A wall of uncertainty to remain high

Large sovereign issuance expected from GCC

We expect global uncertainty to remain high. However, the primary drivers are changing. The usual global drivers of EM asset prices, namely developed markets rates, risk aversion and commodity prices, are being overshadowed by political developments. Their influence on the design of public policies will have long-lasting global economic consequences. As long as globalization instead of technological changes is seen as the main culprit of the rise in income inequality, the de-globalization trend driven by an increase in protectionist policies will continue. This trend will necessarily imply lower global trade and lower capital flows, with significant implications for emerging markets.

Despite our medium-term concerns, price action in EM has improved in recent weeks on the back of renewed inflows. The USD has weakened across the board since the beginning of the year as US real rates peaked in mid-December though inflation expectations continued rising in the US. A combination of stretched short positioning in US rates and rising uncertainty associated with potential developments in US trade policy are likely behind the stabilization in real rates. The short squeeze in CNH and the PBoC decision to tighten liquidity to discourage speculative positions certainly helped stabilize asset prices in the Asia complex. Light positioning in EM and still-high levels of cash holdings helped to trigger the positive price action.

GCC sovereign issuance

EM as an asset class still benefits from diversity, as a large concentration of LatAm and Asia provides an offset to the volatility in the Central and Eastern European countries. The bulk of 2017 sovereign issuance is expected to come from GCC, followed by LatAm. We expect Saudi Arabia, Argentina, Qatar and Kuwait to be the largest gross and net issuers in 2017. Just these four issuers could account for 37 percent of the total sovereign gross issuance. GCC issuance has been increasing rapidly mainly due to low oil prices, with some new issuers in 2016, and we expect 2017 issuance to continue to be high. Among those, we expect Kuwait, with no external sovereign debt, to come to market with about $10bn to finance a budget deficit resulting from low oil prices.

The bold liberalization of the FX regime by the Central bank of Egypt (CBE), accompanied by large hikes to administered energy prices, provides a credible and front-loaded start to the economic reform program. One key risk to monitor in the near term is social stability, as inflation is likely to peak around 25-30 percent and private consumption will be curtailed. Increased competitiveness should help economic activity rebound and gradually narrow external imbalances.

The fiscal reforms introduced so far likely aim to generate annual savings of up to 2.5ppt of GDP in the first year of the IMF program, versus a total target of 5.5ppt of GDP in primary balance adjustment over the life of the program. This includes the introduction of VAT from September (with likely proceeds of EGP22bn or 0.7 percent of GDP and an inflationary impact of c.1.5ppt), wage bill control through the passage of the Civil Service Act, and energy subsidy reform (EGP22bn or 0.7 percent of GDP in proceeds). The impact of currency depreciation on fiscal accounts is likely to be broadly neutral. Unless the EGP weakens much further, the CBE is unlikely to raise rates, and real interest rates are likely to remain supportive of debt dynamics.

USD/EGP waiting for portfolio inflows

USD/EGP is cheap versus its history and could gradually stabilise on the back of efforts to attract FX inflows from multilateral and bilateral sources, as well as from the parallel market. Success is likely to be measured through the return of portfolio inflows, which should provide the first signal of market confidence. The Real Effective Exchange Rate (REER) is at historical lows, although high inflation is likely to dent competitiveness.

The IMF program should unlock additional bilateral funding and gradually help boost domestic confidence and volume in the FX interbank market. While the latter likely remains below preRevolution levels, a portion of the FX backlog has probably been serviced already. While the parallel market has returned to some extent, the narrower USD/EGP differential versus the parallel market could bring some USD supply back to official channels. A functioning FX interbank market rate that ensures smooth entry and exit, and generates enough FX liquidity to service imports and meet the backlog of FX demand (US$3-10bn, according to local press) is needed to bring back a portion of the historically large foreign portfolio investment, in our view.

Saudi Arabia Budget calls for higher oil prices

We think that the Saudi USD peg will hold given sizeable foreign assets and the experience with implementing multi-year fiscal adjustments. Energy policy should shift toward supporting oil prices. Main view: Higher oil prices smooth the adjustment process. We expect twin deficits to narrow but remain relatively elevated. Liquidity is likely to improve and non-oil sector growth should rebound given a more gradual pace of fiscal tightening.

Main risks: A prolonged period of low oil prices, fiscal reform slippage, devaluation, political succession and regional geopolitical threats remain the primary risks. Growth rebound, higher oil prices, gradual reforms are key Saudi priorities The budget statement and medium-term program imply three Saudi policy priorities: easing near-term austerity, supporting higher oil prices and introducing nonoil revenue reforms. The 2017 budget suggests flattish real spending, along with further repayment of government arrears in 1Q17. The authorities appear to be targeting a higher medium-term path for both oil prices and nominal spending. Given that the non-oil revenue fiscal reforms appear insufficient to bring the fiscal deficit towards balance, energy policy is likely to remain focused on supporting oil market rebalancing and hence oil prices. We see the budget being consistent with oil prices of $55/bbl ($65/bbl target, $40/bbl floor) and a fiscal breakeven of $98/bbl.

Budget deficit set to narrow in 2017

We expect the 2017 fiscal deficit to narrow on the back of higher oil prices, discipline in spending and non-oil revenue measures. We see the 2017 budget deficit at SAR316bn ($85bn; 12 percent of GDP) on the back of higher oil prices ($57/bbl), compared with a deficit of SAR402bn in 2016 ($107.5bn; 16.9 percent of GDP) and SAR385bn in 2015 ($102bn; 15.9 percent of GDP). Underlying spending discipline kept the 2016 fiscal deficit in line with budget targets. However, the repayment of contractor arrears (SAR80bn; $21bn) and spending related to surplus projects (SAR25bn; $6.7bn) drove the 2016 fiscal deficit wider.

Medium-term reform drive

The publication of the “Fiscal Balance Program 2020” highlights that the reform program is not derailed, although higher oil prices allow for a better pacing of measures. The authorities are planning the introduction of means-tested cash allowances in 1Q17, with disbursements from June for a total budget cost this year of SAR25bn or c.1 percent of GDP. This is likely to allow further selective energy subsidy reform in 2H17 (including electricity, gasoline and diesel).

Excise taxes on tobacco and sugary drinks are likely to be introduced in 2Q17, and an expat levy will come into force in July 2017.

The budgetary statement and program suggest that the policy aim is for the main tools of the ongoing mediumterm fiscal adjustment to be a combination of higher oil prices and higher nonoil revenues, in line with the planned National Transformation Plan (NTP) fiscal reforms. Oil price recovery is paramount to narrow fiscal imbalances as we estimate 20-25 percent of the medium-term fiscal adjustment will take place through higher oil prices, assuming full NTP implementation.

However, a continuation of the EM rally is far from assured. We expect US real rates to continue moving higher in the coming months on the back of more stimulative fiscal policy, which should translate into a stronger USD and higher risk premium in EM assets. The extent of the move will naturally depend on whether the fiscal easing will be accompanied by a wave of deregulation and protectionist policies.