Fitch Revises Oman's Outlook to Negative; Affirms at 'BBB'

Fitch Ratings has revised Oman's Outlook to Negative from Stable and affirmed the sovereign's Long Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) at 'BBB'.

The issue ratings on Oman's senior unsecured foreign-currency bonds and on the sukuk trust certificates issued by Oman Sovereign Sukuk S.A.O.C. have also been affirmed at 'BBB'.

The Country Ceiling has been affirmed at 'A-' and the Short-Term Foreign- and Local-Currency IDRs at 'F2'.

KEY RATING DRIVERS

Oman's fiscal deficit widened to 21.4% of GDP in 2016, the highest of any Fitch-rated sovereign, after 16.6% in 2015. Although government spending fell nearly 6% from 2015, it was still 8% above budget against a fall in revenue of 17%. High defence spending and the policy of completing infrastructure projects thwarted the government's efforts to achieve the much sharper spending adjustment outlined in the 2016 budget.

A forecast recovery in oil prices, expenditure adjustment, and the implementation of new hydrocarbon projects play a key role in the expected fiscal consolidation in Oman. We forecast that the budget deficit will narrow to 11.9% of GDP in 2017 on the back of higher oil prices and lower defence and investment spending. More fiscal measures are also in the pipeline. A review of corporate tax exemptions and an increase of tax rates is effective from January 2017 and will begin to have a cash flow impact in 2018. The government expects to implement an excise tax this July and VAT in 2018, which Fitch expects to have a meaningful impact on revenue starting in 2019.

The risks to fiscal consolidation are high and the credibility and cohesion of the government's approach continues to be tested. Defence spending could prove difficult to cut given regional security challenges. The government could be reluctant to let infrastructure spending fall because of its importance to growth and to the diversification plan. A small annual increase in civil service salaries highlights the social sensitivity of wage restraint. Similarly, the government's decision to cap the price of a particular grade of fuel pending the introduction of a compensatory mechanism for poorer citizens highlights that subsidy reforms are not yet entrenched.

Oman's external balance sheet strengths are dwindling as the government issues debt and uses its wealth funds to finance deficits and bolster central bank reserves. Sovereign net foreign assets will fall to 14% of GDP in 2018 in our forecast, little more than a quarter of their peak of nearly 58% of GDP in 2015. We estimate that the country moved into an overall net external debtor position in 2016. Under our baseline assumptions, which include a moderate rise in oil prices, implementation of identified fiscal measures and no draw-downs from wealth funds beyond 2019, Oman's government debt will surpass 50% of GDP in 2026 (from 13% of GDP in 2015). As a result, it will soon compare unfavourably with the 'BBB' median government debt ratio of nearly 43% of GDP.

Oman's sovereign net foreign asset position will continue to exceed the 'BBB' median of 3% of GDP, underpinned by the USD18 billion in foreign assets held by the State General Reserve Fund of Oman (SGRF) as at end-2016, which is not included in central bank reserves. This buffer supports Oman's market access and the stability of the exchange rate peg. The reserve coverage ratio, at 5.6 months of current external payments, was slightly below the 'BBB' median and is inflated by the presence of Iranian deposits at the Central Bank of Oman (CBO) worth around USD4.4 billion.

We expect real GDP to contract 0.3% in 2017 before rebounding in 2018. The contraction is led by Oman's commitment to cut oil production in line with Opec. Non-hydrocarbon growth will also slow amid government consolidation and somewhat tighter banking sector liquidity. Growth already slowed to 2.3% in 2016, as growing oil output and strong real estate and construction activity offset a contraction in trade and manufacturing. We expect the Khazzan gas field to come on stream in 2018, eventually increasing gas production by 25% (worth around USD5 billion), supporting domestic industries and allowing Oman to fully utilise its existing LNG export capacity.

Oman scores in line with the 'BBB' median on World Bank governance indicators, held back by low scores on 'Voice and Accountability'. The domestic political scene remains stable, but uncertainty continues to surround the succession to 76-year old Sultan Qaboos, who has undergone extensive medical treatment abroad but has not publicly designated a successor. The constitution stipulates that the ruling family must choose a new Sultan within three days of the post becoming vacant; otherwise a letter is opened with the Sultan's recommendation. We see little risk of sanctions being directed at Oman over its close relationship with Iran.

SOVEREIGN RATING MODEL (SRM) and QUALITATIVE OVERLAY (QO)

Fitch's proprietary SRM assigns Oman a score equivalent to a rating of 'BBB' on the Long-Term Foreign Currency IDR scale.

Fitch's sovereign rating committee did not adjust the output from the SRM to arrive at the final Long-Term Foreign Currency IDR.

Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three year-centred averages, including one year of forecasts, to produce a score equivalent to a Long-Term Foreign Currency IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.

RATING SENSITIVITIES

The main factor that could lead to a downgrade would be continued rapid erosion of the fiscal or external positions, for example as a result of a failure to implement fiscal reforms or due to a renewed fall in oil prices.

The main factor that could lead to a revision of the Outlook to Stable is:

• Narrowing of the budget deficit allowing stabilisation of the government debt/GDP, either through active fiscal measures or a sustained increase in oil prices.

KEY ASSUMPTIONS

Fitch assumes that Brent crude will average USD52.5/bbl in 2017 and USD55/bbl in 2018.

Fitch assumes that an eventual transition of power from Sultan Qaboos will be smooth and ensure broad policy continuity.

Fitch assumes no change to the peg of the Omani rial to the US dollar.