Taking Stock: How Impressed Should we be with the Economic Recovery?

The strength of the ongoing economic recovery remains a subject of considerable debate, with the range of risks confronting the global economy unusually wide.

Even though the basic trend appears positive, the upturn has come to be repeatedly challenged by a combination of fiscal overreach and political problems. Even as the US economy seems to have embarked on a steady, albeit slow, improvement, the Greek crisis in Europe highlights the fiscal costs of the downturn and the failures of economic policy management in recent years.

The inability (or unwillingness) to commit to clear fiscal rules, especially in the presence of a long-standing predilection for exceptionally loose monetary policy, left a number of advanced economies poorly prepared for the downturn. Greece made its situation worse by tolerating inaccurate statistics which, when finally rectified, worsened an already fragile situation because of inevitable downgrades by credit rating agencies.

Even if the European Union – helped by the International Monetary Fund – appears to have successfully avoided the worst-case scenario of a Greek default and a potential disintegration of the Euro-zone, the situation is far from good. The most fiscally vulnerable Euro-zone members still face tough fiscal conditionality for any support and the necessary years of belt-tightening will naturally have an adverse effect on economic growth. The political acceptability of the austerity measures remains in considerable doubt.

The murky international picture inevitably has an impact on the Gulf region. The failure to live up to the expectations generated by its underlying macroeconomic health has been one of the most salient features of the regional economy ever since the oil price corrected sharply in the summer of 2008.

By contrast, the track record of the GCC authorities in supporting economic activity has generally exceeded expectations. The central banks quickly intervened in support of the banking sector by means of a large number of largely pre-emptive measures. As a result, the regional banking sector has been spared from major disruptions, even if some highly leveraged investment banks have faced difficulty. The Dollar pegs, unlike in 2007-2008, have offered additional support by enabling the GCC central banks to echo the loose monetary stance of the US Federal Reserve.

The performance of the GCC Ministries of Finance has been just as compelling. The extremely cautious policy making of the boom years – which stands in very favourable contrast to the performance of most Western economies – left the Gulf governments with minimal foreign debt and large reserves which they have quickly mobilized to boost aggregate demand and support key investment projects. Because of the inevitable lag in government spending, many regional economies took sharp a hit last year but now activity is increasing at a time when the global economy suddenly once again finds itself in uncertain waters.

Even as the robust recovery of the oil price – at least until very recently – has further supported the underlying macroeconomic picture, the private sector has proven almost frustratingly slow to respond. This has been in no small measure due to something resembling a total standstill in financial intermediation. Total bank credit in Saudi Arabia actually declined in 2009 for the first time since 2001. Credit offered by Saudi banks in December 2009 was SAR736.9bn, as compared SAR744.8bn at the end of 2008.

The picture in the rest of the region was broadly similar in spite of the fact that the regional banks have remained profitable throughout the crisis and for instance Saudi banks have considerable room to lend under the current regulatory limits. The situation is other parts of the financial sector little different. In spite of a minor pick-up in the first quarter of this year, IPO volumes are sharply down on past levels. The region’s nascent debt capital markets staged an impressive recovery between the second and last quarter of 2009 but have since relapsed.

How do we account for this? Two factors in particular have deterred banks from their traditional functions. Firstly, the sense of uncertainty that became virtually all-pervasive in the post-Lehman Brothers period has not fully dissipated. There are lingering concerns about problems brewing at regional companies – the notion that the woes of the Global, the Investment Dar, Saad, Al Gosaibi, and Dubai World are not limited to them. And indeed, new problems and revelations have surfaced with disturbing regularity, as if the quash any significant optimism as soon as it as manifested itself.

The impact of these difficulties has been amplified by a lack of information about the magnitude and repercussions of the problems as well as the lack of clearly defined and widely accepted mechanisms and procedures for dealing with such situations. The result has been protracted market anxiety.

Second, the loose monetary policy environment has tended to further accentuate the risk aversion of the banking sector. In an environment where deposits carry effectively zero costs and are amply available because of the risk aversion of investors, banks can opt for very low-risk strategies while still producing acceptable margins. At a time when concerns about credit worthiness and the broader economic environment persist, many banks have preferred to place their money in central bank deposits and government securities. In order for them to more actively embrace riskier ventures, overall sentiment will have to improve further or interest rates start to climb up.

Where does this leave us? In spite of the global turmoil, the situation in the Gulf is showing very tentative signs of improving. Virtually all market surveys point to improving confidence and increasing economic activity. However, the international situation does retain its potential to disappoint.

A lower oil price and stock market weakness inevitably feed through into sentiment locally and the performance of the regional markets. A protracted period of uncertainty hence risks perpetuating the somewhat disappointing track record of last year.

However, over time, investors would likely come to terms with the risks and be comforted by the relatively favourable fundamentals in the region, even if these fundamentals risk deteriorating further in the more vulnerable regional economies. The greatest concern for the Gulf economies is that 2010 will end up looking and feeling disturbingly like 2009.

While this is likely to be prevented, the region can take considerable confidence in its track record of weathering market turmoil and the range of instruments it still commands in its counter-cyclical endeavors. Progress on Dubai World and the Greek crisis, by contrast, might finally usher in a much-awaited recovery.

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