Sultanate of Oman Outlook Revised To Negative; Ratings Affirmed At ‘BBB-/A-3’

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Overview

S&P Global Ratings logoWe expect Oman’s fiscal deficit to significantly widen to close to 20% of GDP in 2016, compared with our earlier estimate of 13% of GDP. However, the sultanate’s net fiscal and external asset positions continue to support the ratings on Oman at the current level.

We are therefore affirming our ‘BBB-/A-3’ foreign and local currency sovereign credit ratings on Oman. We are revising our outlook to negative from stable. The negative outlook reflects that Oman’s fiscal consolidation might take longer than we expect. We meanwhile assume that government financing needs will largely be funded externally due to the sultanate’s narrow domestic capital markets. As a result, the economy’s external debt could exceed its liquid external assets by more than we anticipate, thereby limiting buffers to offset external pressures.

Rating Action

On Nov. 11, 2016, S&P Global Ratings revised its outlook on the Sultanate of Oman to negative from stable. At the same time, we affirmed the ‘BBB-/A-3’ long- and short-term foreign and local currency sovereign credit ratings on the sovereign.

Rationale

The outlook revision reflects that Oman’s fiscal consolidation could take longer than we expect. We meanwhile assume that government financing needs will largely be funded externally due to the sultanate’s narrow domestic capital markets. As a result, the economy’s external debt could exceed its liquid external assets by more than we anticipate, thereby limiting buffers to offset external pressures.

The widening of Oman’s current account deficit and deterioration in its external position has moved in tandem with the worsening of the government’s fiscal position. With government spending remaining relatively high in the context of the sharp decline in government oil revenues, import levels remain broadly supported at levels prior to the sharp decline in oil prices in mid-2014. However, oil export revenues have also declined sharply and we expect the current account deficit to reach double-digit levels as a percentage of GDP for most of the period to 2019. We expect these current account deficits to be largely financed by a sharp increase in government external debt. Should larger fiscal deficits and related wider current account deficits result in external debt exceeding liquid external assets to a greater
extent than we expect, we could lower the ratings. In our view, this would suggest a material weakening of Oman’s external buffers available to offset external pressures. We also note the related deterioration in the Omani government’s net asset position over the period, but expect the sovereign to remain in a small net asset position by 2019.

Large external financing needs close to 120% of current account receipts and usable reserves, coupled with an expected modest decline in foreign currency reserves, is putting pressure on Oman’s narrow net external creditor position (external debt minus liquid external assets. We expect this to decline from a strong 50% of current account receipts (CARs) in 2015 to a debtor position of 26% in 2019.

We note that Central Bank of Oman (CBO) reserve assets have increased sharply by close to US$4 billion from around US$17 billion at the end of 2015 to US$21billion as of August 2016. Most of this reserve accumulation relates to non-resident deposits previously placed in the Omani banking system in 2015, which have since been removed as a liability for the banking system and transferred to the CBO as both a liability and an asset. Given the direct
foreign claim on these assets, we have removed them from our estimate of the CBO’s usable reserves.

Oil production increased to a record high of 358 million barrels of oil in 2015, a 4% increase on the previous year, with exports rising by 5.5% to 308 million barrels in 2015. Production has been maintained at these levels in 2016. However, this increase failed to effectively mitigate the negative effect of lower oil prices, with the government’s oil revenues falling by
about 34% in 2015 and 12% in 2016. Our forecast of the general government balance includes an estimate of the government’s investment returns. Oman’s fiscal flows remain weak after posting 16% of GDP deficit in 2015. Due to weaknesses in average oil prices in the first half of 2016, Oman experienced a larger revenue gap than previously expected. We now expect that Oman’s fiscal deficit in 2016 will reach 19% of GDP before gradually declining to close to 10% by 2019. Some of the fiscal consolidation measures on revenue include raising corporate taxes, increasing fees for government services, and introducing a value-added tax in 2018 with other Gulf Cooperation Council (GCC) countries. The expenditure adjustments have included eliminating fuel subsidies; increasing gas prices; and freezing wage increases while reducing various benefits and bonuses for senior civil servants.

We marginally increased our 2016 current Brent oil price assumptions from $40 per barrel (/bbl) to $42.50/bbl, while keeping our 2017, 2018, and 2019 oil price assumptions unchanged at $45/bbl, $50/bbl, and $55/bbl, respectively (see “S&P Global Ratings Raises Its Oil Price Assumptions For The Rest Of 2016, And Assigns Oil And Natural Gas Prices For 2019,” published Sept. 20, 2016, on RatingsDirect).

Our forecasts for the annual average increase in general government debt (which is our preferred fiscal metric because in most cases it is more comprehensive than the reported headline deficit) have increased to about 9% of GDP over 2016-2019. We understand that the government will finance its deficits largely via the issuance of foreign currency debt. We now estimate that the government’s net asset position will average about 20% of GDP in
2016-2019, much reduced from 53% of GDP in 2015, and falling to about 1% by 2019. We forecast general government liquid assets at about 50% of GDP in 2016, including government deposits at the central and commercial banks, alongside the government’s investment funds, the largest component of which is the externally invested State General Reserve Fund. We consider that the government could draw on these assets were it to face temporary external pressures. In 2016, the government drew down Omani rial (OMR) 1.5 billion from the State General Reserve Fund as part of deficit financing.

We assess the Omani government’s contingent liabilities as limited, including those related to the banking system. We classify Oman’s banking sector in group ‘5’ under our Banking Industry Country Risk Assessment methodology, with group ‘1’ indicating the lowest risk and ’10’ the highest (see ” Banking Industry Country Risk Assessment: Oman,” published Dec. 15, 2015). We assess the Omani banking system as having relatively limited reliance on external funding, as banks are largely funded by domestic customer deposits. We see
moderately high vulnerability to the substantial change in the competitive environment triggered by the low oil prices. On the one hand, due to the decline in government revenues and the significance of public sector deposits in the total bank deposit base (about 36% of total deposits as of August 2016), we expect banks’ cost of funds to prove sensitive to tightening liquidity in the system. On the other hand, the corporate segment remains
narrow and lending to small and midsize enterprises is low. As a result, we expect competition among banks in the retail segment will remain intense, which could create new pressure on asset quality. The still immature domestic debt capital market remains a negative aspect of our assessment of bank funding options.

In 2015, the economy posted very high growth close to 6% real GDP growth, supported by increased investment in the oil sector with new technologies that helped increase oil production to reach 1 million barrels per day. However, continued decline in oil prices through the second half of 2015 and the first half of 2016 has resulted in lower export and fiscal receipts. Oman’s economic performance remains vulnerable to energy prices while the volume of oil production is likely to stagnate at around current levels. In Oman, the
hydrocarbon sector’s contribution to the economy fell to close to 35% of nominal GDP in 2015 following the pronounced decline in oil prices, compared with just under 50% of GDP in 2014. Hydrocarbons accounted for at least 50% of goods exports and just over 80% of government revenues in 2015.

Going ahead, we estimate trend growth in real GDP per capita (which we proxy by using 10-year weighted-average growth) averaging close to negative 2% over 2016-2019, which is well below that in most economies at similar levels of development. Our GDP per capita estimate for 2016 is $15,300, which we expect will recover only slowly to about $17,000 in 2019, compared with $20,600 on average in 2011-2014, largely due to weak real and GDP deflator growth over that period.

We expect slow progress on the government’s Omanization program–a training program for Omani citizens aimed at lowering dependence on foreign labor–due to a skills mismatch between many Omani workers in the private sector and the more attractive pay and conditions of Omanis working in the public sector. However, the government’s recent policy measures in reducing recurrent expenditure–a hiring freeze and suspension of bonuses and promotions–could provide incentives for unemployed Omanis to join the private sector.

In our view, monetary policy flexibility is limited because the Omani rial is pegged to the U.S. dollar. That said, the peg has provided a stable nominal anchor for the economy, particularly because contracts for oil, the main export, are typically priced in dollars. Reflecting the strength of the U.S. dollar versus other key currencies, since April 2014, Oman’s real effective exchange rate has appreciated by about 11%. In our view, this represents a
deterioration in international competitiveness of the country’s modest tradables sector, which is likely to dampen non-oil GDP growth, absent any offsetting factors such as improved efficiency or technological capacity. The transmission of monetary policy is constrained by Oman’s underdeveloped capital market, although we expect to see some growth in local debt and sukuk issuance over the next four years. Nevertheless, we expect the peg to be maintained over the medium term. We estimate reserve coverage (including government external liquid assets) at six months of current account payments over 2016-2019. Rules of thumb for the adequacy of reserve coverage in relation to these measures are 20% and three months, respectively. We also consider the more qualitative aspects of the GCC currency arrangements. At a time of already significant change and regional geopolitical instability, politically conservative regimes such as the GCC are unlikely to decide to increase uncertainty about their economic stability by amending this fundamental macroeconomic policy (see “Middle East And North Africa Sovereign Rating Trends 2016,” published July 13, 2016). We expect these concerns will outweigh the potential economic benefits of removing the currency peg.

Under the rule of Sultan Qaboos bin Said Al Said, the country has undergone steady improvement in human development. Oman now ranks in the 70th percentile of countries in the United Nations Development Program’s Human Development Index. Although this advancement stems largely from high hydrocarbon revenues during the sultan’s reign, we think it also results from effective policymaking, with institutions such as the Consultative Assembly (Majlis Al Shura) and The Council of State (Majlis Al Dawla) involved in the decision making process. However, the sultan exercises absolute power. While the Consultative Assembly representatives are democratically elected, all members of the Council of State are appointed directly by the Sultan, which can pose risks to the effectiveness and predictability of policymaking, in our view.

We understand that the sultan remains popular, but the eventual process of succession remains untested because the country lacks recent experience in smooth transitions of power. Although we expect that succession will be smooth, without any radical policy shifts, we cannot rule out the possibility that Oman could experience a disruptive period of uncertainty if the royal family does not quickly agree on a successor. We do not anticipate that the conflict in neighboring Yemen will affect Oman’s creditworthiness, because it appears unlikely to spill over into Oman, which has remained neutral in the conflict.

Our ratings on Oman are supported by our assumption that it could receive additional support from other GCC neighbors (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and United Arab Emirates), in the event of further significant deterioration in its fiscal or external position.

Outlook

The negative outlook reflects that Oman’s fiscal consolidation might take longer than we expect. We meanwhile assume that government financing needs will largely be funded externally due to its narrow domestic capital markets. As a result, the economy’s external debt could exceed its liquid external assets by more than we anticipate, thereby limiting buffers to offset external pressures.

We could consider lowering the ratings if Oman’s net external position deteriorated more quickly than we currently forecast, perhaps through wider fiscal deficits than we expect. We could also lower the ratings if Oman’s debt-financing risks rose significantly through a combination of substantially higher interest costs as a proportion of revenues and a sharp increase in the share of foreign currency and nonresident holdings of total government debt.

We could also lower the ratings if we saw increasing signs of succession risks that were likely to disrupt governance standards or the functioning of institutions.

We could consider revising the outlook to stable if the foundations of economic growth in Oman strengthened–raising per capita income levels–or if our forecasts for Oman’s fiscal and external positions improved substantially compared with our current projections.