US recession effects in GCC economies

The negatives arising from the US recession should not be ignored, at least in the first half of the year, in GCC (Gulf Cooperation Council) economies, but growth momentum should still be maintained

Will slowdown in the US spill over to the GCC?

Despite the apparent resilience of GCC economies to the fall in crude oil prices and the softening in US economic growth back in late 2006, concerns have been recently voiced over the impact of a stagnant or contracting US economy on the performance of GCC economies in 2008, via the conventional crude oil price channel. We believe these concerns are overplayed.

To start with, we cannot downgrade the downside risks to the US economy in 2008, at least during the first half of the year. Recently released macroeconomic data have been mostly negative and suggestive of rather strong spillover effects to output and employment growth.

Notwithstanding the ravaging effects of the subprime crisis on US financial institutions, the unwinding of the housing market bubble continued to spill over to the real economy in the form of dwindling existing and new home sales, declining investments in residential housing, softening growth in non-farm payroll and ultimately disappointing retail sales figures.

Moreover, the aggressiveness of the policy response in itself has further raised market concerns as to the real magnitude of the crisis. For the first time since the deep recession of 1982, the Federal Reserve slashed the Fed Funds rate 75 basis points in a rare off-meeting move on January 22 .

Furthermore, President Bush urged the Congress to approve a fiscal rescue package equivalent to nearly 1 per cent of GDP. As recession fears shrouded investor sentiment, benchmark crude oil prices softened to around $90 per barrel after hitting an all-time high of $100 on January 2 in intra-day trading.

This immediately brought back to memory the sharp fall of crude oil prices in late 2006, when benchmark crude oil prices plummeted to around $50 per barrel after hitting the then new record-high of $77 in August 2006.

Before delving into the reasons why we think that crude oil prices (and hence the health of GCC economies) will remain unscathed in 2008, we can start by spelling out the key differences between the patterns of volatility in crude oil prices and the US economy in 2006 and at present.
First, the fall in crude oil prices in late 2006 materialized against the backdrop of an increase in Opec production and higher OECD commercial inventories, whereas the fall in crude oil prices in early 2008 is coming against the backdrop of lower OECD crude oil inventory levels, and tight market supply/demand balances.

In the fourth quarter of 2007, average daily Opec production stood at 31.7 millions barrels per day, and it is forecast to increase to 32.6 million bpd in 2008, mainly driven by the increase in Saudi Arabia crude oil production.

Nonetheless, the increase in Opec production is forecast to be fully absorbed by rising demand from non-OECD consumers, mainly China and India, which will leave supply/demand imbalances tight throughout the year.

Moreover, the US Energy Information Administration (EIA) has also noted in its latest Short-term Energy Outlook that OECD crude oil inventory levels were nearly 19 million barrels below their 5-year average by end-2007, compared to 100 million barrels above their 5-year average by end-2006. This is also likely to help support the price of oil throughout the course of 2008.

Second, although the downside risks to the US economic outlook have increased considerably since mid-2007, the policy response has so far been starkly different to that in 2006.
Back in 2006, conflicting economic data constrained the Fed's ability to focus on controlling inflation or stimulating growth, a situation that translated into policy neutrality (i.e. stable Fed Funds rate) from mid-2006 until September 2007.

In late 2007 and early 2008 both the Fed and President Bush's administration have become strictly growth-biased. Simply put, there is consensus on the symptoms, diagnosis and cure.
But what if the Fed monetary stimulus policy and the fiscal rescue package failed in lifting the US economy back to its trend-growth path? Will crude oil prices plunge and ripple through to weaker economic performance in the GCC?

We believe the answer is no, owing to the following reasons: - First, history tells us that US recessions, formally defined as two consecutive quarters of negative real GDP growth rates, have become milder in magnitude and shorter in duration.

From the recession of 1982 until 2007, the National Bureau of Economic Research records only two recessions in the US during 1990/91 and 2001.

These recessions have been relatively mild, and only lasted for less than a year each. This suggests that a possible recession in 2008, given the magnitude of the policy response stated above, should be relatively mild and last until the end of the year at the most.

Second, although the US remains the largest economy in the world, its role as a key driver of global economic growth has been relatively declining.

In its latest revision of Purchasing Power Parity (PPP)-based GDP figures, the IMF estimated the share of the US economy in the global economy in 2007 at 19.3 per cent but the combined shares of China and India at 15.5 per cent, ranking them second and fourth largest economies in the world respectively.

Most importantly, China and India contributed almost half of the global economic growth rate for 2007, whereas the US contributed nearly 7 per cent. The latest IMF update on global economic growth published on January 29 also forecasts only a moderate softening of growth in China, the second largest consumer of crude oil, from a red-hot 11.4 per cent in 2007 to 10 per cent in 2008.

Third, data show that average daily global crude oil consumption has not declined in any calendar year since the recession of 1982 in the US. From 1982 until present, average global daily consumption of crude oil has steadily increased, even during the short-lived recessions of the 1990/91 and 2001.

Outlook

In fact, the EIA's latest Short-term Energy Outlook continues to forecast crude oil consumption to grow 1.6 million bpd in 2008, up from 1 million bd in 2007.

The continued growth in crude oil demand amid US recessions has been driven by the relatively low income-elasticity of demand in the US, as well as the rise in consumption by other OECD and emerging market economies, particularly China and India.

Well, so far so good. But what if the 2008 recession proved to be more like the 1982 recession rather than 1990/91 or 2001? Again, we believe there are additional two lines of defence that could sustain crude oil prices on an upward track through a one-to two-year period of global economic slowdown.

The first line of defence is the existence of limited spare capacity amongst Opec producers (except in Saudi Arabia), coupled with the increase in the marginal cost of crude oil production and delay in capacity additions in non-Opec countries.

The EIA notes that spare capacity in Opec stood at around 2 million bpd in 2007, which is mostly held by Saudi Arabia.

However, given Opec's apparent commitment to maintain current quotas, we rule out a significant increase in Opec production in 2008. On the other hand, the marginal cost of production has been steadily rising in non-Opec countries, owing to the increase in construction and labour costs as well as the gradual ageing of cheaply-drilled wells.

In Canada, the second-largest holder of crude oil reserves in the world after the GCC, the marginal cost of oil production has reportedly increased to around $70 per barrel in 2007.
Finally, the EIA also notes that non-Opec capacity-addition plans have been historically very sensitive to shortages in labour and equipment as well as uncertainty regarding the rate of decline in current production. The second line of defence is the persistence of geopolitical risk in key oil-producing regions.

Notwithstanding the persistence of classical geo-political risks in the Middle East and West Africa, the wave of nationalizations that has recently swept major oil-producing countries (Russia, Venezuela and Ecuador, for example) has been also translated into a gradual deterioration in the investment environment.

If not counterbalanced by domestic capital and technology, the weaker inflow of foreign direct investment into the crude oil sector in these countries may have negative repercussions on production volumes and capacity-addition plans over the medium term.

What if these lines of defences also fall? Will the plunge in crude oil prices put a damper on economic growth in the region in 2008? We believe the answer is again no, unless in the very unlikely scenario that crude oil prices break down through the $40-$50 per barrel levels for a protracted period of time.

The presence of sizable foreign reserve cushions and enhanced access to global capital markets across most GCC states provide the region's governments with ample expenditure-smoothing capabilities during times of financial strain.

By the end of 2007, we estimate the GCC holdings of foreign reserve assets, whether held in the banking system or via sovereign wealth funds, will hover around $2 trillion, nearly 4-5 per cent of global GDP. Even under conditions of temporary stress, the high credit standing of the GCC (A-AA, with stable outlooks) allows easy access to global financial markets.

The reader may be reminded that the emirates of Abu Dhabi, Dubai and Ras Al Khaimah have lately sought sovereign credit ratings from S&P to enhance their access to global financial markets.

Bottom line: inasmuch as crude oil prices decouple from the US business cycle and GCC governments build expenditure-smoothing capabilities, the growth momentum of GCC economies will weather negative global demand shocks in 2008.

In our opinion, the key question that will be facing GCC policymakers in 2008 is not how to sustain growth but rather how to manage inflationary growth.