US-Iran Tensions: A Threat To Gulf Ratings

The rising tensions between the US and Iran is threatening economic activities in the Middle East and can potentially disrupt the flow of oil due to the suspension of shipping activities in the Strait of Hormuz. Tensions in the Arabian Gulf intensified in May 2019 after exemptions from sanctions ended on countries buying oil from Iran, which is the country’s main source of revenue.

The Catalyst

The attacks on foreign crude oil tankers near the Arabian Gulf, the deployment of US troops as well as the US Patriot missile system and surveillance warplanes is threatening to destabilise the Middle East, a region that is already unpredictable.

The US announcement of sanctions on countries that depends on Iranian oil such as Turkey and China was followed by Houthis’ attack on vital oil supply systems in Saudi Arabia, further increasing fears among investors as the Gulf tension threatens crude oil shipments through the Strait of Hormuz.

In a recent report, S&P Global highlighted that the Strait of Hormuz is a critical shipping route for almost one-third of the world’s crude oil supplies, and the vast majority of hydro bon exports from Saudi Arabia, Qatar (LNG), Abu Dhabi as well as Kuwait, Iraq, and Bahrain.

The tension in the Gulf marked by the US’s withdrawal from the Iran nuclear deal in May 2018 reached a boiling point in recent weeks— particularly after the recent downing of an unmanned US drone by Iran’s Revolutionary Guard.

According to S&P, the escalation of tensions in the region could weigh on the creditworthiness of GCC sovereigns and have consequences for Gulf-based entities, possibly banks and some nonfinancial companies.

The effects of a military action

Some GCC countries are expected to be affected more than others, with Abu Dhabi, Kuwait, Qatar and Saudi Arabia’s economy expected to remain stable owing to their large stocks of external assets.

Abu Dhabi and Saudi Arabia have alternative export channels that could partly alleviate the impact of a blockage of the Strait of Hormuz on their economies. Abu Dhabi’s pipeline system can bypass the Strait and deliver up to 1.6 million barrels of oil per day (about 50 per cent of production) directly to a terminal on the Indian Ocean, said S&P.

Similarly, Saudi Arabia’s pipeline system can pump five million barrels per day, about 50 per cent of its daily oil production, from its Eastern Province to a Red Sea port, highlighted the ratings agency.

The current scenario is expected to affect Gulf sovereign ratings due to the increase in funding costs, disruption to foreign direct investment (FDI) flows, equity investments, expat activity, tourism and bank deposit outflows which could damage economic growth prospects and harm government fiscal positions.

S&P explained that prolonged tensions will make global oil prices more volatile and weaken economic growth, while an increase in oil prices would offset some of the impact of capital outflows and weaker economic growth.

Bahrain appears to be the most vulnerable sovereign to the consequences of the US-Iran tensions.  This is because the Kingdom has a weak fiscal position and its economy has by far the highest gross external financing needs, totalling more than 300 per cent of current account receipts plus usable reserves, reflecting its large banking system.  

Similar to other GCC countries, Oman has a large government debt position as well as high fiscal and external funding needs.

The Sultanate is less likely to be affected by military action owing to its geographic location and neutral foreign policy. However, its funding costs have increased in line with those across the region, as seen by the large spread in its 10-year government bond yield.

Iraq is less vulnerable to the current tension and security concerns across the region because of its low debt costs and funding needs, which are met by domestic banks and concessional lending, limited amount of short-term external liabilities and less reliance on FDI financing.

However, Iraq’s position can be counterbalanced by a potential deterioration in its security situation, which has improved since the defeat of ISIS, potentially through the reported Iranian influence on Iraqi institutions, added S&P.

The Gulf’s geopolitical standoff poses a liquidity risk for banking systems in the UAE, Qatar and Bahrain as deposit outflows from expatriate populations can be unpredictable. According to S&P, there are no official statistics on the proportion of expatriate deposits in GCC’s banking system deposit bases. However, given the structure of the populations, the contribution is not negligible.

The heightening US-Iran war of words is likely to force a large population of expats in the region to return to their home countries and most of the expats are expected to go with a significant portion of their deposits. S&P suggests that retail deposits (from citizens and expatriates) in the UAE and Qatar account for approximately one-quarter of the total deposits in their respective banking systems.

Ratings

In March, S&P affirmed its A-/A-2 long and short-term foreign as well as local currency sovereign credit ratings for Saudi Arabia, with a stable outlook. The rating agency stated that the stable outlook reflected its expectation that the Kingdom will maintain its current moderate economic growth as well as retain strong government and external balance sheets over the next two years despite wider fiscal deficits.

Furthermore, Moody’s also affirmed its Aa2 long-term issuer and senior unsecured ratings of Abu Dhabi, with a stable outlook, indicating that any economic risks to the Emirate’s economy are broadly balanced, supported by current oil prices and upside potential from continuing economic diversification efforts.

Abu Dhabi’s fiscal strength is underpinned by the Government’s strong balance sheet and assets under management of the Abu Dhabi Investment Authority (ADIA), which are estimated to be more than $590 billion as of 2018, far exceeding the total liabilities in the wider public sector.

However, the current war of words and close calls between the US and Iran pose a serious threat to Oman. The Sultanate was given 12 months by S&P to steady its public finances and decrease its exposure to external debt or risk an even deeper descent into junk. In April 2019, S&P changed the Sultanate’s outlook to negative while affirming its debt score at BB, two levels below investment grade.

The Outlook

Although tensions have increased, both President Trump and President Rouhani have reiterated that they do not want war and a direct military conflict is unlikely despite the recent downing of the US drone and reports that the US had ordered an airstrike on Tehran.

A direct conflict will economically, socially and politically destabilise the entire region. According to S&P, the increased international pressure to avoid open conflict will help moderate the situation.

The domestic politics in the US also reduces the likelihood of open conflict with Iran, which present complex and avoidable political issues during the runup to the 2020 US presidential elections. US National Security Advisor John Bolton said Iran is increasing aggressive efforts in the Middle East and pursuing nuclear weapons, setting a hawkish tone on the eve of a regional security summit with his Russian and Israeli counterparts.

GCC economies are among the fastest growing in the emerging markets sector largely due to the rise in oil prices which oil prices is expected to trade between $65 and $85 per barrel accounts for three-quarters of the six-nation bloc’s spending, and any instability associated with oil prices pose a serious threat to the sovereign ratings as well as those of major institutions such as banks, oil firms and wealth funds.