Economic Research Forum (ERF)

A stability mechanism for the Gulf countries

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Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates face the dual shock of the pandemic and the oil price collapse. Drawing lessons from the European Union’s response to its sovereign debt crisis, this column proposes a stability mechanism for the countries of the Gulf Cooperation Council aimed at institutionalising solidarity and fiscal discipline among them. The mechanism would issue some special obligations and lend the proceeds at low rates to its members, requiring them to undertake economic reforms in return.

In a nutshell

A set-up similar to Europe’s debt-guaranteeing programme can help the GCC to ensure resilience and sustainability of the finances of all of its member countries.

The GCC Stability Mechanism would issue short-term bonds and transform maturities by lending long-term at a low rate, leveraging its balance sheet to help countries facing difficulties; the borrowing should be as short as possible, while maintaining a rich and reliable investor base.

The GCC Stability Mechanism should be complemented by a competition commission to ensure the borrowing country’s commitment to structural reforms and help spur growth and innovation.

The countries of the Gulf Cooperation Council (GCC) – Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates (UAE) – face the dual shock of a pandemic caused by the novel coronavirus and a persistent collapse in oil prices.

Because of the dual shock, the growth downgrade for the GCC as a whole is 7.5 percentage points in 2020 (World Bank, 2020). This can be considered as the cost of the dual shock (Arezki et al, 2020). But there is wide uncertainty about the estimate, which could be even higher.

The GCC countries must act collectively and boldly today to reduce the risk of an economic depression. A delayed and tenuous response may force authorities to spend even more in the future – among other things, to rescue cash-strapped members, as non-performing loans and bankruptcies become widespread (Ari et al, 2020). A powerful joint mechanism to cushion the blow, and ensure solidarity and stability of the GCC is warranted.

The need for solidarity and stability

So far, GCC countries acting individually have softened the effect of the dual shock. Policy responses have included health interventions and liquidity injections into firms (El-Saharty et al, 2020). Many GCC countries have fiscal space they have been able to tap. For example, taking advantage of low interest rates, Qatar and the UAE raised US$10 billion and US$7 billion respectively to address liquidity issues in the middle of the Covid-19 crisis.

But some GCC members, especially Bahrain and Oman, face large balance of payments and fiscal deficits, and have high sovereign risk premia. For those countries, additional borrowing on international capital markets may be expensive and difficult. The GCC should show solidarity with them while restoring fiscal stability and growth in the medium run.

Tirole (2015) provides a formal framework to show that solidarity between countries, which naturally emerged from fear of spillovers, can be achieved through debt mutualisation. The latter is in the interest of all parties including of the rich rescuer, especially if the resulting spillovers are feared to be large. In line with that rationale, it is often argued that solidarity mechanisms in the European Union (EU) stem from the fact a member’s sovereign default will be far more costly than providing emergency assistance to avoid default (Corsetti et al, 2020).

By regionalising fiscal rules and competition policies, the GCC would lay the groundwork for a mechanism that moves away from local politics, and acts in coordination and jointly for all six members. The mechanism would borrow from international capital markets on behalf of the members, and lend on the proceeds to member countries, requiring borrowers to undertake economic reforms.

In other words, the mechanism would be an intermediary between foreign and local lenders and GCC public borrowers – providing assurance to foreign and local creditors that the loans will be repaid, while allowing its borrowing members to obtain credit at rates they could not obtain on their own on debt markets, if they could borrow at all.

(In the euro area a large share of bondholders in a similar mechanism are residents. In the GCC, bonds from such mechanism could be considered as regional ‘safe assets’, and as such residents, together with regional and global investors, would thus have an interest in holding them.)

Lessons from Europe

During the European sovereign debt crisis that began more than a decade ago, funds had to be lent to states that were members of the EU. When Greece started to have serious problems, the EU relied on bilateral loans, structured following the blueprint of the International Monetary Fund (IMF). Over time, euro area governments developed their own crisis resolution framework, moving away from bilateral loans and creating jointly managed institutions.

First, in May 2010, they created the European Financial Stabilization Mechanism (EFSM), the European Financial Stability Facility (EFSF), and two temporary bailout funds. At the end of 2012, the European Stability Mechanism (ESM) was established as the permanent bailout fund for euro area sovereigns (See Corsetti et al, 2020, for a detailed account of these developments).

Together, the EFSF/EFSM/ESM lent hundreds of billions of euros to several countries that, in turn, were required to undertake reform programmes. These loans, which are currently being repaid (in some cases in advance), have come at no cost to European taxpayers, and have helped countries save billions in interest payments.

Gourinchas et al (2020) estimate net present value transfers from the EU to Cyprus, Greece, Ireland, Portugal and Spain, ranging from roughly 0.5% (Ireland) to 43% (Greece) of 2011 output during the euro area crisis. The European bailout funds finances its loans by issuing debt instruments in capital markets. These debt instruments are backed by guarantees (EFSF and EFSM) and public capital (ESM), allowing them to borrow (and on lend) at AAA rates (lowest borrowing costs).

A critical element of the ESM strategy is that its lending and funding teams manage the institution’s balance sheet strategically. ESM undertakes a strong maturity transformation – like private financial intermediaries – by borrowing and rolling over short- and medium-term debt and lending to members longer-term maturities at the lower (shorter-term) rates at which it funds itself (Corsetti and Erce, 2020).

Of course, there is a limit to the amount of bills (with maturities below a year) that can be sold. In fact, the ESM funding strategy shows that issuance at different points of the yield curve is important to develop a deep and loyal investor base (some ESM bonds have a 45-year maturity). The ESM sells bills and bonds to investors all over the world.

Once the money is in the ESM accounts, the loans are credited on countries, under conditions whose stringency depends on the fundamentals of the borrowing country. To fight Covid-19, Europeans just agreed to allow the ESM to make loans without conditions for up to 2% of a borrowing country’s GDP (Corsetti and Erce, 2020).

Each step in a country’s loan programme is carefully scrutinised by mission chiefs, who regularly visit the programme countries. Conditionality not only plays out during the programmes: Europe has a full package of fiscal rules that must be met once a country has emerged from a programme.

The road ahead

A set-up similar to Europe’s debt guaranteeing programme can help the GCC to ensure resilience and sustainability of the finances of all of its member countries.

The current dual shock presents GCC countries with an emergency not unlike the sovereign debt crisis in Europe. The GCC secretariat can spearhead a campaign to help members realise that a joint guarantee on the debt issuance of this mechanism can serve as a powerful ‘bazooka’ in times of crisis, while fostering fiscal discipline over the medium run.

That is important because, if well designed, programmes granted to borrowing countries should serve as a catalyst to achieving an overall improvement in economic conditions. This regional mechanism can add a regional layer to the global safety net provided by the IMF and regional and global development banks.

Member states would have to contribute paid-in capital and/or guarantees. To borrow US$100 billion at AAA rates, the mechanism would need either capital for 100 billion (like ESM), a joint guarantee by all countries (like EFSM), or an over-provision of guarantees by the stronger rated members (like EFSF).

While the current liquidity squeeze can make it difficult for member countries to contribute capital, sovereign wealth funds and Arab funds could also provide capital to the mechanism – although this would require amendments to their mandates to allow them to operate within the GCC. The contributed capital could be in the form of Treasury securities, other very liquid assets, a lien on future oil revenues, or some combination.

The provision of jointly guaranteed emergency support has another advantage: reducing the risk of a speculative spread that could open between members. Because some GCC members used to bail out Bahrain and Oman with grants, the mechanism would have value to all GCC countries. As mentioned above, it is in the self-interest of other GCC countries to provide such debt mutualisation considering the potential large spillovers stemming from individual member’s default.

To reach a relative size that is similar to the ESM, the GCC Stability Mechanism (GCCSM) could manage prudently the equivalent of 0.45% of the GCC’s GDP. That would be the equivalent of US$18 billion of paid in capital by GCC member states. The paid-in capital would contribute to ensuring GCCSM’s creditworthiness – essential to supporting its capacity to borrow on financial markets at favourable rates.

Raising the capital could be done on a gradual basis. In fact, following the ESM model, capital could be promised without actually being fully disbursed. The ESM, for example, has only US$90 billion in disbursed capital, but almost US$700 billion of promised capital – the difference being callable capital. This arrangement would allow all members to borrow, depending on their circumstances and always in exchange for a commitment to fiscal discipline.

In short, the GCCSM would issue short-term bonds and transform maturities by lending long-term at a low rate – leveraging its balance sheet to help countries facing difficulties. The borrowing should be as short as possible, while maintaining a rich and reliable investor base.

The GCCSM would need to be complemented by a competition commission to ensure the borrowing country’s commitment to structural reforms and help spur growth and innovation. Indeed, the competition body would work hand-in-hand with GCCSM to improve competition by making it easier for firms to enter and leave markets (contestability) as part of its structural conditionality.

Further reading

Arezki, Rabah, Rachel Yuting Fan and Ha Nguyen (2020) ‘Covid-10 and Oil Price Collapse: Coping with a Dual Shock in the Gulf Cooperation Council’, ERF Policy Brief No. 52.

Ari, Anil, Sophia Chen and Lev Ratnovski (2020) ‘COVID-19 and non-performing loans: Lessons from past crises’, VoxEU.org, 30 May 2020.

Corsetti, Giancarlo, Aitor Erce and Tim Uy (2020) ‘Official sector lending in the Euro Area’, Review of International Organizations.

Corsetti, Giancarlo, and Aitor Erce (2020) ‘Maturity, seniority and size: Make sure the ESM’s pandemic crisis support is fit for purpose!’, VoxEU.org, 29 April 2020

Gourinchas, P-O, Philippe Martin and Todd Messer (2020). ‘The Economics of Sovereign Debt, Bailouts and the Eurozone Crisis’, NBER Working Paper No. 27403.

Sameh El-Saharty, Samen, Igor Kheyfets, Christopher Herbst .and Mohamed Ihsan Ajwad (2020). ‘The GCC Countries’ Responses to COVID-19’, World Bank.

Tirole, Jean (2015) ’Country Solidarity in Sovereign Crises’, American Economic Review 105(8): 2333-63.

World Bank (2020) Middle East and North Africa Crisis Tracker, 18 November.

 

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