NBK Economic update

KUWAIT: More than two years into the oil price downturn and Saudi economic growth has slowed significantly. Public investment has been pared back, credit growth has slowed and liquidity has tightened amid reduced deposit flows and rising debt issuance. Facing the prospect of widening fiscal deficits, the authorities have cut back on spending and embarked on a bold and ambitious program of fiscal consolidation.

They froze public sector salaries and benefits, cut fuel and utility subsidies, scaled down public investment projects and raised non-oil revenues via tax hikes and privatization programs. These and other measures form part of the government’s new strategic blueprint for economic restructuring, diversification and fiscal sustainability: the Saudi Vision 2030. Looking ahead, we see the authorities delivering on some of their goals, economic growth resuming, albeit, modestly, in 2018, helped by higher oil prices and by a recovery in consumer and investor confidence.

Real growth to slow in 2016 as fiscal consolidation and subdued private sector activity take their toll on the non-oil economy Real GDP is expected to slow significantly in 2016 to 1.2% from 3.5% in 2015 amid cutbacks in capital spending and weaker consumer spending.

Non-oil growth is also projected to slow considerably in 2016, from 3.1% y/y in 2015 to 0.2% y/y, as the government pushed through with aggressive fiscal consolidation and as the private sector feels the impact of lower retail spending and the overall fall in consumer confidence. Indeed, the non-oil economy could be on the verge of a technical recession, should soon-tobe-published 3Q16 real GDP data show another quarter of negative growth.

Key metrics of consumer and business activity, such as point of sale (POS) and ATM transactions, private sector credit growth and the Purchasing Managers’ Index (PMI), all trended lower in 2016, although the latter was more volatile m/m and did not dip below 50, which would have suggested a contraction in business activity. Looking ahead to 2017 and 2018, activity is expected to pick up as the government resumes paying contractors and as deposits increase on higher oil prices and thanks to the international bond issuance. With deposit flows rising, lending should also pick up. We expect non-oil growth to reach 0.8% and 1.9% in 2017 and 2018, respectively.

Meanwhile, the oil sector continued to expand in 2016, with the kingdom ramping up both crude oil production-to a record 10.5 million barrels a day (mb/d) in 2016-and gas production following the commissioning of the Wasit gas plant. Since oil prices headed south in 2014, Saudi Arabia has pursued its strategy of maximizing market share and accelerated its plan to move up the hydrocarbon value-chain by expanding its refining capacity. The launches of the Satorp and Yasref refineries brought an additional 0.8 mb/d of refined products output capacity. Real oil GDP growth should clock in at 2.5% in 2016 before moderating to 0.5% in 2017 and to 0.4% in 2018 as output gains recede and as Saudi Arabia complies with its reduced production quota under the terms of the recent OPEC/non-OPEC production cut agreement. While Saudi crude output is expected to contract in accordance with the agreement, on a full year basis, we don’t expect production to decline by as much as the 4.5% stipulated in the deal.

Inflation slowing as economic activity cools

Inflation was on a downward trend in 2016, slowing for the seventh consecutive month in October, to 2.6% y/y. Food and beverages were the chief negative influence on the cost of living index. The moderation in inflation comes despite a significant uptick at the start of 2016 in response to the government’s fuel and utility price hikes. With their effects on headline inflation receding throughout the year, increases in the CPI thus tended to reflect other factors such as falling import prices, especially food and clothing (related to the stronger USD and SR in 2016) and moderating house price inflation as well as, more broadly, the contraction in money supply that was a feature for most of the year. The trend should continue into 2017, bringing inflation down to 2.5% before rebounding in 2018 to 4.3% as the economy picks up. Higher energy and utility costs and higher taxes (including VAT) will also pressure CPI in 2018.

Saudi Arabia’s fiscal deficit, having widened significantly in 2015 to -15% of GDP ($96.6 billion), is expected to narrow in 2016 to -12.1% of GDP and further over the forecast period as the government reins in its spending, including its expensive subsidy bill. Of course, expectations that oil prices will be 33% higher in 2018 (averaging $60 per barrel) than their average in 2016, is central to the improvement in the fiscal outlook.

Indeed, given the surprising degree of progress achieved so far, in what is undoubtedly a very bold and ambitious fiscal adjustment program, there is a very realistic chance that the authorities will deliver on their National Transformation Program (NTP) target of a balanced budget by 2020. Subsidies on fuel and utilities have already begun to be reduced (working towards the NTP target of a cut of SR200 billion, or 8.3% of GDP, over 5 years), wages and benefits for public sector workers have been frozen for a year (the NTP sets a target of reducing the wage bill by 5% to SR456 billion by 2020), and outlays on non-essential capital projects have been scaled back, by an estimated 12% in 2015 and 2016.

On the revenue side, though the NTP plan of more than trebling non-oil revenues to SR530 billion ($141 billion, or 17.3% of GDP) by 2020 still appears ambitious, the authorities have made some headway in tapping new non-oil revenues. These include: higher fees on public services, immigration and traffic violations; new taxes on cigarettes and soft drinks as well as on undeveloped urban land (so-called “white lands”); and the introduction of a value-added tax (VAT), which will come into effect in 2018 at a rate of 5%. A rough estimate of the gain to the Saudi treasury resulting from the VAT could be in the order of $10 billion, which would approximate to about 16% of projected non-oil revenues in 2018 and 1.4% of forecasted GDP in that year. The privatization of state entities, including up to 5% of state oil giant Saudi Aramco, and the transformation of the Public Investment Fund (PIF) into the kingdom’s official SWF with a global footprint and assets under management of at least $1.8 trillion by 2030, are key strategic objectives of the Saudi Vision 2030.

Public debt rises

With Saudi Arabia expected to continue to post fiscal deficits over the next few years, public debt is projected to rise markedly from its historic low of 1.6% of GDP in 2014 to at least 23% of GDP in 2018. This is, however, still an extremely low level of debt by international standards. Up until mid-to-late 2016, when domestic and international bond issuance accelerated, the burden of deficit financing fell squarely on the kingdom’s foreign reserves and the government’s accounts at SAMA. Since June 2016, the rate of reserve drawdown has slowed significantly to $7.8 billion per month from an average of $10.9 billion per month in 1H16. Total net foreign assets stood at $572 billion in October, which is still an ample 30 months-plus in terms of goods and services import cover.

2015 witnessed approximately SR98 billion ($26 billion) worth of government bonds sold to local financial institutions, which helped to cover a quarter of the deficit. In 2016, the authorities augmented their domestic bond issuance program with an additional, record-breaking $17.5 billion international sovereign bond sale and a $10 billion syndicated loan from foreign banks. We expect bond issuance to proceed apace during the next two years, with probably at least another $80 billion added to central government debt.

Liquidity conditions improving

Deposit, credit and liquidity indicators continue to point to a banking system that has been pressured by the fall in oil prices, albeit, one that is showing some signs of a recovery following Saudi Arabia’s record international bond sale in October 2016. Bank deposit growth turned positive in October for the first time in 2016, rising by 0.5% y/y on a slight improvement in private sector deposits (3.4% y/y) after the government resumed payments to private contractors.

This should continue over the next few months as the government honors $26.7 billion in back payments. However, deposits from government entities still remain well down, by -8.5% y/y, and are unlikely to expand significantly without higher oil prices. The pick-up in deposits was also reflected in the money supply, with growth in the broadest measure, M3, turning positive in October for the first time since January 2016.

On the credit side, lending to the private sector has been lackluster; October showed a rise of only 6.2% y/y, which is one of the slowest rates since 2011. In contrast, public sector credit growth accelerated significantly in 2016, rising to 31.4% y/y in October. This is the fastest pace of growth in more than three years, a trend that is likely to continue as the government borrows more from banks.

Despite overall deposit growth lagging credit growth, indicators of liquidity in the Saudi banking system have started to improve: banks’ loan-to-deposit ratio (LDR) eased a little last October to 89.1%; the 3-month interbank rate has fallen by around 33 bps from its high of 2.38% in October to around 2.05% as of mid-December; and excess bank deposits at SAMA have increased 24% y/y to almost $53 billion, according to the most recent data.

A number of measures, including their assumption of long-delayed government payments to private contractors, have contributed to this easing in liquidity. SAMA, for example, has alleviated some of the liquidity constraints through its broadening of the window for repo arrangements, reducing the size of its T-bill issuances and by injecting SR20 billion ($5.3 billion) into the deposits of public sector companies. Also, the kingdom’s record-breaking $17.5 billion international sovereign bond issuance in October, of course, has the potential to significantly improve liquidity as well as the government’s fiscal situation. The bond sale should indirectly help the private sector as wellby lessening the pressure on domestic banks to finance the government, thereby freeing up credit lines for private enterprises. These are vital for a healthy and dynamic non-oil economy. Indeed, government bonds, as a share of total bank claims, went from a low of 3.3% in 2013 to a post-financial crisis high of 10.6% in October as bank holdings of government bonds skyrocketed in 2016 to $46.9 billion.

Market perceptions of Saudi sovereign risk moderating

The material improvement in banking sector metrics is reflected in the improvement in market perceptions of risk. In the currency markets, the difference between the spot and forward Saudi-US Dollar exchange rate (SR/USD) narrowed to around 300 forward points by mid-December, having hit its widest margin of 975 points in two decades earlier in the year on speculation that the authorities would be forced to devalue the riyal, in effect abandoning the 30year peg to the US dollar.

The kingdom is, however, unlikely to shift away from an exchange rate regime that has served it well in the past, anchoring both the economy and inflation. The dollar peg provides stability to trade and income flows, especially given the fact that oil, which is priced in dollars, continues to dominate the Saudi economy. Over the last decade, with the exception of 2015, oil has accounted for close to 90% of the kingdom’s export and fiscal revenues. 5-year credit default swap spreads (CDS), though still elevated, have also fallen in the last few months as the outlook has improved. Expectations of higher oil prices in 2017 and beyond in the wake of the recent OPEC deal is also a key factor in the improvement in sentiment.

Borrowing costs rise after the US Fed raises interest rates

SAMA, following the US Fed’s lead, raised its key interest rate, the reverse repo, by 25 bps to 0.75% in December. The repo rate remains unchanged at 2.0%. This, the second rate rise in this cycle, points to further rising borrowing costs, as the US Fed moves ahead with monetary policy tightening in 2017. The main Saudi stock index, the Tadawul All-Share Index ( TASI), reversed course in October after being down21% ytd at one point in the year. As of mid-December, the index was in positive territory, up 3.3% ytd at 7,137, as it continued to ride on the marked improvement in optimism that came about in 4Q16 thanks to the international bond sale and the OPEC production cut agreement, which was positive for oil prices.