Government bonds are a popular remedy to budget deficits across the Gulf Cooperation Council states right now

Market Watch Blog AGSIW | Karen E. Young | Oct 20, 2017

Government bonds are a popular remedy to budget deficits across the Gulf Cooperation Council states right now. Their time of fiscal need is driven by the current era of oil prices at $60 or less, which is a hangover period from historically high oil prices between 2003 and 2014 when states spent heavily on public sector wages, infrastructure investment, education expansion, subsidized energy and water, and social services. From Saudi Arabia’s $12.5 billion issue in October, to Bahrain’s record September issuance, to an inaugural $2 billion sukuk, or Islamic bond, issue by Oman in May following its $5 billion bond issue in March, 2017 has seen a rush to both domestic and international capital markets to take advantage of willing investors and low interest rates. In both domestic and international issuance across the GCC states, there is also an increasing use of sukuks as a debt vehicle.

Abu Dhabi successfully went to capital markets on October 3 and raised a $10 billion bond in three tranches. Abu Dhabi issued a $5 billion bond in 2016 and $3 billion in 2009, also at moments of fiscal stress. The driving force to access debt markets now may have been the ease of low-cost capital while U.S., and hence global, interest rates remain low and investor appetite is high, rather than solely pressure to meet an immediate funding gap. It’s a good time to borrow. Sovereign issuance has surged because states are in need of external finance, but the timing of accessible (and affordable) debt markets is somewhat a happy coincidence for Gulf states, as it coincides with a period of severely reduced revenue.

According to research on allocation of the bond by First Abu Dhabi Bank, investors based in Europe and the United States remain the largest purchasers of the new Abu Dhabi bond, in each of the three tranches. The dominant type of investors are fund managers, which indicates that American and European citizen investors could be significant holders of this debt. How easily the debt has been sold, and the wide interest from investors globally, especially among fund managers, points to the high caliber of the issuance, but also to the normalization of Gulf debt.

Sovereign Debt Issue by GCC Country, 2016 and 2017

Source: First Abu Dhabi Bank

Gulf Fiscal Traditions

What is not easily understood by these investors, however, is that the fiscal process in the Gulf states, in the United Arab Emirates in particular, has some unique nuances. Omar AlShehabi, a political economist at the Gulf University for Science and Technology in Kuwait, has suggested in a new research paper that the historical evolution of the transparency, independence, and accountability of public revenue and expenditure in each of the GCC countries (with limited exception) contains a checkered past. Often fiscal support for many government institutions is outside of normal budgetary reporting and planning processes. The ad hoc nature of Gulf fiscal policy is due in some ways to the nature of fluctuating oil revenue, but also to informal practices of governance.

In the UAE, these practices are attenuated by the federal system, which has encouraged a great deal of autonomy in the seven emirates. This autonomy has allowed separate security functions to co-exist, as well as separate revenue streams that need not contribute to the federal budget. In the UAE constitution, revenue of each emirate, especially from the discovery and export of oil, is independently held and not a federal asset. In addition, the practice of providing support to the federal budget from the revenue accrued directly by the emirate of Abu Dhabi from its oil exports is an informal one, and not constitutionally mandated. Though the tradition of Abu Dhabi support to the entire federation has been enshrined by the generous statesmanship of the founding father, Zayed bin Sultan al-Nahyan, the institutionalization through legal commitments of that support is less concrete.

Gulf Fiscal Current Realities

The current era of cheap money combined with government efforts to liberalize their economies are also changing the ways governments plan for future spending needs and their future sources of financing. While trying to curtail the spending patterns of oil boom and bust fiscal policy, borrowing in the form of short- and medium-term bonds is a good stop-gap measure. It also helps that bond investors have not distinguished much between Gulf Arab state issuers, such that those in weaker financial positions have had relatively easy access to capital. Analysts even suggest that some government issuance was less out of financial need and more to go along with market expectations and regional trends. In the event that it becomes more expensive to borrow, and bond investors have other opportunities at similar or higher interest rates, there could be more scrutiny on Gulf public finance.

For the UAE, that increased attention to federal spending and borrowing habits could come sooner than later. At present, only emirate-level debt issuance is permitted, but a draft law would allow the federal government to issue debt on behalf of the seven emirates, as a whole. (The draft law has been under consideration since 2010.) If federal debt is issued, the federal government would be fully responsible for its repayment. Since contributions to the federal budget are made by only two emirates (Dubai and, mostly, Abu Dhabi), the question of resources for repayment relates directly back to how Abu Dhabi, as an emirate, formalizes its support of the federal budget on a yearly basis. Given the lack of transparency in the UAE federal budget, in both its sources of funding from emirate-level deposits and in transfers from the central government to emirates, the requirements of federal debt issues could mean opening the books on decades of Abu Dhabi support to the federation (including a range of increased social support in 2011 to the smaller and weaker economies of the northern emirates.)

For example, the level of support Abu Dhabi offers to its federation partners is not clearly established in line item transfers of the 2017 federal budget. The fiscal health of the weaker northern emirates will depend on continued transfers and infrastructure investments from Abu Dhabi. Cooperation and transparency in the federal budget will be essential in a period of reduced oil revenue, but also in a period of fiscal reform in which new tax implementation and debt issuance will raise questions of resource sharing and redistribution. As mentioned, Abu Dhabi and Dubai provide funding to the federal budget. Those two emirates have very separate sources of income, from both their outwardly placed investments in entities like the Abu Dhabi Investment Authority, the sovereign wealth fund of Abu Dhabi funded by its oil revenue, and Investment Corporation of Dubai, the investment fund owned by the government of Dubai, funded more by its real estate and business holdings. Both Abu Dhabi and Dubai have multiple other revenue streams from emirate-level, government-related entities, but all of these are independent of the federal government and its potential collateral in borrowing.

Public Sector Transfers in the UAE

Source: IMF Country Report No. 17/219, July 2017

VAT Implementation in 2018

Moreover, federal cooperation and transparency will be put to the test as the value added tax (VAT) is implemented in early 2018. The new tax law, Federal Decree-Law No. (8) of 2017, does not stipulate how the revenue will be collected or shared, other than it goes to the newly created federal tax authority based in Abu Dhabi, seemingly bypassing emirate-level governments.

The impact of these fiscal reforms include, as of October 1, new excise taxes on tobacco, energy drinks (100 percent), and sugar drinks (50 percent). The VAT will go into effect on January 1, 2018 at 5 percent, except on insulated sectors such as transport, property, and hydrocarbons. These taxes should contribute 4 percent of gross domestic product by 2019, easing out of the federal deficit, according to a report by EFG Hermes.

New sources of federal revenue may shift existing contributions, as Abu Dhabi and Dubai contribute roughly 25 percent to federal revenue in agreed but undisclosed amounts, according to the International Monetary Fund. Accordingly, revenue from fees and dividends of public entities (such as the telecom Etisalat) make up roughly 75 percent of federal revenue. The expectation from the reforms is that the federal government will emerge from a roughly -2.6 percent of GDP fiscal imbalance in 2017, to a surplus of just over 2 percent in 2018, according to research by the IMF and EFG Hermes.

The federal government adopted a five-year budgeting cycle for 2017-21 with annual and medium-term budgets approved by the UAE’s Federal National Council, all with a stated goal of achieving a balanced budget on a consistent, but not mandatory, yearly basis.

Overall Deficit and Debt, UAE

Local sources suggest that what is reported as a transfer from Abu Dhabi to the federal government budget (which should amount to roughly 25 percent of government revenue, combined with contributions from Dubai, according to IMF estimates) is a very small portion of actual financial support, on the order of 5 to 10 percent of actual funds transferred from Abu Dhabi to other emirates for social, infrastructure, and direct financial support. Funds from Abu Dhabi, as an emirate, transferred to the six other emirates are much more significant than the federal budget suggests in ministry-level expenditure. Therefore, the federal budget outlays in emirate-level support do not fully reflect how Abu Dhabi, as one of seven emirates, makes substantial additional transfers to its federal partners.

In the 2017 UAE federal budget, a large part of the allocation remains dedicated to employee compensation. Of the 46.3 billion dirham allocation (about $12.6 billion), nearly 38 percent, or 17.5 billion is salaries and benefits. This expenditure in itself is a direct transfer of support across the emirates, as many federal employees in Abu Dhabi institutions are from other emirates and commute daily or weekly. Of unreported support, it is more difficult to track transfers, especially via government related entities, loans, and investments.

UAE Federal Budget 2017, Abbreviated Subtotals (in UAE Dirhams)

Not only is the amount of financial support from the Abu Dhabi government to the other emirates underreported, federal budget support also tends to fluctuate significantly from year to year. As a result, in the federal budget there is significant volatility in expenditure across ministries from year to year. For example, according to research by Ahmed Mansour at UAE University, the highest shifts from the base are recorded in the cases of higher education, electricity and water, and oil and energy budgets. The higher education budget experienced three tremendous shifts of (359 percent) in 1990-91, (1683.71 percent) in 1992-93 and (1320 percent) in 2004-05.

Shifts in public policy priorities, especially before the use of the five-year medium-term forecasts, have created institutional windfalls that have also been distributed somewhat unevenly by emirate in efforts to build capacity, especially in education and health care service provision, where it was weak. The 2017-21 five-year budget of 248 billion UAE dirhams ($67.5 billion) includes a spending package of 48.7 billion UAE dirhams on “happiness of the people” in education (20.5 percent), health care (8.6 percent), pensions (8.2 percent), and security provisions.

The general trend in fiscal expenditure at the federal level has been upward, much of it related to wage growth in the public sector and to subsidize government-related entities. According to a 2015 report by the IMF, government expenses grew by about 10 percent on average in 2000-14 in real terms with the largest transfers to Abu Dhabi’s government-related entities, security, defense, administrative spending, and grants to foreign governments. Wage growth increased 10 percent on average annually between 2000 and 2014, raising the average monthly wage in public administration to the levels compared with the financial intermediation and mining sectors.

UAE Government Expenditure

Source: IMF, IMF Country Report No. 15/220, August 2015

As debt is an increasingly used tool to fund government expenditure in the UAE at the individual emirate level and soon perhaps at the federal level, the budgeting process will need to take on a more nuanced character. IMF simulations suggest that a binding deficit rule of 3 percent of GDP over 10 years implies a rising debt trajectory with government debt reaching 45 percent of GDP, also in 10 years. To maintain a stable debt trajectory at 30 percent of GDP (the government of Dubai’s target), an overall deficit of 1 percent of GDP at most could be sustained. Further, the earnings of outwardly placed investments in both the Abu Dhabi Investment Authority fund and from the Investment Corporation of Dubai, are directed to their respective emirates and ruling families. These funds are vulnerable to changes in global equity markets, and to draw down from their owners, which could have implications for the availability of funding to the federal budget in the form of transfers from the emirates of Abu Dhabi or Dubai.

If the federal government begins to issue its own debt, the assets it claims as collateral will likely be the few federal-level revenue generators, such as the telecom Etisalat. As the northern emirates have also begun to issue debt, especially in the form of sukuks, the precedent of federal support set in the Dubai debt crisis could again become relevant. The emirate of Sharjah most recently issued a $500 million sukuk in 2016, and Ras Al Khaimah issued a $1 billion sukuk in 2015, with plans to do so again in 2017.

As the UAE moves to a five-year budget cycle, and increases its debt issuance by emirate and perhaps by the federal government, there will be pressure to release more detailed line item expenditures. As government-related entities (both federal and emirate-level) go through privatizations and seek their own funding, their balance sheets will require more transparency as well. There may be a need for more concrete and public commitments by Abu Dhabi and Dubai in support of the federal government, which might require some legislative clarity or more formal institutionalization of the practice.

This article was originally published by the Arab Gulf States Institute in Washington (AGSIW)

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.