Getting back on track
Amidst many difficulties Saudi Arabia may be facing, on the back of the Kingdom’s reforms, the economy is resilient enough to weather the storm.
Saudi Arabia will experience an interesting year. Following the announcement of the Government’s Vision 2030 and its National Transformation Programme, 2017 is the year to see the implementation and effectiveness of these reforms.
The IMF in its recent World Economic Outlook Update reduced its growth forecast for Saudi Arabia in 2017 from two per cent previously to 0.4 per cent. The main reason for this change in outlook is the oil GDP, where, because of the OPEC Agreement, and the cut in oil output, the IMF assumed that oil GDP will somewhat contract this year.
“The non-oil sector we expect to grow. We downgraded that marginally, but we do expect a recovery in non-oil growth—a modest recovery in non-oil growth this year. That is because we've seen, I think, confidence rebound a little bit in recent months after the sovereign bond issue, the government has been now paying the delayed payments, so that has been positive for confidence. We are also expecting a little bit less of a fiscal consolidation (phonetic) this year, than over the previous two years. That should also be supportive of the non-oil growth,” explained Tim Callen, Assistant Director and Mission Chief for Saudi Arabia at the IMF in a recent press conference on the economic developments in the Kingdom.
The Executive Board of the IMF, in its latest consultation report with Saudi Arabia, conducted in July 2016, noted that bank deposits in the country have declined, but growth of credit to the private sector remains strong. Capital buffers are high, NPLs low, and banks are well provisioned against loan losses. Based on current policies, the fiscal deficit was projected to narrow to 13 per cent of GDP in 2016. Non-oil revenues were expected to increase, while spending restraint, particularly on the capital side, will result in a substantial reduction in expenditure.
The fiscal deficit is expected to be financed through a mix of deposit drawdown and domestic and international borrowing. The current account deficit is projected to narrow to 6.4 per cent of GDP in 2016 and then move close to balance by 2021 as oil prices partial recover. SAMA’s net foreign assets are expected to fall further in 2016, but the pace of decline will slow over the medium term.
On the back of various economic and fiscal reforms, Saudi Arabia could possibly be upgraded to emerging market status by MSCI. The index provider said that the Capital Market Authority’s recent reforms made a significant contribution towards bringing the Saudi equity market closer to emerging market accessibility standards. These included the move towards T+2 settlement (expected to be implemented during the second quarter of 2017); regulations and procedures surrounding adoption of a Delivery versus Payment (DVP) system including the segregation of custody and settlement; and easing of the Qualifying Foreign Investor (QFI) restrictions. MSCI indicated that there is a possibility of the MSCI Saudi Arabia Index being part of the watch list for inclusion in the MSCI Emerging Markets Index as part of the upcoming classification cycle that will be launched in June 2017. This upgrade—if materialises—could drive significant returns over the subsequent two years.
Recent forecasts have predicted a Saudi budget deficit of $85 billion in 2017, compared to $107.5 billion in 2016, with oil prices rising to $57/barrel. The macro environment in Saudi Arabia is believed to remain weak, according to Credit Suisse in a recent market investment report. Despite being one of the worst performing markets globally, earnings downgrades have kept valuations from becoming outright cheap. Downside risks to growth remain due to continued pressure on government spending, potential for further subsidy reforms and continued weakness in consumer spending.
Saudi Arabia’s fiscal and current account balances have moved into deficit and growth is starting to slow. IMF highlighted the need for a gradual but sizable and sustained fiscal consolidation as well as balancing the budget over the medium term. Expenditure and revenue reforms, including continued gradual adjustment of energy prices with compensation for lower-income households, introduction of a VAT and excise taxes, containment of the government wage bill, and improved public investment management and spending efficiency.
The IMF also suggested the development of a medium-term fiscal framework and strengthening the annual budget process, with better integration of the Public Investment Fund and Aramco into the budget. It also encouraged the authorities to take an integrated asset-liability management approach to financing the fiscal deficit. Additionally the increased role of the private sector in the economy through privatisation and public-private partnerships are expected to improve the business environment, develop local capital markets, encourage FDI, and support SMEs. Continued labour market and education reforms are also needed to encourage private sector employment of Saudi nationals and increase labour force participation of women.
Concerns about the Saudi Arabian riyal devaluation is said to be one that is misplaced. Credit Suisse in its report suggested that the risk devaluation is negligible. The political and economic costs are far too high for the Kingdom—a devalued riyal would certainly reduce fiscal deficit, but at the cost of significantly higher imported inflation. A devaluation could also destabilise the financial framework of the country (and by extension, of the broader Gulf region) and, in a worst case scenario, it could trigger significant capital flight.
Callen highlighted that the pegs remain appropriate for the GCC countries. The pegs give confidence to investors, both domestic and foreign. It also gives credibility to monetary policy by being tied to the dollar. Taking a look at the structure of most Gulf economies, their exports are predominantly oil, which is priced in US dollars. Therefore the peg remains appropriate for those and a number of other reasons.
Saudi Arabia has enough tools at its disposal to avoid any devaluation in the foreseeable future, notes Credit Suisse. Foreign exchange reserves are 15 per cent lower YoY and 23 per cent lower than their mid-2014 peak, but at about $550 billion, the reserves are still close to 100 per cent of GDP and provide adequate cushion for defending the peg. This number does not include Saudi Arabia’s holdings of US treasuries totalling $96 billion as at October 2016, down from its recent peak of $124 billion in January 2016.
Reforms that have been carried out have assisted in strengthening the financial system, and the banking sector is well positioned to weather lower oil prices and slower growth, according to the IMF. Authorities are urged to continue to closely monitor credit quality, strengthen the macro-prudential framework, and finalise the framework for bank resolution and liquidity provision.
Nevertheless, this position may be compromised due to the stress in the Saudi construction sector which could lead to rising problem loans and higher provisioning costs for banks in the Kingdom. Moody’s in a commentary on the subject, explained that the decision of the Saudi government to rein in fiscal deficits in a lower oil price environment has resulted in a significant contraction in capital expenditure in the Kingdom. This has slowed economic activity, particularly in the construction sector.
A continued deterioration of government accounts has led to a broad reassessment of the pipeline of government projects, which has resulted in a mix of project cancellations, extensions of timelines and delayed payments to contractors while demand for credit from the construction sector rose. These dynamics were said to have fuelled newspaper headlines amid signs of growing financial pressure in the industry, including large-scale redundancy plans at construction conglomerates such as Saudi Oger, and Saudi Bin Laden.
Bank lending to the sector has increased by 19.7 per cent year-on-year as of June 2016, well above the total credit trend of 8.9 per cent over the same period.
Banks’ exposure to the building and construction sector, as reported by SAMA, amounted to SAR 113 billion as of June 2016, or 7.9 per cent of their total loans and advances. This represented a 19.7 per cent increase year-on-year, well above the 8.9 per cent increase in total bank credit over the same period. This strong growth was attributed primarily to increasing levels of receivables in 2015 and in the first half of 2016, which pressured cash flows of corporates in the sector. As a result, the construction sector's credit-to-GDP ratio increased to around 90 per cent as of June 2016, up from 69 per cent from 2014. The trend is strongly negative, as rising levels of indebtedness heighten the sector's vulnerability to liquidity risks and increases in financing costs.
Moody’s estimated total on and off balance sheet credit exposure to the building and construction sector to represent around 58 per cent of banks' tangible common equity. This sizeable exposure, including some clusters of loans to large contractors and material related off balance-sheet exposures, leaves the banks susceptible to the growing challenges in the sector. While Saudi banks are expected to face increased problem loans and higher provisioning costs over the next 12 months, Moody’s expect the magnitude of the asset quality deterioration to be within the banks' profit margins. Capital buffers are believed to be robust and can absorb material stress from downside scenarios in the building and construction sector.
In spite these alarming findings, last September SAMA announced that it would provide Saudi banks with about SAR 20 billion ($5.3 billion) of time deposits on behalf of government agencies, and introduce seven-day and 28-day repurchase agreements. These moves follow prior deposit injections of approximately SAR 12 billion since the start of 2016 and are credit positive (according to Moody’s) for Saudi Arabia’s banks, which continue to face pronounced liquidity pressures as a result of recent deposit outflows, a consequence of depressed oil prices.