainstay of Gulf economic activity and development models for the last two decades. The new normal, as described in a recent report on the industry by MEED and Mashreq bank, is a “lack of new project opportunities [that] has led to a squeeze on construction industry cash flow, which has been made all the more damaging by the endemic problem of delayed and late payments to contractors and suppliers.”

Because so much of economic activity in the Gulf states is driven by government spending on infrastructure and contracting, a delay in payments in these large projects trickles down to local suppliers and the thousands of foreign laborers who rely on wages to send remittances back home. According to research by MEED and HSBC, capital investment spending across the GCC states remains stagnant (minus some recent stimulus by Saudi Arabia). GCC-wide since 2015, there is also little expansion of credit to the private sector.

The effect on contractors has been fierce. With little new work and less access to finance, there has been a starving out of much of the sector. The firms that have survived have gone through difficult restructurings to weather the downturn in construction activity. As these firms face cash flow problems, there has been a strong interest from governments to seize assets and nationalize operations. Moreover, the emergence of political motivations to diminish the role of major players in the contracting sector, especially within the Saudi market, has further weakened competition and created add-on effects in labor markets, with thousands of workers left unpaid and stranded.

In Saudi Arabia, the state seizure of assets of both the Bin Laden Group and Saudi Oger point to a consolidation in the sector, much to the future advantage of state-planned developments, as in Neom. The first contracts are being awarded to start building Neom, including new palaces for the royal family. Bin Laden Group (and its new state ownership) has received one of these palace contracts. Neom is expected to attract public and private investment upwards of $500 billion.

If the Saudi government, through its Public Investment Fund (or perhaps through newly created firms linked to the Saudi leadership) becomes the major owner of both construction giants and service providers, it will essentially be self-dealing contracts for major new developments. In fact, where there is expected growth in construction-related awards in the GCC states in the coming years is largely isolated in Saudi Arabia and the UAE. According to MEED, there is a $2 trillion project pipeline of planned, but as yet unawarded, contracts in the GCC starting in 2018. Of these, $1.2 trillion are in Saudi Arabia and more than $700 billion in the UAE, some linked to the Expo 2020 project in Dubai.

As the MEED-Mashreq Construction Hub project documents, the construction sector is vital to the economic stability of the GCC. It accounts for the largest share of employment in the UAE; in 2016, construction jobs employed 1.2 million people, or about 20 percent of the workforce. Salaries in construction are notoriously low and go to low-skilled foreign migrants, yet they still account for about $13.6 billion per year, or 12 percent of the national total in the UAE. The Saudi construction market is much bigger, with about $144 billion of construction and transport projects underway. Per capita, however, Qatar is the largest market in construction expenditure, with about $32,000 of construction and transport projects underway per person in the emirate. By comparison, per capita construction expenditure in Iran is about $320. Construction and broader contracting businesses are second only to oil and gas production in determining the health of Gulf economies. More and more, the construction sector is weakened by limited competition and government intervention – either by political means or by failure to meet payment obligations in a timely way.

The importance of externally guaranteed financing, either through import-export banks or third party financing in public-private partnerships, is vital. Securing the stability of private sector firms, and helping them triangulate dependence on government contracting, cash flow, and access to capital markets, will not only create a more efficient and transparent sector, but also help reduce volatility in labor markets, especially for vulnerable low-wage workers. Conversely, a concentration in ownership in the sector will further fuel delayed payment schedules, encourage practices of connected tenders and “kick-backs” that have been part of established, yet corrupt, business practice in the region. For Carillion, it is too late; but for private firms in the Gulf and new entrants as foreign investors and owners, the pipeline of opportunity exists for those willing to take risk, while being cautious in their project financing.

This article was originally published by the Arab Gulf States Institute in Washington (AGSIW) https://agsiw.org/payment-delayed-economic-risk-gulf-contracting-practices/

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.