Qatar’s credit quality to decline if tensions persist: Moody’s

For Qatari banks, diplomatic row with fellow GCC countries is credit negative

LONDON, June 8: On Monday, eight mostly Arab countries, including Saudi Arabia (A1 stable) and the United Arab Emirates (UAE, Aa2 stable), announced that they had severed diplomatic ties with Qatar (Aa3 stable). In addition to severing diplomatic relations, Saudi Arabia, UAE and Bahrain (Ba2 negative), which, like Qatar, are all members of the Gulf Cooperation Council (GCC), as well as Egypt (B3 stable), which is not a GCC member, announced the suspension of air, land and sea transport, banned their citizens from visiting Qatar and gave Qatari nationals two weeks to leave their respective countries.

The move to isolate Qatar is unprecedented in the GCC’s history. Even though we, at Monday’s, do not expect disruptions to Qatar’s ability to export oil and gas via sea routes, imports might become costlier and tourism from the region will likely suffer. If the situation persists, it will negatively affect the sovereign’s credit strength, primarily through higher funding costs, the potential crystallization of contingent liabilities on the government’s balance sheet and a likely drain on foreign exchange reserves.

Given its geographical proximity to Saudi Arabia and the UAE, Qatar’s dependence on imports from those countries is sizable. In 2016, according to International Monetary Fund statistics, around 14% of Qatar’s total imports came from those two countries, with about 25% of all food and basic goods’ imports, as well as construction materials, such as those used in preparation for the 2022 FIFA World Cup. A prolonged disruption of trade links could require using potentially more costly alternatives, which in turn would increase inflationary pressures.

From an export perspective, the UAE is by far the largest recipient of Qatari exports, receiving about 5% of total exports, in addition to being a major transit hub for trade to other parts of the world. However, given that the majority of Qatar’s exports are hydrocarbon and predominantly natural gas, which is predominantly exported by sea to countries that did not take action Monday, we expect a limited effect on foreign-exchange inflows in the balance of payments and on government revenues. Even though the UAE announced that it will close its maritime area to Qatari vessels, tankers carrying Qatari gas will be able to use Iranian and Omani waters to reach the Indian Ocean.

The initial financial market reaction has been relatively manageable: yields on Qatar’s most recent 10-year international bond (issued June 2016) rose 20 basis points to 3.36% on Monday and narrowed slightly to 3.35% on Tuesday, and the Qatar Exchange Index decreased by a total 9.8% from its closing the previous week. But a prolonged or deepening rift between Qatar and its GCC neighbors would potentially have a more marked financial effect and increase funding costs for the sovereign and other Qatari entities.

An escalation could include restrictions on capital flows, which would be negative for Qatari banks’ liquidity and funding. Tighter domestic liquidity in 2016 drove banks to increase foreign funding, which correspondingly drove the increase in Qatar’s total external debt to about 150% of GDP in 2016, according to our estimates, up from around 111% in 2015. In a scenario of a rapid loss of confidence from international investors and depositors from other GCC countries, the government might have to step in to support domestic banks.

In such a scenario, Qatar’s government debt burden would likely rise beyond our current baseline projections of around 48% of GDP in 2017 and debt affordability metrics would weaken. Although Qatar has reasonably strong financial buffers — we estimate that total assets managed by the Qatar Investment Authority were almost 200% of GDP in 2016 – not all of these assets are liquid and external. Therefore, a pick-up in foreign investment outflows would drain foreign-exchange reserves from their current level of $34.8 billion and weaken Qatar’s external liquidity position.

We expect that Qatari banks’ funding costs will likely rise for debt securities (11% of foreign funding), and there is a risk of withdrawals from non-resident deposits (43% of foreign funding) and interbank facilities (46% of foreign funding) because a portion of these are sourced from the GCC. The liquidity squeeze could intensify in the event of further escalation of tensions, which could include restrictions on capital flows or change in investor sentiment. The rift, the worst since the creation of the GCC in 1981, could also be negative for regional economies, business confidence and credit growth opportunities for GCC banks if it persists.

The tensions with other GCC countries have come at a time when the reliance on the foreign funding has increased for Qatari banks. Over the past two years, deposits from the hydrocarbon-rich Qatari government and relatedentity deposits into the local banks have declined because of the fall in oil prices. The decline in local deposits drove foreign funding to increase to 35% of total liabilities as of March 2017 versus 23% in 2014. Among the largest Qatari banks, Qatar National Bank’s (Aa3 stable, baa16) foreign funding accounts for 49% of its total liabilities, while The Commercial Bank’s (A2 negative, baa3) is 40% of its total liabilities and Qatar Islamic Bank’s (A1 stable, baa2) is 30%.

Against these risks as a result of higher reliance on foreign funding, Qatari banks’ had a healthy but declining stock of liquid assets of around 24% of total assets at the end of 2016. Qatari banks also started booking longer-term maturity deposits, which improved their asset-liability mismatch and helped them comply with the Qatar Central Bank’s new Basel III liquidity metrics. Additionally, we expect the Qatari government to support the banks if needed, as it did during the 2009-10 financial crisis to maintain investor/depositor confidence and financial stability when both equity and property prices were declining.