Jun. 11 2019 — Tensions in the Arabian Gulf increased in May 2019 after exemptions from sanctions ended on countries buying oil from Iran. Since then, Iran has been accused of retaliating against the sanctions by allegedly damaging infrastructure and commercial shipping vessels in the Gulf. Also, Iran is now threatening to restart its nuclear program. Furthermore, the U.S. government has announced that it is sending 1,500 more troops to the Middle East, in addition to the naval and air resources already present in the region. Investors are asking how we view the situation from a credit perspective and how our ratings could be affected.
Why haven't there been any rating actions so far on Gulf entities?
We have not changed any of our ratings or outlooks on Gulf-region issuers thus far mainly because, in our base case, we do not expect direct military conflict between the U.S. and Iran or their regional allies. Moreover, we expect the Strait of Hormuz to remain open. In fact, our ratings on Gulf sovereigns already take into account the region's current geopolitical volatility.
Why don't you expect direct conflict?
Although tensions have increased, both President Trump and President Rouhani have reiterated that they do not want war. A direct conflict would be economically, socially, and politically destabilizing for the entire region, including for U.S.-Gulf allies. We believe that international pressure to avoid open conflict will also help moderate the situation.
From the perspective of U.S. domestic politics, we think that open conflict with Iran could present complex and avoidable political issues during the run-up to the 2020 U.S. presidential elections. On the Iranian side, we think Iran's government would want to sidestep conflict that could compound mounting economic hardship following the imposition of U.S.-led sanctions.
What could cause tensions to escalate?
The apparent lack of diplomatic relations between the U.S. and Iran could increase the possibility of rising tensions. Despite likely mediation attempts from the international community, we see the possibility of tensions building between the respective regional allies of Iran and the U.S., with possible spill-over effects in Iraq, Syria, and Yemen. Gulf Cooperation Council (GCC) countries might become further involved, and the complex politics in Israel, Lebanon, and Jordan could also be affected. The consequences could be even more unpredictable should Russian support for Iran be more pronounced.
Iran has informed the European signatories to the 2015 Joint Comprehensive Plan of Action (JCPOA; the nuclear non-proliferation deal) that they have until early July 2019 to facilitate Iranian oil sales, failing which it will no longer abide with certain measures in JCPOA. Increasing uranium enrichment beyond the levels agreed in the JCPOA could elicit a strong response from those opposed to the Iranian regime.
The Arab League and GCC convened emergency summits on May 31, partly with the intention of addressing possible responses to Iran's alleged aggression. Statements from the GCC summit condemned Iran's actions, but subsequent statements from regional leaders indicate a desire to de-escalate tensions.
How might this situation unfold, and would you lower any ratings?
Although our base case is that there will be no direct military conflict between Iran and the U.S., we've considered two potential stress scenarios.
Scenario 1: Unlikely at this stage
Under scenario 1, we envision credible threats to block the Strait or even a blockage put in place for a few days. As in the past, when closure threats were made by Iran, we believe international pressure would quickly be brought to bear or, alternatively, there might be a military skirmish. Either way, due to the Strait's international significance, we would expect the threats to subside and any blockage to be resolved relatively quickly.
The Strait of Hormuz is a critical shipping route for almost one-third of the world's seaborne crude oil supplies. The vast majority of hydrocarbon exports from Saudi Arabia, Qatar (LNG), Abu Dhabi, Kuwait, Iraq, and Bahrain pass through the Strait. Oman, being outside the Strait, would not have its non-Gulf exports physically blocked by a Strait closure
Scenario 2: Quite remote at this stage
Under scenario 2, we envision the Strait of Hormuz being closed for an extended period.
The rating impact in scenario 2 would likely be more pronounced than in scenario 1.
Both scenarios could weigh on the creditworthiness of GCC sovereigns and have consequences for Gulf-based entities, possibly banks and some nonfinancial companies.
The main ways in which the scenarios might affect our Gulf sovereign ratings include via an increase in sovereigns' funding costs, disruption to foreign direct investment (FDI) flows and equity investments, expat and other population movements, and bank deposit outflows, which could damage economic growth prospects and harm governments' fiscal positions if assets were deployed to offset these negative effects, including for foreign exchange support. Prolonged tensions would likely make global oil prices more volatile and could weaken global economic growth. Under either scenario, an increase in oil prices could offset some of the impact of capital outflows and weaker economic growth. However, in scenario 2, Gulf sovereigns would be unlikely to benefit much from higher oil prices if the Strait were blocked.
Which Gulf sovereigns are the most at risk?
Under either scenario, some GCC countries would likely be more affected than others. Certain sovereigns--Abu Dhabi, Kuwait, Qatar, and Saudi Arabia--would likely be better cushioned by their large stock of government external assets.
Additionally, Abu Dhabi and Saudi Arabia have alternative export channels that could partly alleviate the impact of a blockage of the Strait on their economies. Abu Dhabi's pipeline system can bypass the Strait and deliver up to 1.6 million barrels of oil per day (about 50% of production) directly to a terminal on the Indian Ocean. Saudi Arabia's pipeline system can pump 5 million barrels per day, also about 50% of its daily oil production, from its Eastern Province to a Red Sea port. However, recent drone strikes by Yemen's Houthi rebels on the Saudi pipeline suggest that this alternate route could be vulnerable.
Bahrain appears to be the most vulnerable Gulf sovereign to the consequences of the scenarios. Bahrain's fiscal position is weak and its economy has by far the highest gross external financing needs, totaling more than 300% of current account receipts (CARs) plus usable reserves, reflecting its large banking system. We note that Bahrain is in a net external creditor position (see "What's Behind Our Credit View On Bahrain And Oman," published May 5, 2019, on RatingsDirect).
Oman is, we believe, less likely to be directly affected by military action owing to its geographic location and neutral foreign policy. However, its funding costs have moved with those across the region, as illustrated by recent developments in the 10-year government bond yield. Additionally, Oman has a large government debt position as well as high fiscal and external funding needs.
We see Qatar as vulnerable because of its high external financing needs, at about 180% of CARs plus usable reserves, largely due to the foreign funding of its banking system. We note offsetting buffers, such as adequate liquidity in the banking system and expected support from government and related entities, as we observed in 2017 when Qatar was boycotted by neighboring countries. Nevertheless, the banking system's high dependence on external debt remains a comparative weakness.
All things being equal, Iraq would likely be less vulnerable to a funding shock mainly because of its low debt costs and funding needs, which are largely met by domestic banks and concessional lending; limited amount of short-term external liabilities; and no reliance on FDI financing. Offsetting this relatively insulated position, however, is the potential for a deterioration in Iraq's security situation, which had been improving, potentially prompted through reported Iranian influence on Iraqi institutions.
How might the loss of expat deposits affect the banking system?
Deposit outflows from expatriate populations can be unpredictable. There are no official statistics on the proportion of expatriate deposits in the GCC banking system's deposit bases. However, given the structure of the populations, we understand that the contribution is not negligible. If heightened geopolitical risks were to lead expats to return to their home countries, we think a portion of their deposits could go with them.
Such a situation could pose substantial liquidity risks for the banking systems in the United Arab Emirates (UAE), Qatar, and Bahrain. For example, we estimate that retail deposits (from locals and expatriates) in the UAE and Qatar account for around one-quarter of their respective banking systems' total deposits.