Saudi economy resilient despite oil crisis

NBK MACROECONOMIC OVERVIEW AND OUTLOOK

KUWAIT: Despite the more than 50 percent decline in oil prices since June of last year and the knock-on effect that it has had on real output, Saudi Arabia’s economy has, so far, proven quite resilient, growing by 4.0 percent y/y in 2Q15. (Chart 1.) In the oil sector, which grew by 4.8 percent y/y in 2Q15, production has surged to a record high, in excess of 10.0 million barrels per day (mb/d)on average so far in 2015. (Chart 2.) The kingdom is looking to protect its market share amid the price slump and to respond to burgeoning domestic demand for crude. Local demand has largely been spurred by increases in refinery capacity, as Saudi Arabia moves up the value chain with increased output of refined petroleum products, although power generation continues to utilize greater volumes of the kingdom’s crude output. For the year as a whole, we forecast real oil GDP growth to accelerate to 3.3 percent from 0.7 percent posted in 2014, which is an upward revision from our previous forecast of 1.9 percent. Going into 2016, oil sector GDP growth is expected to slow, to 0.7 percent y/y.

Non-oil activity remains buoyant as well, growing by 3.4 percent y/y in 2Q15 and supported by elevated government spending. However, there are signs that the economy is cooling: GDP growth in the last quarter slowed for the third successive quarter and key metrics of consumer and business activity such as point of sale (POS) and ATM transactions, private sector credit growth and business confidence, have all been slipping on a year-on-year basis over and above what might normally be expected during the slow summer/Eid season. The picture is further confirmed by the September reading of the Saudi Purchasing Managers’ Index (PMI), which fell to a three-month low of 56.5 in the month. The PMI tracks business conditions among more than 400 non-oil private sector firms. The headline PMI fell to a three-month low in September as growth in new orders and output eased. The pace of job creation also seemed to be slowing. Having said that, both business activity and employment growth remained healthy-indeed payroll numbers have increased for 18 consecutive months. Taking this into consideration, annual non-oil growth is projected to slow from 5.3 percent in 2014 to 3.7 percent this year and next. Real GDP is forecast to expand by 3.5 percent and 2.4 percent in 2015 and 2016, respectively.

Solid but slowing employment growth as output moderates

Looking at Saudi employment trends, the recent PMI survey findings have chimed with employment data provided by the central statistical office showing the number of Saudis taking up employment, for example, increasing by 56,000, or 1.1 percent to 4.9 million over the last year (1H14-1H15). Again, though, this is a noticeable slowdown from the 5.6 percent and 8.9 percent annual growth rates witnessed in 1H14 and 1H13, respectively. Also, this is slower than both the 4.5 percent y/y increase in the rate of expatriate employment growth recorded in 1H15 and the 4.0 percent y/y increase in the pace of overall economic growth over the same period; up until June of this year, Saudi job creation had been proceeding at a faster rate than overall GDP growth. Nevertheless, the proportion of Saudis employed in the private sector, the Saudization ratio, which is a key metric of the government’s Nitaqat program, has steadily improved, from 9.9 percent in 2009 to 15.2 percent in 2013 (the last year for which data is available).

Also, between 2010 and 2013, the number of Saudis entering the private sector each year increased three times faster than the number of Saudis entering the public sector21.6 percent y/y vs. 7.4 percent y/y, respectively. Moreover, the Saudi unemployment rate has also fallen steadily and gradually since 2011, from 12.4 percent to 11.6 percent as of mid-2015.

Inflation remains subdued

Consumer price inflation in Saudi Arabia remains subdued at 2.1 percent as of August, largely reflecting depressed international food and commodity prices as well as a stronger dollar, to which the riyal is pegged. The dollar’s rise against a basket of currencies over the last year has rendered the kingdom’s non-dollar-denominated imports less costly, effectively raising the purchasing power of Saudi consumers. Nevertheless, there are tentative signs that inflation in the largest constituents of Saudi Arabia’s cost of living indexhousing, food and transport-is beginning to pick up. Housing and utility costs increased by 3.9 percent y/y in August while prices in the food and transport categories increased by 2.1 percent y/y and 1.7 percent y/y, respectively. Inflation is expected to rise gradually over the next year or so, bringing the average annual rate to a still modest 2.3 percent in 2015 and 2.6 percent 2016, respectively.

Fiscal deficits

The kingdom’s fiscal account, having swung into deficit in 2014 (-2.3 percent of GDP) for the first time since the financial crisis, looks likely to widen markedly this year, to an estimated -22.4 percent of GDP. This is due to a combination of burgeoning expenditures, including King Salman’s $32 billion accession bonus announced last February, the escalating (and as yet, undisclosed) costs of the Yemen conflict, and lower oil revenues following further falls in oil prices this year. Recognizing the need for fiscal consolidation, the authorities have scaled back some of their capital spending on non-essential infrastructure, such as new stadia, for example. They have also, according to the IMF, lowered the threshold for approval for new projects from SAR 300 million to SAR 100 million. On the revenue side, apart from the move up the value chain i.e. selling increasing volumes of refined petroleum products rather than solely crude oil, a tax on vacant land is planned along with, perhaps, energy subsidy cuts for commercial and industrial users. A new VAT law has also been mooted. Pending the rollout of these revenue-side reforms, we expect 2016’s narrowing fiscal deficit, of-16.3 percent of GDP, to reflect some restraint on the current but especially capital spending side of the fiscal accounts.

Falling reserves have spurred the issuance of Saudi Arabia’s first sovereign bonds

since 2007

For the time being, the burden of financing the deficit has fallen on the kingdom’s large reserves, which have declined by a cumulative $83.5 billion over the last year, or -11.2 percent, to $662.2 billion as of August. While reserves still provide a very healthy 31 months of import cover, the quickening pace of reserve depletion in 2015, equating to $8.6billion per month, has unsettled markets and encouraged speculation that Saudi Arabia could be forced to abandon its peg to the dollar. Falling reserves also prompted the authorities to announce, in August, their first local currency bond issuance program since 2007. SAR 20 billion ($ 5.3 billion) worth of bonds was sold to public institutions and local banks across three tranches of 5-year, (1.92 percent yield), 7-year (2.34 percent yield) and 10-year (2.65 percent yield) maturities. Approximately SAR 100 billion ($27 billion) will be sold before year-end, over five monthly issuances of SAR 20 billion ($5.3 billion). This should help finance around 20 percent of the $146 billion fiscal deficit expected this year. The program is expected to continue at a similar pace into 2016, with the possibility of up to 40 percent of the projected deficit in 2016 being covered through debt issuance, according to unofficial sources. The remaining shortfall will be financed by drawing down the kingdom’s still sizeable reserves and assets.

At 2016’s projected spending rate, Saudi Arabia could, therefore, through a combination of debt issuance and reserve drawdown, weather a period of low oil prices (in the $5055/bbl range) for at least two years before even half of the kingdom’s foreign reserves are depleted. Moreover, the authorities would seem to have ample fiscal space with central government gross domestic debt a very low 1.6 percent of GDP ($11.6 billion) in 2014, having aggressively paid back their obligations during the years of high oil prices. Even if debt issuance proceeds as described, gross outstanding public debt would still only rise to $38.8 billion, or 6.0 percent of GDP this year, and to $83.3 billion, or 12.2 percent of GDP in 2016. These are still very low levels of public debt by international standards.

While banks’ interest margins should improve through participation in the bond issuance program, banking sector liquidity will need to be monitored Issuing debt of up to $45 billion over the course of a year or two, or even several year, would, nevertheless, have implications for the domestic banking system, in terms of potential changes in banks’ asset allocation and appetite for lending, as well as liquidity. On the positive side, banks’ net interest margins and revenues should improve as banks shift from lower yielding, short-term liquid assets to higheryielding, longer-term government securities. As of July 2015, short term, liquid assets such as cash, deposits with banks and the central bank, as well as treasury bills, accounted for only $106 billion, or 18 percent of the Saudi banking system’s balance sheet. So there is plenty of scope to accommodate bond issuance by the government in the short term without constraining liquidity. Things would get trickier, however, were low oil prices to persist for several years and liquidity conditions tighten on a combination of un-abating debt issuance and slowing bank deposit growth. Deposit growth, especially on the government side, has already begun slowing down, falling to 6.6 percent y/y as of endAugust-its lowest level since late 2010-and the 3-month interbank rate, the Saudi Arabia Interbank Offered Rate (SAIBOR), has tacked sharply upwards during 3Q15, by 12 bps to 0.895 percent, to reflect both slowing deposit growth and the recent sovereign bond sale.

Moreover, on the credit side, there is always the risk that the sovereign debt issuance program could begin to crowd out bank lending to the private sector, with obviously negative effects for non-oil economic growth.

Large projected fiscal deficits and reserve drawdowns as well as the start of debt issuance sparked concerns in August that Saudi Arabia would be forced to abandon its peg to the US dollar In August, financial markets grew concerned over the prospect of Saudi Arabia recording large fiscal deficits, the increasing rate of its international reserve drawdown in 2015 and its decision to tap the bond markets. Attention focused on the sustainability of the kingdom’s fixed exchange rate to the US dollar after China devalued its currency, the renminbi, and after another hydrocarbon producer, Kazakhstan, abandoned its peg to the US dollar altogether. With echoes of previous oil price crashes that put pressure on its fixed exchange rate, the Saudi riyal one-year dollar forward rate spiked, to 410 points on the 24 August, and the 5-year credit default swap spread (CDS) widened significantly, almost doubling to 110 bps on the same day.

The authorities are unlikely, however, to shift away from an exchange rate regime that has served them well in the past, anchoring the economy and inflation during previous bouts of oil volatility, economic downturns and externally-induced shocks. 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, accounting for more than 80 percent of the kingdom’s export and fiscal revenues.

Bearish sentiment

Meanwhile, the local equity market continues to be roiled by low oil prices and weaker sentiment. The Saudi Tadawul All-Share Index (TASI), despite edging up slightly over the last month, was still down by -10.4 percent yearto-date at 7,462 as of 6 October. (Chart 18.) Up until mid-August, TASI had largely been in positive territory, boosted by the opening of the stock market to foreign investors in June, but a couple of recent ‘negative outlook’ assessments by ratings agencies Fitch and S&P seemed to compound the market’s anxieties, weighing heavily on the index. Worth watching over the next few months will be the market’s reaction to the announcement that the kingdom will ease restrictions on foreign ownership in retail and wholesale business, from the current maximum of up to 75 percent to 100 percent. While domestic firms would be expected to come under pressure with the added competition, overall, the effect should be positive for the economy, with foreign direct investment (FDI), private sector employment of Saudi nationals and, ultimately, Saudi consumers benefiting.