Growth to moderate amid fiscal consolidation
The effects of the decline in oil prices have finally caught up with the Saudi economy. Non-oil activity slowed considerably in 2015 as government finances swung into deficit and consumer confidence took a hit. The flow of deposits into the banking system and credit to the economy also moderated substantially. Liquidity has consequently tightened. Three months into 2016 and market sentiment is still predominantly bearish: equities are firmly in negative territory; CDS spreads and interbank rates remain elevated; and speculative pressure on the currency in the forward market persists.
The ratings agency S&P, for its part, downgraded Saudi Arabia’s credit rating by two notches to A- in January. Nevertheless, faced with a sizeable fiscal deficit and pressure on its foreign reserves, the government unveiled its first austerity budget in recent memory. While reiterating their support for the non-oil economy, the authorities envisage greater spending restraint, especially in terms of non-essential infrastructure outlays and, significantly, the gradual removal of costly energy and utility subsidies.
Revenue generating measures such as privatizations and value added tax (VAT) are also planned. Despite the challenging outlook, the commitment to fiscal reform appears serious; and with its substantial financial reserves, the kingdom is relatively well placed to successfully negotiate the current downturn.
Real oil growth to slow in 2016 as crude output remains at 2015’s high levels; natural gas expansion should boost real oil growth.
Real oil output expanded by 3.1% in 2015 after oil production surged to a record high of 10.2 million barrels per day (mb/d) on average. Elevated output was a direct result of Saudi Arabia’s twin strategy of maintaining market share and progressing up the hydrocarbon value-chain (by increasing production of refined products). The launch of the Satorp and Yasref refineries during 2014-15 brought an additional 0.8 mb/d of refined products output capacity. Real oil GDP is therefore forecast to expand by 0.9% and 1.1% in 2016 and 2017, respectively.
The key determinant of the performance of the Saudi non-oil economy is government spending. Last year, amid cutbacks in investment spending and tighter control of current spending, non-oil growth moderated to 3.6%, from 4.8% in 2014. 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 slipped on a year-on-year (y/y) basis. Recent readings continue to indicate subdued activity; January’s PMI of 53.9, for example, was the lowest figure in the survey’s 6-year history. Growth in output, new orders and exports has slowed compared to 2014.
Nonetheless, it is easy to overstate the degree of the slowdown, and it should be borne in mind that the non- oil economy is still expanding and creating jobs. With the likelihood of further cuts to government spending this year, however, we have revised down our non-oil growth forecast in 2016 to 2.1%.
Inflation accelerated sharply in January following fuel and utility price hikes by the government. Consumer prices, as measured by the kingdom’s cost of living index, increased by 4.3% y/y in January from 2.3% y/y in December. The transportation category, which accounts for 10% of the total index, posted the most dramatic increase in 21 years, rising from 1.3% y/y in December to 12.6% y/y in January after the government raised the price of gasoline by as much as 67% in an effort to reduce its expensive subsidy bill. Similarly, the housing and utilities segment, which has the greatest weight in the index with 20.5%, increased by 8.3% y/y in January, from 4% y/y in the previous month after the government raised water and electricity tariffs. We have therefore raised our inflation forecast for 2016 from 2.6% to 3.5% and for 2017 from 2.9% to 3.9%.
Saudi Arabia’s fiscal deficit widened significantly in 2015 to -15.9% of GDP ($104 bn), from -3.6% of GDP in 2014. This was due to a combination of elevated expenditures, including King Salman’s $23.4 bn accession bonus, and lower oil revenues. Oil revenues fell by 51% in 2015 in response to a further drop in oil prices during the year.
In what was the most austere budget in recent memory, the Ministry of Finance (MOF) penciled in spending cuts of -2.3% budget-on-budget and -12.6% over actual 2015 spending. Revenue is projected to fall by a further -28% budget-on-budget and -15% compared to realized 2015 revenue. This would result in the kingdom recording its second consecutive fiscal deficit in 2016, of $87 bn. The authorities stated that the fiscal shortfall will continue to be financed by a combination of debt issuance and reserve drawdowns, with emphasis on the former.
As well as reiterating its commitment to limit runaway current spending and rationalize capital spending by scaling back infrastructure outlays, the government unveiled a number of key reforms. These include cutting costly energy and utility subsidies, which went into effect at the start of the year, privatizing certain sectors of the economy, including possibly some of ARAMCO’s assets, and raising nonoil revenues by charging higher fees for public services and levying new taxes on undeveloped urban land and consumer spending (VAT).
VAT is likely to be a GCC-wide initiative to be rolled out possibly in 2018 at a rate of 5%. A rough estimate of the gain to the Saudi treasury resulting from the introduction of a VAT could be in the order of $9.6 bn, or 22% of non-oil revenues. This would approximate to around 1.5% of GDP.
In any case, given the focus on spending restraint and our projection that oil prices will average $45 per barrel (bbl) this year before rising by 33% to $60/bbl in 2017, we expect the fiscal deficit to narrow to -14.2% of GDP this year and to -7.6% of GDP in 2017.
According to January data, the kingdom’s official foreign reserves stood at $602 bn (92% of GDP), a decline of $132 bn, or 18%, compared to a year ago. (Chart 10.) While reserves still equate to a healthy 30 months of imports, the increasing rate of reserve depletion did prompt the authorities to begin issuing sovereign debt for the first time since 2007. Approximately SAR 98 bn ($26 bn) worth of government bonds across three tranches of 5, 7 and 10-years were sold to local financial institutions in 2015, helping to cover about a quarter of the deficit. We expect debt issuance to accelerate in 2016 and 2017, with the authorities aiming to finance at least 60% of the kingdom’s projected fiscal shortfall.
At this pace, and barring any further damage from lower oil prices, the kingdom’s foreign reserves could plausibly still be in excess of $500 bn (70% of GDP) by the end of 2017. Public debt, however, would rise over this period, from a historic low of 1.6% of GDP in 2014 to an estimated 17.5% of GDP by the end of 2017. These are still extremely low levels of debt by international standards.
The fall in oil prices has had a very noticeable effect on the Saudi banking system. This is not surprising given the sensitivity of domestic deposits and credit to changes in oil prices and government spending, respectively. Bank credit growth, for example, having averaged 11.2% y/y during 2010-2014, moderated to 8.2% y/y in Jan 2016, as the contraction in government infrastructure spending created fewer lending opportunities. Regulations implemented in 2014 requiring higher downpayments on housing loans also contributed to this trend.
At the sectorial level, credit to public sector enterprises witnessed the most marked slowdown, falling from an average of 10.6% y/y during 2010-2014 to -13% y/y by January 2016. Private sector credit growth held up better on the back of double-digit increases in lending to the construction, services and commercial sectors, but was also somewhat impacted, slowing from a five-year average of 12.2% y/y to 9.9% y/y in January 2016.
Bank deposit growth slowed significantly as well, from 14.5% y/y in mid-2014 to 3.4% y/y in January 2016. In what was the most visible manifestation of falling government revenues, the deposits of public sector entities contracted by -1.5% y/y in 2015. But while SAMA data from January showed that public sector deposits rebounded by 7.8% y/y, private sector deposits, increased by only 1.7% y/y. This is the most lackluster rate of growth since 1998.
Liquidity tightens amid slowing deposit growth and increasing government bond issuance
With overall deposit growth lagging credit growth, the banking system’s loan-to-deposit (LD) ratio increased to 85% by the end of 2015. Consequently, concerns about tightening liquidity increased as the year progressed. The 3-month Saudi Arabia Interbank Offered Rate (SAIBOR), for example, tacked sharply upwards in 2H2015; as of 18 March 2016, rates had risen by about 101 bps to 1.78%, which is the highest in 7 years.