Low oil prices are slowing or reversing deposit growth at Gulf Arab banks, but not enough to cause the liquidity squeeze that bankers fear.

Deposits from governments, quasi-government bodies and national oil companies provide around 10 to 35 per cent of banks' non-equity funding in the six-nation Gulf Cooperation Council, Moody's Investors Service estimates.

Those deposits, which tend to be cheaper for banks than tapping wholesale funding markets, keep the banks highly liquid while boosting their profitability.

The plunge of oil prices since last June threatens that comfortable picture. GCC governments, which were obtaining around 90 per cent of their income from oil exports, now have much less fresh money to deposit with banks, and may have to withdraw some to cover budget deficits.

In the worst case, this could trigger a liquidity shortage, reducing the banks' ability to lend to companies and hurting Gulf economies.

So far, however, the danger is being averted - partly because governments appear to be managing their funds carefully to limit the pressure on banks. Deposits are not falling nearly fast enough to put serious pressure on banking systems, and interbank money rates remain ultra-low, showing total liquidity is still ample.

The one-year Saudi interbank offered rate sank to 0.981 per cent this week, its lowest since October 2011. United Arab Emirates and Qatari money rates have stayed similarly soft.

"The oil price drop has not materially impacted bank lending in the region thus far, and there are no signs of liquidity abating with pricing holding fairly firm," said Steven Perry, global head of debt markets and syndications at First Gulf Bank , one of the UAE's biggest lenders.

"I also don't expect pricing to necessarily move up because of potentially lower deposits in the first half."

Bank lending growth in several countries is slowing: Saudi banks' private sector claims rose 11.6 per cent from a year ago in January, the slowest rise since December 2011, while Qatar's 5.3 per cent total credit growth was the lowest in several years.

But bankers and economists see the lending slowdown as a natural adjustment after years of rapid growth, not the result of a lack of funds available for loans.

"We might see Gulf banks being a little more selective in lending. They are likely to adopt a more conservative stance toward loans to the private sector, and particularly to retail," said Standard & Poor's credit analyst Timucin Engin. But lending to state-linked projects will remain strong, he added.

DEPOSITS

The impact of low oil prices can be seen in total deposits at Saudi commercial banks, which fell 2.0 per cent month-on-month in January, the biggest drop in over a year. Deposits in Qatar fell 2.2 per cent in January; in the UAE, December deposits edged up only 0.5 per cent from September, slowing from quarterly growth rates of 4 to 5 per cent seen early last year.

If oil prices stay low over the coming year, the two smallest and financially weakest GCC economies, Bahrain and Oman, could see bigger deposit drops and face heavier pressure on liquidity. Their governments lack the ample resources of their neighbours and may be forced to draw more money from the banking system to pay their bills.

But the big, wealthy Gulf governments have several ways to handle low oil prices without running down commercial bank deposits. One is using funds deposited at the central bank; the Qatar central bank's obligations to the government shrank 46 per cent from a year earlier to 23.90 billion riyals ($6.57 billion) in January, their lowest level in two years.

Governments can also run down assets held abroad in their huge sovereign wealth funds and bring the money home - something which could actually increase liquidity in the domestic banking system rather than reducing it.

Saudi Arabia, which projects a record state budget deficit of $38.7 billion for 2015 due to cheap oil, is widely expected to cover at least part of that deficit by selling foreign assets, a strategy it has adopted during lean times in the past.

It may already have started doing so; net foreign assets at the Saudi central bank, which acts as the country's sovereign wealth fund, edged up just 1.2 per cent from a year earlier to 2.725 trillion riyals ($727 billion) in January.

Asset growth has come down from double-digit rates seen in 2013. One reason is appreciation of the US dollar, which has reduced the value of assets held in other currencies such as the euro, but Saudi Arabia may also be selling some assets to cover expenses at home.

Last month central bank governor Fahad al-Mubarak said authorities were considering whether to cover the budget deficit by using their fiscal reserves, borrowing from the domestic financial market "which is characterised by a liquidity abundance and a low lending cost", or a combination of both.

If the Saudi government did embark on a major programme of domestic borrowing to cover its deficit, that could tighten liquidity somewhat, but perhaps not dramatically.

Commercial bank deposits exceeded loans to government, quasi-government and private sector bodies by $48 billion in January, more than this year's entire projected budget deficit of $38.7 billion.

The anticipated start later this year of US interest rate hikes, which Gulf central banks are expected to imitate because of currency pegs to the US dollar, may have more of an impact than cheap oil in tightening banking system liquidity.

"During the second half of 2015, if oil remains at current pricing levels and clients focus on expansionary capex (capital spending), then borrowing costs may edge up," Perry said.

Even then, however, the effect may be minor. "Even if the Fed increases the interest rates, in the short end you are looking at an increase of around 10 to 25 bps, which is not going to materially impact funding costs," said a senior banker at a foreign institution in the Gulf. – Reuters