Abu Dhabi and Dubai: Macro & Corporate Outlook It is not all about oil

• The UAE stands out among its GCC peers as best equipped to cope with potentially prolonged weakness in oil prices given its diversified economy and solid buffers, in our view. Banking sector liquidity may be affected, but LDR is below 100%, while sovereign support and continued deleveraging in the corporate sector should help.

• Abu Dhabi’s corporates should continue to benefit from supportive technicals. A state-driven focus on deleveraging should continue to result in lower bond issuance by Abu Dhabi large corporates in 2015. This, coupled with ample local bank liquidity and a shortage of sovereign paper, will continue to support most of Abu Dhabi quasi spreads despite lower oil prices, in our view. That said, we believe already tight spreads in the complex provide little room for further spread compression; we maintain Market Weight ratings on ALDAR and IPIC and an Underweight on Mubadala. In this report, we downgrade TAQA to Underweight from Market Weight as we believe its current spread valuations do not account for the effect of lower prices on its leverage yet.

• Dubai’s economic recovery is unlikely to be dented by lower oil prices. While preparations for the Expo 2020 are ongoing, we expect GDP growth to reach about 5.7% y/y in 2014 and 2015 and accelerate only thereafter. We expect the Dubai government to continue its fiscal consolidation. Along with higher growth, fiscal improvements should allow government debt-to-GDP to continue declining in 2014 and 2015.

• Dubai non-financial FX debt (c.$104bn at the end of November 2014, largely unchanged y/y) remains large, but its burden appears more manageable with the supportive macroeconomic growth set to persist in the medium term, efforts by some of Dubai’s indebted GREs to alleviate their debt burdens, more conservative bond issuance plans by large corporates and our expectations of continued Abu Dhabi’s support.

• Dubai’s corporate spreads are well anchored despite strong performance over the past 12 months, given our positive view on the economic growth and our expectations of bond redemptions by Dubai’s large corporates. Our top picks in the Dubai space are DAMACR ‘19s, DUBAIH ‘17s, and JAFZSK ‘19s.

• We initiate on Investment Corporate of Dubai (INVCOR) with a Market Weight rating in this report (see page 21). 100% owned by Dubai’s government, ICD owns stakes in a number of the best performing corporates and banks in Dubai, underpinning its strong dividend capacity and its important strategic role in the emirate. These positives are, however, balanced by the risks related to its poor disclosure, which leaves us with limited comfort on ICD’s credit profile at present, despite the currently compelling spread valuations.

Diversification helps mitigate oil price challenges

We think the UAE stands out among its GCC peers as the best equipped to cope with potentially prolonged weakness in oil prices given its diversified economy and solid buffers. Banking sector liquidity may be affected, but LDR is below 100%, while sovereign support and continued deleveraging in the corporate sector should help. Dubai’s diversified growth model and its improved growth and fiscal prospects around Expo 2020 should limit the impact of lower oil prices.

Economic diversification efforts are paying off, strengthening UAE’s profile The renewed possibility of a prolonged period of low oil prices highlights the key challenges posed by the limited progress on diversification of export and fiscal revenue bases in many GCC countries, and their vulnerabilities to extreme oil price volatility. Among those countries, we think the UAE stands out as the best equipped to face oil price headwinds and is the most capable of adapting to the structural changes in the global oil markets.

Ongoing official efforts to diversify the UAE’s economic structure and encourage the expansion of the non-hydrocarbon sectors, notably in Dubai, have seen the share of the non-hydrocarbon sector increase from 44.7% of GDP in 2000 to 61.1% of GDP in 2013 (Figure 1). Diversification efforts have also contributed to containing the role of the public sector in driving non-oil GDP growth. After rising sharply in 2009 to 30.6% of non-oil GDP, the share of public-sector consumption and investment in total non-oil GDP fell back to 25.3% by 2013. This compares with 56.6% of non-oil GDP in Saudi Arabia and underscores the reduced role of the public sector in steering UAE’s economic activity, although it remains important (Figure 2).

This reduced reliance on oil revenues is reflected in the increasing share of non-hydrocarbon in the UAE’s exports and fiscal revenues (Figure 3 and Figure 4). This is partly explained by the growing share of investment income earned on net foreign assets, as well as the rapid expansion in non-oil exports of goods and services (notably from Dubai). The diversification of the economy and the composition of its resource base have also allowed the UAE to keep its external breakeven oil price around USD64/bbl, based on exports of 2.6 mbpd in 2014 (Figure 5), while its fiscal breakeven oil price has fallen from USD93/bbl to USD79/bbl over the past three years (Figure 6).

In other words, and assuming UAE’s oil export volumes over 2014/2015 remain constant, we estimate that the country will still enjoy a large CA surplus as long as the average oil price remains above USD64/bbl. As such, the impact of falling oil prices on the UAE’s external and fiscal positions is likely to remain manageable, in our view. We have revised our forecasts for the current account surplus to 12.3% and 6.8% of GDP, respectively, in 2014 and 2015, based on our commodity team’s estimate of Brent prices falling from USD99/bbl to USD72/bbl. On the fiscal front, however, we expect the Abu Dhabi government to slow its expenditure growth (ie, through announced subsidy cuts and the review of some investment projects) and possibly revisit and scale back its generous aid to neighbouring countries. This would allow the UAE’s consolidated budget to maintain a modest fiscal surplus of 6.1% and 5.4% of GDP in 2014 and 2015 respectively (see Gulf States Quarterly Outlook: Adjusting to an elusive floor, 5 December 2014, for revised forecasts).
In addition to the above, the UAE’s fiscal capacity has been bolstered and its financial buffers strengthened significantly. The accumulation of large external and fiscal surpluses over the past decade and strategic management of its net foreign assets helped to increase FX reserves at the central bank and expand the asset base of Abu Dhabi’s Sovereign Wealth Fund (ADIA) to almost 120% of the UAE’s GDP (our estimate as at end-2014)(Figure 7). Finally, UAE’s overall public debt remains low at less than 12% of GDP providing ample fiscal space if necessary to meet additional financing needs (Figure 8).

Banking liquidity likely to continue support growth despite falling oil prices Recent improvements in the performance of the banking sector supports our view on the likely limited impact of lower oil prices on the UAE economy. The latest available data reported by Moody’s highlight slight improvement in the banks’ profitability on the back of higher asset growth and more moderate pace of provisioning. Asset growth crept up to 15.4% y/y in Q3 14 up from 11.9% y/y in 2013 and 8.3% y/y in 2012. In particular, loan growth during the first nine months of the year was 8.6% y/y, accelerating from 7.7% y/y at end-2013 and 3.7% at end-2012. Notwithstanding the parallel acceleration in deposit growth the Loan to Deposit Ratio (LDR) stood at 97.7% at end-September 2014 (Figure 9), lower than the 108% level registered in 2008 when oil prices fell sharply and caused a liquidity squeeze in the system. This is likely to continue supporting economic growth, notably in Dubai as the need for funding Expo 2020-related projects picks up steam, although it is worth noting that liquidity is more ample in Abu Dhabi than in Dubai based banks.

Buoyant economic growth and expanding loan portfolios resulted in improvement in banks’ asset quality, along with continued deleveraging of GREs and strengthened regulatory frameworks. NPL ratios declined to 8.7% y/y compared to 9.2% in 2013 (Figure 10) as reported by Moody’s. For the whole year, we expect new NPL formation to continue to recede, aided by an improved operating environment and greater scrutiny in credit underwriting practices. Finally reported capital adequacy (Tier 1) ratios stood at 15.9% at end September, reflecting a solid capital base, despite a slight retreat from its 16.4% level in 2013. While a fall in oil prices may affect deposit inflows (namely in Abu Dhabi banks through the size of government deposits), the sovereign ownership of many of these banks, as well as the ability and willingness of the sovereign to intervene (as witnessed in the past) will ensure that both their liquidity and capital remains supported, we think. Dubai’s growth model and improved performance limits oil price impact Dubai’s diversified and buoyant economic activity ahead of Expo 2020 are likely to mitigate the impact of falling oil prices, as much of the investments are likely to be driven by the private sector with only a limited contribution from government, as we discussed in Dubai: gearing for 2020. After registering growth of 4.6% y/y in 2013, growth in 2014 continued unabated. Q1 14 GDP growth stood at 4.2% y/y slightly higher than growth in Q1 13. We estimate growth had accelerated over the past few quarters based on various available economic activity indicators.

During the first nine months of the year, the number of business licences granted rose by 14.8% y/y in 2014, ushering in prospective increases in investments in the year to come (Figure 11). Similarly, passenger traffic through Dubai’s airport rose 9.9% y/y in the first nine months of the year to 52.4, up from 49.4mn last year. Dubai Airports World expects it to grow to 78.4mn in 2015 and 103.5 mn in 2020, compared with 57.7mn in 2012. In parallel, tourism continues to flourish with the number of hotel guests increasing by 26% y/y in the first half of the year. Meanwhile trade activity through Dubai’s ports, airports and free zones accelerated. With signs of buoyant activity increasingly becoming broad based across sectors, we expect growth to reach 5.7% y/y in 2014 and 2015 and to accelerate thereafter as the final plans for the Expo are expected to be endorsed in Q4 15 (Figure 12).

On the fiscal front, Dubai’s public finances continue to improve. Fiscal revenues rose strongly in 2013, particularly non-tax revenues, which were 22.4% higher than the budget assumption and 18.1% above 2012’s level, driven by the acceleration in growth and trend increase in population. Expenditure growth also remains modest, notably current spending.

As such, the overall fiscal balance registered a smaller-than-budgeted deficit of only 0% of GDP compared to a deficit of 0.4% in 2012. In 2014, we expect the fiscal accounts to register a surplus of 0.4% of GDP as expenditure growth continues to be subdued until the final investment plans related to Expo 2020 are officially approved in October 2015. Accordingly, while we think the fiscal surplus could increase in 2014 and 2015, an expected acceleration in investment spending during the 2015-2019 period for Expo 2020-related projects is likely to result in lower surpluses from 2016 (Figure 13 and Figure 14). However, the realisation of small primary surpluses, along with higher growth, bodes well for keeping Dubai’s public debt ratio on a downward trending path, as highlighted in Figure 15.