Saudi Arabia's Balancing Act

The reasons why Moody’s recently affirmed Saudi Arabia’s A1 credit rating are pretty clear: Saudi Arabia’s money may be running out, but it still has plenty to spare. In its annual credit analysis on the Kingdom, Moody’s listed Saudi Arabia’s credit strengths as a strong but deteriorating fiscal position; substantial external liquidity buffers; a large stock of proved oil reserves with low extraction costs; and prudent financial system regulation.

Fiscally fit

Moody’s assesses Saudi Arabia’s fiscal strength as “Very High”, based on the Government’s famously large financial

resources, low but rising debt levels and high debt affordability. It expects Saudi Arabia’s debt trend to improve over the next two years to three years, and the debt level to remain below 30 per cent of GDP.

 However, lower oil prices since 2014 have turned previously large fiscal surpluses into deficits. This has nibbled at the government’s fiscal strength through a rapid increase in government debt, reaching around 19 per cent of GDP in 2018, and a simultaneous drawdown of foreign currency assets which shrank by an amount equivalent to 28.5 per cent of 2018 GDP during 2015-18.

Nevertheless, the Government’s fiscal buffers still fully cover the entire stock of government debt. This is likely to decline in the next few years as debt edges upward toward 30 per cent of GDP. Still, the Government’s broad foreigncurrency buffers will likely continue to substantially exceed Government debt in the foreseeable future. For now, its finances are immunised against shocks.

Black out?

Despite Saudi Arabia’s efforts to wean itself off the black stuff, oil remains the lifeblood of its economy. Oil and gas output continues to account for about 43 per cent of Saudi Arabia’s real GDP, Moody’s noted, making economic growth extremely slippery.

OPEC+ agreed to another coordinated production cut in December 2018 in response to the sharp drop in oil prices during the last quarter of 2018. This latest output cut, equivalent to around three per cent of the group’s total production, became effective in January 2019 and is due to last until the end of June 2019.

Such strategic oil production shifts over the past two years have been the main driver of volatility in real GDP growth, according to Moody’s, causing the economy to contract in 2017 after growing 1.7 per cent in 2016 before contributing to the 2.2 per cent recovery in 2018.

In 2019, Moody’s expects that flat crude oil production will dampen an expected acceleration in non-oil growth and a boost to the hydrocarbon sector from the scheduled ramp-up of the new Jazan oil refinery and the Fadhili Gas Plant. The latter is expected to increase Saudi Arabia’s natural gas-processing capacity by around 16 per cent over the next two years.

Growing plans

Over the next five years, Moody’s expects that Saudi Arabia’s economy will grow at a rate of between two per cent and 2.5 per cent per year – markedly lower than the 4.6 per cent growth rate recorded during the boom years of 2011-16. With oil prices constrained and limited space to increase production, Saudi Arabia will lack the means to provide large and steady fiscal stimulus.

However, beyond the oil fields there are ambitious plans which will shape Saudi Arabia’s future. The Kingdom’s efforts to diversify its economy are critical to long-term growth, with Moody’s suggesting that Saudi Arabia’s credit rating could be upgraded if the country moves away from oil faster than planned.

Despite Saudi Arabia’s enthusiasm, Moody’s warned that structural reforms and diversification will take time to have a noticeable impact, especially given the Kingdom’s relatively limited set of natural comparative advantages and high labour costs.

On the plus side, political and popular support for the Government’s ambitious reform momentum remains very high and the ownership of the reform programme has deepened beyond the Council for Economic and Development Affairs led by Crown Prince Mohammad bin Salman.

The Government is also pinning its hopes on several giga projects focused on the underdeveloped tourist and entertainment sectors to fire up the economic diversification drive. These projects are expected to be mostly financed by private sector investors with some contribution from the budget and the Public Investment Fund.

Privatisation of state-owned and operated enterprises is another key channel for implementing structural reforms, hence the establishment of the National Centre for Privatisation to develop the legal framework for public-private partnerships. Most famously, the much-anticipated initial public offering (IPO) of national oil company Saudi Aramco is slated for 2021.

 Budget blues

Just as in 2017, the improvement in the fiscal position in 2018 was driven by revenue growth. Despite a near doubling of tax revenue due to the introduction of VAT, Moody’s reported that more than 80 per cent of the revenue increase came from higher oil revenue.

Higher revenues were also the reason for 2018’s fiscal outperformance relative to the budget. The 2018 deficit came in lower than budgeted, as revenue exceeded budget assumptions by 16 per cent even though spending exceeded budget targets by more than 10 per cent. Although lower than historical averages, Moody’s said that budget overspending in 2018 was still very significant.

About a third of the increase over the budgeted amount was due to the extension of social spending announced by a royal decree after the budget had been passed, while the rest materialised as the Government took advantage of higher oil prices to accelerate some payments toward the end of the year.  

 Sizing up

When it comes to economy, size matters. Saudi Arabia weighs in with a nominal GDP of $689 billion in 2017, making it more than three times the size of the median for A-rated countries.

However, size isn’t everything. For now, the Kingdom’s capacity has been constrained by the economy’s relatively low level of diversification away from hydrocarbons. Nonetheless, the large size of the Kingdom’s economy and its large and fast-growing population relative to the other GCC peers hold promise for future economic diversification.

Moody’s also considered Saudi Arabia’s income per capita, measured as per capita GDP in purchasing power parity (PPP) terms. At $54,595 in 2017, according to IMF estimates, Saudi Arabia’s GDP income per capita is above many rating peers. This is good news, as high per capita income typically reflects high capacity to absorb external shocks that may put negative pressure on economic growth and employment.

Guiding Governance

Guiding governance Saudi Arabia generally scores modestly well on Worldwide Governance indicators, however Moody’s warned that in most cases its scores are below those of its peers. On a scale of 1 to 100, with 100 the most effective, the Kingdom ranks 55 for government effectiveness, 54 for rule of law and 64 for control of corruption.

Government effectiveness measures perceptions of the quality of public services, the bureaucracy, policymaking and government credibility. Saudi Arabia’s percentile rank on this indicator was 51 in 2015 and 34 in 2011, indicating an improving trend. This improvement reflects streamlining of bureaucracy, including through the restructuring of the council ministers into two subcabinets.

Borrowed time

As Saudi Arabia’s debts creep up, the Kingdom will have to be careful about how they are managed. With sizeable fiscal deficits expected over the rating horizon, Moody’s highlighted how Saudi Arabia’s gross funding requirements will also increase.

To limit the risk of crowding out domestic, private sector borrowing and the erosion of the Central Bank’s foreign exchange reserves, the Government’s borrowing has been skewed toward international capital markets during 2016-18, leading to a buildup in external Government debt.

Moody’s foresees a shift back towards domestic borrowing over the coming years. The Government has already started monthly domestic Sukuk issuance. Furthermore, to improve secondary market liquidity in these securities, primarily held by domestic financial institutions, domestic Sukuk have been listed on the local bourse.

Domestic Sukuk issued under this new programme constituted around 19 per cent of total Government debt at the end of 2018. Although the Kingdom’s fiscal deficits will inevitably grow, the country is spoilt for choice about how it will plug the gaps in its finances. Moody’s scores Saudi Arabia’s Government liquidity risk at ‘very low’

The Government has access to ample sources of liquidity both from domestic and international capital markets and is unlikely to encounter difficulties in financing fiscal deficits. Beyond annual Eurobond and international Sukuk issuance, as well the monthly domestic Sukuk issuances, the Government has also been able to tap syndicated loans, borrowing $10 billion for five years in August 2016, which was then upsized to $16 billion and refinanced with extended maturities and on better terms in March 2018.

During the first three months of 2019, the Government issued $7.5 billion of Eurobonds and $6 billion equivalent of domestic Sukuk. While Saudi Arabia’s balance sheet remains the envy of the GCC, it seems money isn’t everything. Oil price volatility and socio-economic challenges posed by strong population growth and elevated unemployment are conspiring to jeopardise its rating.

Its stable outlook reflects Moody’s view that the risks to Saudi Arabia’s credit profile are broadly balanced. There remain many factors—including rising debts levels and maintaining the momentum for reform—which could tip its rating either way.