Crunch time

By Ben Thompson, Senior Editor

In recent years, the Gulf has been a magnet for developers attracted by the prospect of big returns. But with a global economic downturn starting to bite, the region’s construction sector might need to re-evaluate its spending priorities, argues Senior Editor Ben Thompson.

“Such soul-searching is leading the region's governments to re-evaluate their spending priorities - with infrastructure being the main beneficiary”
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It was supposed to be the glittering jewel in Dubai’s crown, a 62-storey, $600 billion tower of steel and glass that would provide the centrepiece to the emirate’s high-profile Palm Jumeirah development. It had the backing of the region’s most successful building firm and carried the name of one of the world’s most recognized business tycoons. Most importantly, work was already underway.

But late last year, in an announcement that sent ripples of fear throughout the Gulf’s booming construction sector, government-backed property developer Nakheel pulled the plug on its landmark Trump International Hotel and Tower, citing the current global downturn as the deciding factor. “Nakheel is delaying long-dated infrastructure work on some of our projects in order to ensure that our business model is aligned to meet market demand,” the company said in a statement. “We have a responsibility to adjust our short-term business plans to accommodate the current global environment.” Around 15% of the company’s workforce was laid off, with further work postponed indefinitely. And while the company was at pains to stress this didn’t signal the end for the prestigious project, it’s hard not to feel that the development’s tagline “Believing is Seeing” may have been misjudged.

Up until that point, most observers had been bullish on the outlook for the region’s construction sector and its ability to weather the global financial downturn. Sure, projects still at the design stage would be put on the backburner, but the assumption was that those in the actual development phase would carry on as planned. Not anymore. Work has also slowed on Dubai’s Waterfront and Palm Jebel Ali developments, while a number of other real estate developers have since announced layoffs, including Damac Holding, Omniyat and Tameer Holding Investment. The message to contractors and consultants working in the region is clear: no project is safe from the economic slowdown.

To date, Dubai – which is seen as the most heavily dependent on the property development business and has been the centre of the real estate boom – has borne the brunt of the economic backlash as access to credit has tightened, but other Gulf states are also looking nervously at the markets for signs of a slowdown in their own backyards. There’s no doubt that private sector projects are drying up fast as investors and speculators beat a hasty retreat from the market, and it’s now a case of survival of the fittest, according to Chuck Wood, Managing Director of Rockwell Group’s Middle East office in Dubai. “The projects that have strong financials are going to move forward, and the more independent developers with less secure financings may have trouble,” he acknowledges.

Time to take stock
But is it all bad news? A growing number of commentators believe a correction in the market has been long overdue, with Wood chief among them. “At least it will shake out the speculation that’s been in the market that’s been fuelling unrealistic growth,” he says.

Architect Eric Kuhne agrees. “The biggest threat is when a piece of property becomes more of an investment and less of a place for people to work and live; this is what has happened in the Gulf. Developers have been more interested in making money than in building harmonised communities,” says Kuhne, whose firm Eric Kuhne Associates has been involved in the Middle East for over a decade. He believes Dubai, the region’s hub, will actually benefit from an economic slowdown. “It will give the industry time to take stock and give everyone a breather,” he says. “If there was less appetite for development in the region, it may be quite good. At this point, a little introspection will work.”

Such soul-searching is leading the region’s governments to re-evaluate their spending priorities – with infrastructure being the main beneficiary. As with Barack Obama’s economic stimulus package for the US, many see the funding of public works as key to job creation and economic stability; Gulf leaders are pouring more than $1.4 trillion into a series of grand schemes (including the economic cities in Saudi Arabia, the Doha Convention Centre and Tower, and Dubai’s Metro transport system) in an attempt to boost economic growth. The hope is that a spending spree may jumpstart their faltering domestic economies. As a result, Saudi Arabia, Qatar, Dubai and Oman have all announced huge capital expenditure plans for major infrastructure projects this year, and the deep pockets of regional governments mean they are well placed to press ahead with public works programmes.

And they need to. According to a report from the United Nations Conference on Trade and Development, infrastructure development in GCC countries has not kept pace with the rapid economic and population growth in many cases, and the future investment needs of developing countries for infrastructure development far exceed the amount currently planned by governments, the private sectors and other stakeholders. “Whether it is electricity black-outs in Kuwait due to a lack of peak load capacity, water shortages in Jeddah because of water losses in the pipeline system and insufficient desalination plants, or trucks queuing up in front of Dubai’s overloaded sewage plant, the GCC countries are in dire need of modernising their infrastructure,” explains Dr Eckart Woertz, Programme Manager for Economics at the Gulf Research Centre.

In that respect, a change in focus from property development to social infrastructure provision could be just what is needed – and unlike Western nations, the oil-rich Gulf states are in a good position to proceed without resorting to huge borrowing. “Surplus revenues generated over the past few years through robust oil prices and investment income have produced massive current account surpluses and these are still available to fund major state infrastructure projects,” confirms Mark Hanson, Chief Executive of the Bahrain-based Islamic investment bank, Global Banking Corporation.

Infrastructure gets a boost
So while most analysts forecast a cooling-off period in the real estate sector, new and existing plans to build more roads, railways, schools and hospitals are all expected to continue. “The governments have said that they’re going to stay the course on these projects,” says Abraham Akkawi, Middle East Leader of Infrastructure at Ernst & Young. “The only impact might be a delay on a few projects here and there, but we haven’t seen any announcements of major delays or cancellation of infrastructure projects that are specifically geared to provide services to the public in general, such as transportation and environmental projects, water, electricity or social housing projects.”

Take Saudi Arabia, for example. As part of its 2009 budget, the kingdom is ploughing $32.6 billion into education, including the construction of 1500 new schools, a new female university campus in Riyadh and the Medical City for King Saud University. In terms of health and social services, $13.9 billion will be spent on building 86 new hospitals with a total capacity of 11, 750 beds. And in the transport sector, the government has set aside $10.5 billion for the development of 5400km of new roads, intersections and bridges.

The UAE, and Dubai in particular, has announced a similar expansionary budget aimed at reducing the shortfall in private investments. Public spending is expected to reach $10.3 billion in 2009, up 42% from last year, with infrastructure funding of around $3.3 billion. Transport will provide the focus, with money generated from the sale of naming rights for Metro stations being used to part-fund construction costs on the $4.2 billion two-line system, scheduled to open in September this year. The social sector will also benefit, with $2.3 billion earmarked for the development of health services, education and public housing.

And in Qatar, thanks in large part to its huge natural gas reserves, the government is planning its largest ever budget for 2009, with an increase in spending on development projects. “The two main areas of focus at present are building infrastructure and developing policy and regulations,” says Ali Abdulla Al Abdulla, Director-General of Qatar’s Urban Planning and Development Authority. “With regard to infrastructure, we are looking five to twenty years out.” One report suggested investment could hit a staggering $222 billion as the country aims to move away from its dependence on energy and focuses more on its goal of becoming a knowledge economy.

“We will see less emphasis on projects that have higher revenue risk or commercial risk, and more emphasis on projects that have cash flow predictability,” confirms Akkawi. “The projects we’ll see getting the green light are the ones that are backed by government, directly or indirectly, such as public infrastructure.”

Meeting the shortfall
Nonetheless, in the face of strong population growth and increased economic diversification, even the well-stocked coffers of the GCC nations may struggle to meet the growing demand for infrastructure services over the long-term. A recent Ernst & Young study indicates that rising construction costs and dramatic economic growth mean infrastructure needs are rapidly outstripping the region’s public resources – record exports of oil in recent years notwithstanding – and that despite current civil engineering projects in the six GCC countries totalling US$1.3 trillion in value, more investment will be required. For example, despite the Middle East boasting two-thirds of the world’s desalinization plants, the World Bank has predicted that the amount of water available per person in the region will halve by 2050 as a result of population and economic growth and climate change.

This suggests that a significant capital investment will soon be needed to meet demand, and that government funding alone will not be enough to make up the investment shortfall. “Even with the large amount of revenue generated from oil exports in the region, governments are having to find alternate means of funding the expansive infrastructure development plans required to meet rapidly growing demand,” says Akkawi.

He believes public-private partnerships (PPPs) could hold the key to solving the funding challenge. Middle East governments traditionally have contracted with regional or international companies to design and build infrastructure such as airports, ports or roads, with government agencies usually operating the infrastructure. While that is still true today, Akkawi feels governments will increasingly need to look at forming PPPs with the private sector to build and operate these projects. Such partnerships provide private investors and contractors with new business opportunities in the Middle East, and enable governments to share the risks of project development, draw on the knowledge and experience of the private sector and leverage public investment in infrastructure with private capital.

The market for such projects is huge, and Akkawi suggests that as much as $100 billion of PPP investments in the Middle East and North Africa region will be required over the next five years to supplement government funding. “Most Middle Eastern countries are still in the early days of looking at PPP, but the indication is that they are taking it very seriously as a financing model,” he says. “PPP offers certainty of price and certainty of delivery, and as a result we expect the current trend towards continued greater private sector participation in infrastructure in the Middle East to continue over the long-term.”

Over the last few years PPP has started to take shape across several industries in GCC countries such as Saudi Arabia, Oman and Egypt, and Akkawi insists this upward curve needs to continue if modernisation programmes are to be fully realised. Expansion of the PP model will help create jobs in the private sector, provide quality services and facilities for citizens and stakeholders, and lift much of the burden of development from the already overloaded shoulders of the public sector.

The great escape?
Of course, in the short-term there is a global financial crisis to be dealt with first, and Akkawi is quick to acknowledge that the credit crunch will take its toll. “I think it will have an impact, especially on projects that are not necessarily part of a government concession,” he explains. “More commercial projects are likely to suffer – I think there will be some discussion about delaying some of these and re-looking at them. But at the end of the day, money goes wherever the projects are, wherever there is a need for them.”

And it is for this reason that the future looks promising for the region’s construction sector, despite the property slump. There is a clear and pressing need for such infrastructure modernisation programmes. Investment levels are high. And the proposed projects have the backing of the various governments concerned.

“We are very bullish about the outlook,” confirms Akkawi. “As long as the price of oil stays around its current figure or higher, that’s going to be a major driver; we feel that, for the next couple of years at least, most countries in the GCC countries have enough reserves to withstand even a prolonged international recession.”

And with the cost of materials continuing to decline in light of the downturn, the second half of 2009 may be a good time to start building in the Middle East, at least for developers that have the resources to do so. if a developer can be sure there is a market for what it is building, more projects will become economically viable; for major infrastructure projects backed by government money, it could act as a catalyst, encouraging clients to build faster to take advantage of the cheaper prices.

“No doubt the global credit crisis will have some effect on regional project finance pricing, terms and time-to-close, but it is too early to determine the magnitude,” concludes Phil Gandier, a colleague of Akkawi’s and head of Transaction Advisory Services at Ernst & Young. “There are billions of dollars of announced infrastructure projects in the pipeline that have been planned on the assumption of varying levels of private sector participation. These projects are critical to the economic growth of the countries in the region, especially GCC countries.” They might also hold the key to the region’s ability to withstand, and recover from, the current global recession.

Fast facts

• The infrastructure sector saw record deal volumes last year, with a total value of $221 billion
• The industry also witnessed a 90% increase in the average deal size
• OECD estimates that by 2030, around $71 trillion will be required to meet global investment needs in roads, rail, telecommunications, electricity and water

New horizons?

As the global credit crisis hits the Gulf, could other parts of the Middle East be set for their own construction renaissance?

The recent frenzy of activity in the Gulf means most contractors have full order books for 2009 – but prospects for 2010 are less certain. As major projects are completed, resources will need to be redeployed, but the slowdown in the region’s project markets means that there is concern about a lack of opportunities.

Iraq could offer the region’s contractors the best prospects. In 2003, international contractors were poised to undertake the rebuilding of Iraq – potentially the world’s largest construction project – but that potential seemingly evaporated as the security situation in the country continued to deteriorate.

Now, however, contractors will have to search for new opportunities. One option is to pursue contracts in the infrastructure and oil and gas sectors, which are more secure. But the volume of work there is limited and closely guarded by existing players. Another option is to expand geographically. For many, Saudi Arabia looks promising: with a large population, its real estate market is relatively insulated from global economic shocks, although falling oil prices could stifle any major surge in activity. And in the longer term, markets such as Libya could also become more attractive.

But it is Iraq that perhaps offers the best opportunities for the region’s construction firms – provided it is able to keep a lid on its security problems. It will take years for this potential to be fulfilled, but the promise of early 2003 could yet be revived.

Long-term health

“Infrastructure finance has shown itself to be more resilient to the credit crunch than many other markets, boasting a good track record of well-structured deals supported by stable assets,” argues Richard Abadie, Global Head of PricewaterhouseCoopers’ Infrastructure Finance Advisory business. “Fundamentally, the appetite for infrastructure finance remains strong, especially for core, stable operating infrastructure.”

As evidence of this trend, he points to a growing pipeline of new projects and a rise in the number of infrastructure funds. Nonetheless, he concedes that the credit crunch and global economic slowdown will continue to dampen activity in all financial markets, and warns that the infrastructure sector will be no exception. “The financial risk of the infrastructure business is largely driven by the borrower; it is therefore reasonable to expect short-term reductions in profitability and possible debt restructuring where borrowers have overlaid excessive financial risk over the long-term fundamental business risk,” he says.

The long-term health of the infrastructure finance markets is, he continues, dependent on the return of the institutional debt markets to the infrastructure sector. Until then borrowers, and consequently users and taxpayers, will continue to pay higher prices for private finance. And while good deals with appropriate risk apportionment and strong commercial structures will continue to find finance, it is unreasonable to expect a quick return to the peaks of recent years. “While some borrowers as well as many government procurers refer to terms reverting back to the height of the market, it is a naïve notion to expect the markets to revert to the low pricing obtained in the first half of 2007,” concludes Abadie. “Such conditions are unlikely to be seen again, or at least not in the average career-span of most infrastructure financiers.”