Saudi Arabia: Life after oil

In October, the IMF’s gloomy prediction that Saudi Arabia could be bankrupt by 2020 made headlines around the world; but with tiny Government debt and massive fiscal reserves, surely things can’t be that bad?

The future of Saudi Arabia is certainly splitting opinions. While Standard & Poor’s has slashed its debt rating and Fitch Ratings has revised its outlook to negative, Moody’s has affirmed its ratings and maintained its stable outlook. While some economists point to diminishing reserves and a young population that needs investment, others point to promising new measures outlined in its 2016 budget, aimed at reigning in spending and diversifying the economy.

The one thing that everyone can agree on is that Saudi Arabia is heavily dependent on the price of oil, which has taken a 50 per cent tumble since June 2014. Saudi Arabia derives about 40 per cent of its GDP, 90 per cent of Government revenues, and 85 per cent of exports from the hydrocarbons sector. Although there has been a push to encourage private sector growth, this is largely dependent on funding from the public sector, which brings us back to a dependency on hydrocarbon revenues.

BLACK GOLD

Saudi Arabia’s mighty fiscal reserves have already been injured by the fall in oil prices. The country’s reserves shrank to 74.2 per cent of GDP at the end of 2015 from 87.2 per cent at the end of 2014, according to data from RAM Ratings. Central Government deficit widened to 15 per cent of GDP in 2015, when it stood at only 2.3 per cent at the end of 2014. Overall, the oil price slump brought the year’s fiscal revenue down by a painful 41.8 per cent.

Saudi Arabia’s fiscal power may be waning but, thanks to years of high oil prices, it still has solid financial buffers. Standard & Poor’s estimates Government liquid assets at about 111 per cent of GDP for 2015-2018.

“In our view, this level of assets significantly offsets the concentration risk related to the economy's hydrocarbon dependency,” the ratings agency said. “However, we could reassess our view that the Government has an exceptional buffer to offset most economic or financial shocks should liquid assets fall below 100 per cent of GDP.”

The worry is that reserves could diminish quickly if oil prices remain low. In its 2016 budget, Saudi Arabia slashed its forecast for Government revenue by 28.1 per cent; this assumes, somewhat optimistically, an oil price of around $40.6 a barrel – higher than the current price level. According to RAM Ratings, if the price of oil per barrel falls lower than the Government’s assumption by just $1, budgeted revenue would nosedive by about SAR 9 billion.

The corrosive effect of lower oil prices can already be seen on Saudi Arabia’s banking sector, which has always been considered solid thanks to ample liquidity. Saudi banks’ annual reports for 2015 make worrying reading, with a dramatic slowdown in deposit growth. According to Moody’s Investor Services, Saudi banks’ high-level annual results for 2015 show deposit growth slowing to just one per cent in 2015 from 12 per cent in 2014.

“In the context of oil prices that have declined by more than 75 per cent since June 2014 and a 14 per cent reduction in the 2016 Saudi Government budget, this lower deposit growth is credit negative for Saudi banks,” the rating agency said. “Lower deposit growth will limit banks’ capacity to lend and refinance existing borrowers and increase borrowing costs, which will reduce asset quality and drive increased provisioning costs for banks.”

Saudi banks mainly depend on domestic deposits, with the role of market funding being limited by a strict loan-to-deposit ratio of 85 per cent. The International Monetary Fund (IMF) warned that reduced oil inflows and slower Government spending growth will continue to slow deposit growth, which in turn will weaken credit supply.

“As corporate profits are affected, NPLs will likely rise, although the more subdued nature of this credit cycle compared to past cycles—owing to SAMA’s [Saudi Arabian Monetary Agency] stepped up regulation and supervision of banks—should mean the impact on asset quality is limited,” said the IMF in a recent report. “The reduced supply of credit and weaker bank and corporate balance sheets will have feedback effects on growth.”

As a knock on effect, bank loans will be harder to obtain and more expensive. The sector which will be most hurt by this are SMEs, which contribute around 33 per cent to Saudi Arabia’s GDP.

“Saudi banks are making it difficult for start-ups to get off the ground by decreasing loans to new entrepreneurs, despite the fact that these loans are backed by a Government SME Loan Guarantee Programme,” said Michael Armstrong, FCA and ICAEW Regional Director for the Middle East, Africa and South Asia (MEASA).

NEW DIRECTION

It seems Saudi Arabia’s only option is to look beyond oil and tighten its belt until non-oil revenues pick up. Its 2016 budget unveiled new measures to rationalise expenditure, increase non-oil revenues, and improve the fiscal policy framework.

KEY HIGHLIGHTS FROM SAUDI ARABIA’S 2016 BUDGET

Price hikes in petrol and utilities and a reform of generous subsidies are to be implemented over the next five years.

A hike in petrol prices of 66 per cent (91 octane) and 50 per cent (95 octane) was announced in December.

The growth of public sector salaries, allowances and bonuses are to be slowed.

Privatisations of Government-owned companies, including oil giants, are planned.

A medium-term expenditure framework with a budget ceiling and a debt management office are in the works to improve management of public finances.

Water prices for industrial, Government and large corporate users more than doubled and electricity, and gas and diesel prices were raised.

Taxes on tobacco and soft drinks are to be raised.

Plans for a GCC-wide value-added tax are in the works, although unlikely to be implemented before 2018.

“The new 2016 budget for Saudi Arabia, announced at the end of December last year, aims to reduce the current deficit to SAR 326 billion, down from SAR 367 billion for 2015,” explained Armstrong. “One of the measures is to cut projects spending to SAR 840 billion (down from SAR 975 billion) and improve their efficiency to counterbalance the negative effects of falling oil prices. However, the cuts to public expenditure will exert a powerful drag on GDP growth. We expect non-oil GDP growth of just 1.5 per cent in 2016, the weakest since 1994, followed by a gradual recovery to three per cent in 2017.”

The conundrum Saudi Arabia faces is that to increase non-oil revenue, it must continue to invest in the private sector and infrastructure; however, lower oil prices has put the Government under pressure to cut spending. The country’s large reserves are the main factor protecting its credit rating, and it can’t risk frittering away too much of its capital. “Although the Government has begun to cut back on expenditures, further cuts are likely to reduce the fiscal deficits,” said Moody’s. “Without such cuts and/or non-oil revenue increases, the Kingdom's creditworthiness will be affected.”

Although the 2016 budget included steps to rationalise spending and boost the non-oil sector, the effect this will have is negligible when faced with the lowest oil prices for 11 years. “Whilst the Government is taking the initiative to address the problem of falling oil prices, the announced measures will have a modest effect – our forecast is for a deficit of 14 per cent in 2016, only 1.5pp narrower than last year,” said Armstrong. “Measures to cut expenditure are countered by the 11 per cent fall in overall revenues that are expected as a result of weaker oil prices. However, taking those steps was certainly needed to avoid the deficit’s growth getting out of control.”

POSITIVE CHANGE

Even though the new measures will do little to stem the effect of falling oil prices, they are considered positive for the future of Saudi Arabia. The IMF noted that SAMA’s regulation and supervision is being strengthened by the reforms. “Formalising the macroprudential framework to clearly establish responsibilities and the way countercyclical policy tools will be used would further enhance policy implementation,” it said in a statement.

The fuel subsidy reforms are also considered a positive step. These include a 50 per cent increase in higher quality 95-octane petrol prices, a 66 per cent increase in lower quality 91-grade petrol prices, and a 74 per cent increase in diesel fuel prices.

“These fuel-price reforms are credit positive for the sovereign because they will lower current expenditures and bolster Government finances dented by the downturn in global oil prices, while reducing macroeconomic distortions,” Moody’s said in a recent comment. “Although fiscal gains from subsidy reform are likely to be moderate this year, we expect gains to accelerate when oil prices increase. Total subsidies and transfers composed about 4.9 per cent of all consolidated expenditures in 2014, although this likely understates the costs of energy price distortions because the subsidies are implicit – prices are kept artificially low, but this does not have a direct cost on the Government’s balance sheet.”

The IMF estimates that the opportunity cost from low energy prices in Saudi Arabia amounted to nearly 10 per cent of GDP in 2014. The price hikes will also lead to efficiency gains, reducing wasteful overconsumption driven by artificially low prices. According to the IMF, closing the price gap between Saudi Arabia’s domestic fuel prices and international prices would lead to efficiency gains of 1.5 per cent-2.1 per cent of GDP.

SAUDI ARAMCO TO LIST?

Perhaps the most noteworthy reform is Saudi Arabia’s plan to float Government-owned companies. The news that energy giant Saudi Aramco, the country’s national oil company, is considering an IPO sent shockwaves throughout the financial world. Saudi Aramco is the world’s biggest energy firm, and likely one of the most valuable companies in existence. Saudi Aramco confirmed the news in a statement on its website.

“Saudi Aramco confirms that it has been studying various options to allow broad public participation in its equity through the listing in the capital markets of an appropriate percentage of the company’s shares and/or the listing of a bundle of its downstream subsidiaries,” the statement said. “This proposal is consistent with the broad and progressive direction pursued by the Kingdom for reforms, including privatisation in various sectors of the Saudi economy and deregulation of markets, which the company strongly supports.”

If the listing goes ahead, Saudi Aramco, thought to have 10 times the reserves of rival oil producer Exxon, would become the world’s most valuable quoted company. Apple, Google and Facebook would all be in its shadow. Estimates vary, but its value is being put upwards of $1 trillion.

More significantly, however, the listing would herald a new age for Saudi Arabia, which has always protected its cheaply produced oil from outside involvement. With the transparency an IPO demands, any cries of corruption would be quashed. It signals a move towards modernisation and a progressive, international business environment.[IM4] 

THE DOWNSIDE

Of course, the shakeup was bound to have some negative impacts on a population unaccustomed to change. The hike in energy prices, for example, was bound to prove unpopular.

“Saudi Arabia is planning to cut planned spending by 14 per cent in 2016, raising the prices of gas, diesel, water and electricity,” said Armstrong. “These measures will most likely meet with a backlash from a society that is used to cheap energy prices. Businesses will have to face higher energy bills which might have an impact on their operations and create obstacles to future investments. Salaries may well experience downward pressure as businesses seek to reduce costs. Furthermore, the price of goods and services are likely to increase as businesses shift some of the burden to consumers.”

According to Moody’s, the price hikes are just the beginning, and energy will have to become even more expensive to help the Government reduce its deficit. “Although these unprecedented price hikes are credit positive, Saudi Arabia still has some way to go to fully close that gap. Indeed, even with these reforms, Saudi Arabia’s diesel prices remain much lower than those of regional neighbours,” Moody’s said.

Many economists seem to think that although the new measures are promising, they are simply too little, too late.

“The magnitude of the oil price decline means that the 2016 budget forecasts total revenues of SAR 513.8 billion, down from an estimated SAR 608 billion last year,” said Fitch Ratings. “Budgeted spending at SAR 840 billion is below estimated actual spending for 2015 (SAR 975 billion), but this leaves a projected deficit of SAR 326.2 billion ($86.9 billion), around 13.5 per cent of GDP. This is by far the largest fiscal deficit that the Saudi authorities have budgeted for.”

Another criticism is that many of the new measures are somewhat vague, with objectives stated without a method or timeline.

“The measures include various cuts to subsidies…’Saudisation’ of the workforce, and privatisation of some state owned enterprises; but in many of these areas details remain far from clear,” said Armstrong. “Measures to boost the non-oil sector take time to have an impact on business confidence – growth in the non-oil sector has been slowing since 2013 and financial indicators suggest lending to the sector is also slowing.”

Although some steps, such as VAT and corporate tax are considered a good move, the implementation will be too slow to have any impact in the immediate future. “A value-added tax approved by the Gulf Cooperative Council is unlikely to be implemented in Saudi Arabia before 2018, according to Government communications,” Standard & Poor’s pointed out. “As such, fiscal revenue will continue to be pressured by low oil prices, with very limited room for revenue diversification in the near term.”

Low oil prices are conclusively the biggest threat to Saudi Arabia’s economy, however other problems are lurking in the background. The Saudi riyal continues to be pegged to the US dollar, which provides stability but chains the country’s monetary policy to that of the US Federal Reserve, leaving little flexibility to use monetary policy. Tensions are also heightening with Iran, which is threatening to exasperate an oversupply of oil as sanctions are eased. Potential security risks undermine confidence and foreign investment, and drive up security costs. Its Government is also at a nascent stage, and decision-making is highly centralised.

However, the new measures show that Saudi Arabia is committed to modernisation. The old adage goes that it is never too late to change; only time will tell if this will hold true for Saudi Arabia.

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