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GCC Banks Return To Form, Can It Last?

After a strong first half, Gulf Cooperation Council banks are returning to form. S&P Global Ratings expects that earnings for most GCC banks will reach almost pre-pandemic levels by year-end 2022, amid high oil prices and rising interest rates, supporting their creditworthiness.

In the second half, we forecast a more visible strengthening of regional banks' interest margins and a manageable pick-up in cost of risk, amid lingering effects from the COVID-19 pandemic via loans that benefited from support measures and were then restructured. Combined, these factors will be a net positive for banks' earnings.

In the first half, margins slightly improved in most systems as banks progressively repriced assets and liabilities. Among the four largest GCC markets, Kuwaiti and Saudi banks showed the strongest performance, with earnings already almost reaching pre-pandemic levels, while Qatari and United Arab Emirates (UAE) banks are taking a bit longer to recover.

Below we look at the region's four largest markets in more detail.

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Saudi Arabia: Stronger Profitability Thanks To Growth And Higher Rates

Saudi banks' financial performance has almost recovered to pre-COVID-19 levels.  We expect an average return on assets (ROA) of 2.0% in 2022 compared with 2.1% in 2019. Credit to the private sector expanded 8.5% over the first half, somewhat faster than our assumptions owing to stronger-than-expected mortgage growth, which we assumed would slow owing to market saturation and a pick-up in demand for corporate credit driven by Vision 2030 projects. The strong economic rebound also kept aggregated cost of risk low, at about 46 basis points (bps), and the share of Stage 3 loans broadly flat, estimated at about 2%. In addition, banks' nonperforming loan (NPL) coverage stood at 160%-170% in 2022. Average net special commission income margins have been broadly flat despite a pick-up in the Saudi Interbank Offered Rate, with a disparity emerging between mostly corporate banks that will gradually benefit from increasing rates, and retail, mortgage-heavy institutions that will see less of a boost owing to a large share of fixed-rate assets.

Higher credit growth momentum will continue into the second half.  We now expect credit growth to reach about 15% in 2022. This momentum is mostly due to stronger-than-expected performance in the mortgage portfolio, even though we continue to believe that higher interest rates and market saturation will eventually curb mortgage origination. We also believe that corporate lending will start contributing to loan growth. The gradual increase in interest rates will continue to feed Saudi banks' margins, eventually pushing them up by year-end. However, we expect cost of risk to somewhat increase over the second half to 70 bps-80 bps as some of the loans restructured post-pandemic are reclassified. Overall, we expect the systemwide ROA to stabilize at 1.9%-2.1% from 2022.

Spillover from the global slowdown and higher interest rates could eventually weigh on Saudi banks.  The Saudi economy, and consequently the banking sector, have been supported by a dual rebound in oil production and oil prices. However, the increasing risk of recessions in the U.S. and Europe, along with higher interest rates, could pressure the operating environment, especially if oil prices drop. We also note that higher interest rates could result in a shift away from non-commission-bearing deposits, which may pressure banks' margins.

Qatar: Slower Credit Growth As World Cup Build-Up Ends

We expect private sector credit growth of 5% in 2022, less than half the average rate seen over the previous three years.  Consumption lending is likely to see the strongest growth, buoyed by the World Cup at the end of the year and positive sentiment stemming from high natural gas prices. However, government construction projects--the main growth spur previously--have mostly been completed, which is shown in banks' first-half performance. Overall credit could reduce slightly if lending to the government continues to decline in the second half, which we view as likely given our projected fiscal surplus of about 12% of GDP.

Banks' significant exposure to the wealthy public sector will continue to support solid asset quality.  Our projections anticipate that central bank rate hikes, following those by the U.S. Federal Reserve, could pressure some Qatari borrowers, with a marginal effect overall. However, high inflation in Turkey, and to a lesser extent Egypt, will likely be more material contributors to cost of risk over 2022, which we still estimate at pandemic levels of about 100 bps. As a result, we expect an NPL increase toward about 3.6% of total loans this year from 3.2% at year-end 2021.

Net interest margins are expected to further widen this year.   However, along with higher funding costs, hyperinflation-related adjustments stemming from Qatari banks' presence in Turkey will slightly constrain net income growth. Still, on balance, we expect these trends to provide positive momentum, supporting solid capitalization.

A key system vulnerability--its large stock of external debt--is likely to continue reducing over the rest of 2022.  Both lower demand and the introduction of new prudential regulations to discourage non-resident-driven balance sheet growth led to a nearly 25% reduction in nonresident funding in the first half compared with year-end 2021, which was offset by an increase in interbank lending. In turn, the stock of external liabilities declined about 6% and we expect this trend to continue for the rest of the year. However, replacing nonresident deposits with domestic sources, which has been very visible in the corporate sector so far over 2022, will likely increase overall funding costs.

Kuwait: Higher Oil Prices Create A Supportive Environment

Higher oil prices and the economic recovery have supported faster lending growth and lower cost of risk.  Banks' stronger earnings were mainly due to a further reduction in cost of risk and higher lending growth of 9% year-on-year in the first half (calculated based on banks that control almost 60% domestic market share). This came as higher oil prices supported the country's economic recovery and improved the operating environment. We saw lower margins than we expected in first-half 2022 amid repricing of liabilities and higher competition in lending activities. Noninterest income continued to benefit from the improved operating environment. However, higher inflation and the resumption of some costs as the pandemic wanes spurred a 10% increase in operating costs compared with first-half 2021, offsetting the benefits from higher revenue.

Momentum may slow in the second half, with some NPL formation.  We expect cost of risk will continue to decline, to 85 bps in 2022 from 90 bps in 2021, partly due to adequate provision coverage of NPLs (close to 200%). However, lending momentum will likely slow after a strong first half, while margins should improve slightly. Cost of risk should also increase in the second half since some banks have recovered loans in first-half 2022. Meanwhile, we expect some NPL formation toward the second half, mainly on continued pressure from oversupply in the commercial real estate sector (predominantly office space), but from lower levels than last year. Stage 2 and 3 loans dropped to 7.9% and 1.4% of total loans in first-half 2022 from 9.6% and 2.5% in first-half 2021 on an improving operating environment and write offs at year-end 2021.

We expect residential and retail real estate prices to gradually recover but concerns in other parts of the market could hinder banks' asset quality.  Banks' exposure to real estate and construction was about 25% of total lending at June 30, 2022. We understand that part of this exposure is to companies with diversified income streams and, therefore, expect NPL formation to taper off. The residential real estate sector (homes for citizens) remains robust with rising volumes and prices. Generally, we do not see this segment as a source of material risk for banks, since loans are backed by salary assignments from Kuwaiti citizens.

Similarly, the investment sector (primarily rental apartments for expats) is slowly recovering from the correction experienced over the past year related to an exodus of expats amid COVID-19 fallout. We expect this to continue in the next 12-24 months spurred by the stronger economic outlook and, to a certain degree, expats returning. However, a sustained recovery could be hindered by various headwinds, including ongoing oversupply. The commercial real estate sector (mainly offices) remains under pressure due to subdued demand for office space and the shift to online retail prompted by the pandemic, amid excess supply. This should lead to some NPL formation toward the end of the year.

UAE: NPLs To Remain Contained As Support Scheme Ends

Higher interest rates will support banking sector profitability.  Banks' performance improved in first-half 2022 on the back of lower cost of risk and higher interest rates. The Central Bank of the UAE (CBUAE)'s COVID-19-related targeted economic support scheme (TESS) helped the system through a period of stress, limiting the increase in NPLs. At the same time, the macroeconomic environment has started to improve thanks to higher oil prices and recovery in the non-oil sector. Better operating conditions led to higher lending growth in first-half 2202 compared with 2021, although this could be tempered by increasing interest rates in the second half. We expect the trend of higher interest rates and lower cost of risk to continue supporting banks' profitability.

We expect asset quality to stabilize.  In our view, NPL increases will remain contained as the economy improves and corporate activity recovers. On June 30, 2022, Stage 3 loans as a percentage of gross loans stood at 5.6%, compared with 6.1% at year-end 2021. Stage 2 loans stood at 6.0% for the first half. The construction sector and some small and midsize enterprises will take longer to recover and be the chief contributors to NPL formation. However, the extension of some TESS measures to vulnerable sectors during second-half 2022 will provide additional recovery time. We expect cost of risk of 100 bps–110 bps in 2022-2023, compared with 116 bps in 2021. Banks' provisioning coverage of NPLs was adequate at 90% in June 2022, supporting this cost of risk normalization.

Real estate prices have recovered but remain below 2014's peak.  In the past few months, we've seen strong demand for residential real estate, demonstrated by a surge in transaction numbers, price increases, and record presales for developers. Villas saw the biggest rises in demand and prices, as buyers' preferences changed due to COVID-19-related restrictions. Properties remain relatively affordable, with prices 25%-30% below 2014's peak, despite a significant uptick in the past few months. In first-half 2022, demand remained uninterrupted, fueled by higher oil prices, which are underpinning the economic recovery and positive sentiment in the GCC. At the same time, external pressure from rampant inflation is less acute than elsewhere in the world, and the devaluation of emerging currencies underpins the UAE's attractiveness thanks to the stability of the dirham (AED), which is pegged to the U.S. dollar. The Russia-Ukraine conflict has also reportedly boosted demand for real estate. That said, the addition of about 30,000-35,000 units over 2022 is expected to contain price and rent increases, which have already moderated sequentially since the start of 2022. We also expect slower growth in mortgage transaction volumes due to further interest rate hikes, although we don't expect this to be disruptive given that only an estimated 20%-25% of transactions are mortgage based.

We expect the UAE's inclusion on the Financial Action Task Force's gray list will have a limited effect on banks' business or credit profiles.  We note that UAE banks had a significant gross external debt position of 23% of total assets on June 30, 2022. The system also held significant external assets at the same date, leading to an overall net external asset position. Although the gray listing might increase the cost of external debt, we believe banks have ample margins to withstand this.

Uncertain Prospects In 2023

GCC banks' strong momentum so far in 2022 may not be enough to shield them from adverse developments in 2023. Under our base-case assumptions, we expect global oil prices to average $85 per barrel (/bbl) next year compared with $100/bbl for the remainder of 2022. Moreover, S&P Global Ratings now sees the chance of a U.S. recession, as determined by the National Bureau of Economic Research, at 45% in the next 12 months (40%-50% and closer to 50% heading into 2023 as cumulative rate hikes take hold). In Europe, escalating geopolitical risks and high inflation could mean weaker economic growth. This would hurt global growth and pressure commodities prices, leading to knock-on effects for the GCC region and its banks.

This report does not constitute a rating action.

Primary Credit Analyst:Zeina Nasreddine, CFA, Dubai + 971 4 372 7150;
Secondary Contacts:Mohamed Damak, Dubai + 97143727153;
Benjamin J Young, Dubai +971 4 372 7191;
Roman Rybalkin, CFA, Moscow + 7 49 5783 4094;
Puneet Tuli, Dubai + 97143727157;

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