Wednesday 11, January 2017 by Georgina Enzer

Saudi Arabia in focus

<!--[if gte mso 9]><xml> </xml><![endif]-->By Jean - Michel Saliba, Bank of America Merrill Lynch

Capital outflows overshadow fiscal reforms Balance of Payments (BoP) data suggests financial outflows are continuing, likely reflecting private sector hedging and official outward flows. Methodological compilation issues mean the size of such outflows may be difficult to ascertain accurately. Within the official sector, the outward investment mandate of the Public Investment Fund (PIF) needs to be carefully managed in order not to pressure reserves. 

Ongoing fiscal reforms and higher oil prices could bring the current account deficit nearer to balance over the coming years as the external breakeven oil price hovers around $60/bbl. The drop in SAR Fx forward points reflects this but capital outflows and fiscal slippage remain risks. If outflows persist, authorities may consider resorting to administrative measures as the commitment to an open capital account is central to attracting foreign investment under the economic reform programme, in our view.

Fiscal consolidation drives current account adjustment

Fiscal discipline over 9m16 has helped narrow the current account deficit. The current account deficit stood at 5.2 per cent of GDP over 9m16, compared to 8.7 per cent of GDP in 2015. Furthermore, the current account balance recorded a small surplus of $2.1 billion in 3Q16, while the trailing current account deficit stood at $46.7 billion (7.6 per cent of GDP).

Government fiscal consolidation has been the main driver of external balances, alongside oil prices. The quarterly trade surplus improved in 3Q16, standing at $19.5 billion (oil prices of $45.8/bbl), compared to a low of $3.3 billion in 1Q16 (oil prices of $34.5bbl). Quarterly imports compressed materially, plunging by 32 per cent yoy to $25 billion, down from a quarterly peak of c$40 billion. The invisibles balance has also improved, largely on the back of lower government payments for goods and services and stabilisation in outward remittances.  

Non-oil sector recession drives down import demand Narrowing of the current account deficit mirrors the sharp slowdown in nonhydrocarbon sector activity over recent quarters. The non-oil economy was in recession over 9m16 as real non-hydrocarbon GDP growth contracted by 0.3 per cent yoy, from 3.2 per cent yoy in 2015. This was largely driven by contraction in the non-oil government sector, as the non-oil private sector maintained a marginally positive real growth rate.  

Oil prices approaching external breakeven levels With the external breakeven oil price around $60/bbl, higher oil prices and ongoing fiscal reforms are likely to drive the current account nearer to balance over the mediumterm. stabilisation in real terms of government spending suggests that imports are likely to rebound. Even if crude oil production cuts are fully reflected into exports, the higher oil price compared to September levels more than fully compensates for this.  

Capital outflows accentuate Fx reserve loss, unlike historical precedents While the market is focused on the fiscal outlook, this should not obscure the other challenge facing authorities, which is to tame the capital outflows. This situation is relatively peculiar for the Saudi authorities. Historically, Saudi current account surpluses were associated with financial account deficits as sterilisation of oil export receipts translated into acquisition of foreign assets. Our breakdown of the net International Investment Position (IIP) shows large holdings of foreign assets by the semigovernment and private sector. The repatriation of Fx assets by government entities, part of which is managed by SAMA off-balance sheet, minimised Fx reserves loss.

Capital outflows pick up

 Financial flows were the largest driver of Fx reserve loss in 9m16. Adjusting for the issuance of a $10 billion sovereign syndicated loan, the pace of financial outflows in 9m16 would have picked up over the same period of 2015. While the financial account gap augmented by net errors and omissions stood at $36 billion in 9m16, the current account deficit stood at $25 billion over the same period. This compares unfavourably to 2015, where the drain from both sources was roughly matched at c$57 billion. 

While accumulation of currency and deposits appears to have slowed down versus 2015 levels, outflows from net errors and omissions have picked up instead over the past year. Outflows through net errors and omissions stood at $59.5 billion between 4Q14 and 3Q16, with an average outflow of $14.7 billion over the last four quarters. Acquisition of foreign currency and deposits also totalled $26bn over 4Q14-3Q16 or roughly $3 billion per quarter over the same period. Liquidation of $16.7bn in foreign securities of independent government agencies over 11m16 helped support Fx reserves.

A word of caution Methodological compilation issues mean the size of such capital outflows may be difficult to ascertain accurately. Large errors and omissions have been persistent over the period 2005-2013, averaging 6.5 per cent of GDP. This could reflect an under-recording of imports or lack of comprehensive coverage of private sector financial flows. There appears to be inconsistencies between BoP and IIP data. Private sector deposit dollarization appears benign and government entities have de-dollarised. 

PIF mandate needs close coordination with monetary authorities

The restructuring of the Public Investment Fund (PIF) into a SWF with a mandate to increase overseas assets is likely to contribute to investment outflows, pressuring Fx reserves. A $3.5 billion foreign investment deal concluded in June. SAR100 billion ($26.7bn) was transferred to the PIF from government accounts late last year. Alongside repayment of arrears, this helps explain the large SAR192bn ($52 billion) drop in central government deposits at SAMA over October-November despite issuance of a $17.5 billion external bond. While government entities - in this case, likely PIF - increased their deposits at SAMA in October by $22 billion, these have dropped by $9.2 billion in November. This suggests that PIF has re-deployed part of its new capital. While domestic investments are also part of PIF’s mandate, announced partnerships ($10 billion co-investment mandate with RIDF and up to $45 billion in seed capital for a technological investment fund over five years) suggest future outward investment flows.

 

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Capital outflows overshadow fiscal reforms Balance of Payments (BoP) data suggests financial outflows are continuing, likely reflecting private sector hedging and official outward flows. Methodological compilation issues mean the size of such outflows may be difficult to ascertain accurately. Within the official sector, the outward investment mandate of the Public Investment Fund (PIF) needs to be carefully managed in order not to pressure reserves. 

Ongoing fiscal reforms and higher oil prices could bring the current account deficit nearer to balance over the coming years as the external breakeven oil price hovers around $60/bbl. The drop in SAR Fx forward points reflects this but capital outflows and fiscal slippage remain risks. If outflows persist, authorities may consider resorting to administrative measures as the commitment to an open capital account is central to attracting foreign investment under the economic reform programme, in our view.

Fiscal consolidation drives current account adjustment  Fiscal discipline over 9m16 has helped narrow the current account deficit. The current account deficit stood at 5.2 per cent of GDP over 9m16, compared to 8.7 per cent of GDP in 2015. Furthermore, the current account balance recorded a small surplus of $2.1bn in 3Q16, while the trailing current account deficit stood at $46.7bn (7.6 per cent of GDP).

Government fiscal consolidation has been the main driver of external balances, alongside oil prices. The quarterly trade surplus improved in 3Q16, standing at $19.5bn (oil prices of $45.8/bbl), compared to a low of $3.3bn in 1Q16 (oil prices of $34.5bbl). Quarterly imports compressed materially, plunging by 32 per centyoy to $25bn, down from a quarterly peak of c$40bn. The invisibles balance has also improved, largely on the back of lower government payments for goods and services and stabilisation in outward remittances.  

Non-oil sector recession drives down import demand Narrowing of the current account deficit mirrors the sharp slowdown in nonhydrocarbon sector activity over recent quarters. The non-oil economy was in recession over 9m16 as real non-hydrocarbon GDP growth contracted by 0.3 per centyoy, from 3.2 per centyoy in 2015. This was largely driven by contraction in the non-oil government sector, as the non-oil private sector maintained a marginally positive real growth rate.  

Oil prices approaching external breakeven levels With the external breakeven oil price around $60/bbl, higher oil prices and ongoing fiscal reforms are likely to drive the current account nearer to balance over the mediumterm. stabilisation in real terms of government spending suggests that imports are likely to rebound. Even if crude oil production cuts are fully reflected into exports, the higher oil price compared to September levels more than fully compensates for this.  

Capital outflows accentuate Fx reserve loss, unlike historical precedents While the market is focused on the fiscal outlook, this should not obscure the other challenge facing authorities, which is to tame the capital outflows. This situation is relatively peculiar for the Saudi authorities. Historically, Saudi current account surpluses were associated with financial account deficits as sterilisation of oil export receipts translated into acquisition of foreign assets. Our breakdown of the net International Investment Position (IIP) shows large holdings of foreign assets by the semigovernment and private sector. The repatriation of Fx assets by government entities, part of which is managed by SAMA off-balance sheet, minimised Fx reserves loss.

Capital outflows pick up Financial flows were the largest driver of Fx reserve loss in 9m16. Adjusting for the issuance of a $10bn sovereign syndicated loan, the pace of financial outflows in 9m16 would have picked up over the same period of 2015. While the financial account gap augmented by net errors and omissions stood at $36bn in 9m16, the current account deficit stood at $25bn over the same period. This compares unfavourably to 2015, where the drain from both sources was roughly matched at c$57bn. 

While accumulation of currency and deposits appears to have slowed down versus 2015 levels, outflows from net errors and omissions have picked up instead over the past year. Outflows through net errors and omissions stood at $59.5bn between 4Q14 and 3Q16, with an average outflow of $14.7bn over the last four quarters. Acquisition of foreign currency and deposits also totalled $26bn over 4Q14-3Q16 or roughly $3bn per quarter over the same period. Liquidation of $16.7bn in foreign securities of independent government agencies over 11m16 helped support Fx reserves.

A word of caution Methodological compilation issues mean the size of such capital outflows may be difficult to ascertain accurately. Large errors and omissions have been persistent over the period 2005-2013, averaging 6.5 per cent of GDP. This could reflect an under-recording of imports or lack of comprehensive coverage of private sector financial flows. There appears to be inconsistencies between BoP and IIP data. Private sector deposit dollarization appears benign and government entities have de-dollarized. 

PIF mandate needs close coordination with monetary authorities The restructuring of the Public Investment Fund (PIF) into a SWF with a mandate to increase overseas assets is likely to contribute to investment outflows, pressuring Fx reserves. A $3.5bn foreign investment deal concluded in June. SAR100bn ($26.7bn) was transferred to the PIF from government accounts late last year. Alongside repayment of arrears, this helps explain the large SAR192bn ($52bn) drop in central government deposits at SAMA over October-November despite issuance of a $17.5bn external bond. While government entities - in this case, likely PIF - increased their deposits at SAMA in October by $22bn, these have dropped by $9.2bn in November. This suggests that PIF has re-deployed part of its new capital. While domestic investments are also part of PIF’s mandate, announced partnerships ($10bn co-investment mandate with RIDF and up to $45bn in seed capital for a technological investment fund over 5 years) suggest future outward investment flows.

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