Thursday 15, June 2017 by Jessica Combes

Saudi Arabia: Transformation Starts Now


Bank of America Merrill Lynch’s (Merrill Lynch) report GEMs Paper #28: Saudi Arabia: Transformation starts now, provided insights and outlook on how Saudi Arabia’s fiscal reforms.

The paper further considers the oil-price environment, potential MSCI inclusion and other macroeconomic trends will impact the country’s overall market, and various segments including: energy, banking, healthcare, petrochemicals, real estate, defence, and equity strategy.   

span lang="EN-GB">Macro Overview  

The potential MSCI EM watch list announcement in mid-June and possible Aramco IPO in 2018 are likely to fundamentally alter capital markets and aid diversification efforts, partly through investments led by the Public Investment Fund. 

In Merill Lynch’s base case with stable oil prices at $50/bbl, Fx reserves are likely to continue falling, albeit at a slower pace and after stabilising during 2018 on the back of MSCI EM and oil sector privatisation Fx inflows. Stabilising Fx reserves much longer will however require oil prices rebounding above $50/bbl and a moderation in the current pace of capital outflows. Sustaining domestic confidence and enhancing domestic investment opportunities to provide an outlet for repatriation of private sector capital will likely be key going forward. Should oil prices average instead $40/bbl, net fiscal proceeds are insufficient. The fiscal deficit would hover close to 10 per cent of GDP, Fx reserves could half to 35 per cent of GDP with no sign of stabilisation, and capital outflows could accelerate.

A sustained drop in oil prices is a key risk. Oil prices above $50/bbl are conducive to helping reforms succeed while oil prices below $40/bbl are likely to endanger macro stability. Within this price band, further reforms or wider imbalances are likely. Commitment to reforms may falter, should the impact of reforms be much larger than anticipated. The sheer size of measures at hand suggests execution risk, should implementation capacity fall short. Regional geopolitics may delay, but not derail, reforms as political leadership priorities shift in the near-term.

The sensitivity of the macroeconomic adjustment to oil prices is large. At $53/bbl, it is estimated that the fiscal deficit will settle at 4.9 per cent of GDP in 2020, while SAMA Fx reserves will settle at 51 per cent of GDP and government debt will reach 29 per cent of GDP. The monetary coverage Fx reserves will remain decent as Fx reserves will cover 4.2 times the monetary base and 0.7 times the monetary supply, from 6.2 and 1.1 respectively currently.

It is conservatively assumed that capital outflows will continue at the same pace. As Merrill Lynch assumes the current account will likely be in balance, the financial account will likely be the main driver of Fx reserves. Should capital outflows continue, Fx inflows associated with the potential Saudi Aramco IPO and MSCI EM inclusion would likely be critical to stabilise Fx reserves in 2018, even assuming the PIF redeploys part of the assets in foreign acquisitions. Should capital outflows slow down or the PIF invests mostly in domestic assets, Fx reserves could be more supported than our initial projections.

At $53/bbl, it is likely that the resultant mild imbalances are likely to be financeable, but Merrill Lynch would expect the government to potentially turn focus to further reforms post-2020 as needed. At oil prices between $40/bbl and $50/bbl, the macroeconomic outlook is in a relatively grey zone where further reforms may be necessary. Recall that every $10/bbl swing in prices causes a c$20bn (c3 per cent of GDP) and a c$30bn (4.4 per cent of GDP) move in the fiscal and current account deficit, all else being equal.

The picture changes however at $40/bbl. At this constant level of oil prices, the fiscal deficit will remain large at 9.8 per cent of GDP in 2020 even with the fiscal reforms, while SAMA Fx reserves will drop materially to 35 per cent of GDP, from 73 per cent of GDP currently, with no sign of stabilisation, and government debt will reach 39 per cent of GDP, from 13.1 per cent of GDP at end-2016.

The monetary coverage Fx reserves will deteriorate markedly as Fx reserves will cover 2.7 times the monetary base and 0.5 times the monetary supply. These monetary ratios will approach but remain somewhat better than levels seen in past episodes of speculative pressure on the dollar peg. Still, capital outflows could accelerate, and oil sector privatisations as well as MSCI EM inflows may be impacted and no longer be sufficient to stabilise Fx reserves.

FX & Domestic Liquidity  

Saudi EXD bonds seem well priced, as deteriorating fundamentals, uncertainty about reforms and oil exposure are reflected in some premium over ratings. Risk-reward in oil credits currently look relatively poor.  

Domestic liquidity improvement has likely run its course, and the dollar peg holds. However, more risk premium should be priced in long-dated Fx forwards as Fx reserves are likely to fall, albeit more slowly, and as fiscal consolidation success depends partly on oil prices.

The resumption of domestic issuance in 3Q17 is likely to modestly tighten domestic liquidity but much less than during 2H15-1H16. The domestic banking sector liquidity has improved, with excess deposits at SAMA standing at SAR107bn in April, compared to SAR54 billion in September 2016 and to an average of SAR75 billion in 2014. With the deceleration in private sector credit growth and some stabilisation in private sector deposits, the overall Loan-to-Deposit (LDR) ratio stood at 87.4 per cent in April, from 90.3 per cent in September. The targeted payment of cash allowances to Saudi households from 3Q17 onwards should support deposit formation, although a portion is likely to be utilised to meet higher utility and gasoline bills.

Continued large sovereign issuance of external debt‎ is expected, supplemented by issuance from Saudi Aramco and the Ministry of Housing. Following the issuance of a $9 billion international Sukuk, the government is also expected to resume issuing domestic debt over 3Q17, then issue a conventional international bond of at least $15 billion in size in 4Q17.

span lang="EN-GB">Oil  

On Merrill Lynch’s estimates, oil demand should keep growing by 1.1 million b/d p.a. out to 2022, falling short of average annual non-OPEC oil supply growth of 830, 000 b/d. It is likely that Brent crude oil prices will average $50 to $70/bbl over the next five years. Below this price band, oil supply rationing and rapid EM demand growth are expected to push prices higher. Above, a surge in global oil supplies and EM demand destruction has been seen, curbing any additional price gains.

OPEC is unlikely to re-engage in a price war over a five to 10 year window. From a pure economic standpoint, Saudi Arabia would likely be better off maintaining steady production and allowing prices to rise to maximise their long-term oil revenue. Saudi Arabia needs a certain combination of price and quantity when it comes to oil to meet budgetary requirements and higher output should bring more revenues. Yet, over a 15-year period, Saudi total oil revenues at $50/bbl and 18 million b/d of production would equate to $4.90 trillion. Meanwhile, a combination of $65/bbl and 12 million b/d production would bring in $4.30 trillion. Yet, given production costs of $10-to-$20/bbl, our work suggests that it simply would not pay off for Saudi to aggressively invest in domestic oil productive capacity, even if assuming a zero discount rate on incremental future revenues.

span lang="EN-GB">Banking

Saudi banks could enjoy a significant opportunity to grow lending. Penetration remains low, particularly in the retail sector, and banks will benefit from government support to the private sector. Asset quality deterioration and crowding out risks are the two key concerns.

Saudi Arabia is facing a period of elevated risks on account of the prevailing low oil price environment. More specifically, slower economic growth, cuts in government expenditure, a significant driver of economic growth, the introduction of fiscal consolidation policies, such as subsidy removals and higher costs.

With Saudi economic growth having slowed sharply since late 2014 when oil prices collapsed, loan growth in the Saudi system has also abated materially. Periods of slowing loan growth are typically well correlated with a rise in non-performing loans and there are already signs that NPL ratio is set to increase materially from current levels. Factors driving this include weaker corporate cash flows–Saudi aggregate earnings fell 24 per cent 2014-16; slower capital deployment from the government; continued stress on receivables, although this has abated from peak levels seen in 2016; and higher lending rates, which put pressure on ability to pay back loans.

Still, with the Saudi banks being amongst the best capitalised in the world, with relatively healthy NPL coverage, although NPL ratios have room to move upwards, and strong liquidity, it is well placed to absorb. Further, it is believed that much of the deterioration in asset quality has already been reflected in the Saudi Bank's consensus earnings estimates.


Merrill Lynch remains confident the economic reform process offers opportunities for the domestic Saudi healthcare sector in both the short and long-term. Following the release of the Vision 2030 Realisation Programmes overview, the previously released National Transformation Plan (NTP) remains the most important programme impacting the healthcare sector, in our view, with only indirect impacts from others. In the short-term, there are opportunities to collaborate with the government on investment and, in the longer-term, the roll-out in private insurance, when achieved, should substantially increase the addressable market.


The Saudi government is expected to keep prioritising downstream expansion into refining and petrochemicals. In conjunction with reforms to be introduced as part of the Fiscal Balance 2020 that will see domestic energy prices gradually rise to international reference prices, the Saudi government is likely to provide support in the form of: a) temporary funding; and, b) financing to improve efficiency. In addition, Petrochemical players, particularly SABIC, are expected to be key beneficiaries of the National Companies Promotion programme.

Fiscal reforms  

The policy initiatives in the Fiscal Balance 2020 programme and the ongoing reforms are generally neutral for consumers in Saudi Arabia, especially for Saudi citizens, with some positive reforms announced recently. According to Merrill Lynch, those most at risk from lower income/higher expenses will be the low-mid income white collar expatriates, which are estimated to represent roughly 15.8 per cent of total employed expats.

span lang="EN-GB">Real Estate

The NTP and Vision 2030 have a number of targets related to the Housing programme and real estate sector which are strategic sectors in the vision. The most important objective is to enable citizens to obtain a suitable residence and increase home ownership among Saudi families.span style="color: #00659b;">

The Kingdom is looking to address a large untapped demand in the Saudi real estate market particularly in the affordable housing segment where the shortfall is estimated at 1.2 million units. In fact, there is currently a mismatch between the demand which is concentrated in the SAR 200,000 to SAR 900,000 range and the supply which mainly in the upper segment.

span lang="EN-GB">Defence

Saudi Arabia is increasing its regional role as a Security and Defence nation in the Middle East. Defence is one of the key industries that Saudi is pinpointing for investment as part of its future strategy plans, and one where it is well placed to become a global leader. Saudi Arabia has one of the largest defence budgets globally, and as regional tensions present an ongoing issue, its focus on defence investment is expected to remain broadly intact regardless of the price of oil.



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