How the Gulf construction industry can rebuild in 2017

It has been a challenging year for the construction market across the Gulf Cooperation Council, as governments come to terms with the lengthy suppression of the oil price and the need to rationalise their state expenditure.

There has been a realisation that the diversification of regional economies is now a major priority with real urgency, rather than something that is simply nice to have. The bright spot of the GCC diversification story is clearly the United Arab Emirates, with oil targeted to decrease as a percentage of gross domestic product from 30 per cent to 20 per cent by 2021, with a 0 per cent contribution by 2066.

Regional deficits are significant and are either stabilising or growing. Saudi Arabia is forecasting a budget deficit of $87bn in 2016 — down from $98bn in 2015 — which is 14 per cent of GDP, and Oman doubled its deficit from 2015 to 2016 for the first seven months of the year to $10.4bn. It is inevitable that major government infrastructure schemes will undergo major scrutiny, redesign and rescaling, delays, and possible cancellation as vanity projects are separated from need-to-do schemes, and serious consideration is given to alternative financing models such as Public Private Partnerships and Build Operate Transfer.

This is perhaps best referenced by the delay in the GCC rail network that, while providing a cost effective way to transport goods, requires a significant quantum of upfront investment.

With government financing for construction schemes under pressure, the pressure release should be private sector funding. In recent history this would have fallen primarily on the regional banking community, but the fact of the matter is that banks have relied heavily on government deposits during the high oil price era to provide lending to both the government and private sector.

This can be seen by the Saudi Arabian Monetary Authority’s report in July that deposits were 3.3 per cent lower to June 2016 compared to the previous year, as well as the loan to deposit allowances in February rising from 85 per cent to 90 per cent. Coupled to first quarter data from Moody’s on the deposit to loan ratios reaching 101 per cent for UAE banks, it is no coincidence that we see tightening credit terms and a higher degree of selectivity around lending to the markets.

With tightening credit terms and softening real estate prices, especially in the UAE, a significant minority of mixed use developments may well have to be reassessed for their feasibility in the short term or delayed until real estate transaction values turn more positive.

Inevitably, government policy is moving towards borrowing, bond issuances and shoring of the banking system with the liquidity. This is seen in the two short-term loan injections by SAMA this year – one for $4bn in July and the other for $5bn in September — as well as the $17.5bn bond issuance by the Saudi Arabia.

It is forecast that GCC countries could need $560bn by 2019. The positive from this is that the GCC governments as a whole have internationally low debt to GDP ratios. Saudi Arabia’s was 5.9 per cent in 2015, up from 1.6 per cent in 2014 but significantly lower than the 25.8 per cent of 2006. This should enable access to funds if international markets buy in to regional reform policies — although global liquidity is tightening quickly, so the transformation of the regional economies will be placed under significant scrutiny.

Looking at the major regional markets, construction awards in 2016 have significantly declined year to date, with Saudi Arabia having only awarded $18bn by the end of Q3 and struggling to meet Faithful+Gould’s predictions of just under $30bn by year end. This has been all but completely reliant on the private sector and Saudi Aramco and would still represent a contraction of 16 per cent from 2015 — a huge decline from the 2012 peak of $66bn. The UAE is on course to hit $43bn in 2016, down 25 per cent, as Abu Dhabi’s awards slow to a trickle.

For 2017, the UAE is expected to be the bright point among regional markets with a slight pickup from the 2016 low. We are forecasting a $45bn award programme as Expo 2020 related construction programmes ramp up and Abu Dhabi increases the amount of work available in the market.

However, 2017 for Saudi Arabia still looks heavily reliant on the private sector and Saudi Aramco. Our current forecast is for the market to contract further to $27bn. Although should 2016’s predication be missed this will most likely be due to the non-award of the Makkah Metro, which would then fall into 2017 and could increase this forecast.

This is a consequence of the project management office (PMO) implementation and the subsequent lack of government work, as all government entities and government related organisations are obliged to roll PMOs out. With government work currently in development or in the pipeline, the effective implementation of PMO’s will pass the trillion dollar mark impacting not just the $750bn government potential works but sentiment and engagement from the private sector’s $250-300bn of schemes. This PMO undertaking is unprecedented on a global scale in terms of its ambition and the schemes and values associated with it, and with the complexity and scale of change management required to build long-term capability for the country.

In terms of where construction inflation is and has been going in Saudi Arabia, we have seen negative growth to date in 2016, recording an official decline of 2 per cent.

However, in real terms, should a scheme have funding and is able to proceed, a 5 per cent to 10 per cent discount could reasonably be achieved. For 2017, we are reasonably of the belief that inflation will return to the Saudi market as it becomes impossible to ignore the upcoming VAT introduction in the GCC and the fact that most construction schemes will have part or the majority of their build programme fall into the post VAT environment. However, we don’t see all of the VAT inputs being passed through in 2017 and forecast that construction inflation will reach 1.5 per cent in the kingdom.

For the UAE, we see a similar story for the industry’s inflation, although 2016 will be flat as opposed to going negative mostly due to the quantum of awards that Dubai has provided year to date. These represent some 70 per cent of the UAE’s total to the end of Q3. This is broadly due to an expected increase in tenders through Q3 and Q4 that aligns to the Expo 2020 delivery dates. We saw construction inflation go negative by 0.5 per cent in H1 and expect inflation to be positive to counter balance in H2. For 2017, inflation is expected to pick up slightly quicker that Saudi to 3 per cent as awards commence in Q1 and Q2 and the market starts to show signs of recovery from the contraction in 2016.

Regionally, the peak and trough of awards has done little since the global financial crisis to fully stabilise the industry and can still be in part one of the attributing factors to the slightly transient nature of the region. Steady and stable government investment into the infrastructure of the region is paramount to ensure that the industry remains robust and contributes effectively to the diversification of regional economies. It will also encourage private sector investment in the industry and attract and retain the best talent to deliver these schemes, while providing a training and development legacy in global best practice for countries in the region.

The mid-term outlook from 2018 onwards for the region’s contracting market is relatively positive. The region has large infrastructure needs — both social and non-social — with a young and growing local population and a requisite requirement to continue a rapid diversification away from the petro dollar and reliance on government sector jobs and subsidies. In many respects, the regions markets are on a path to maturity from frontier or developing economies to developed markets.

David Clifton is regional development director at Faithful+Gould