Wealthy Nations Daily Update - Saudi Arabia

Unquestionably Saudi Arabia faces a number of challenges; Christine Lagarde noted at the conclusion of her visit to Saudi Arabia that the economy “has performed strongly in recent years, but is now facing the challenge of adjusting to the sharp drop in oil prices. …. Prudent fiscal management has helped build-up substantial policy buffers over the past decade, but reforms that would put the large fiscal deficit on a firm downward path are needed. The banking sector is in a strong position to weather lower oil prices and weaker growth.”

Reserves can be used as a counter-cyclical buffer along with debt issuance as Saudi Arabia is starting from a position of strength with debt to GDP of 1.6% at the end of 2014.  Such a low debt level gives Saudi Arabia huge financial flexibility.  Fiscal adjustment needs to take place; the IMF is estimating a fiscal deficit of 19.5% of GDP for 2015, but this is then forecast to decline as “one-off” expenditure declines and large investment projects complete.  This will be a key area to watch going forward, particularly if the oil price remains at current levels.  The military intervention strategy in the Middle East needs to be monitored; an expensive and an extended war intervening in the Yemen and elsewhere would be negative.

On our net foreign asset analysis Saudi Arabia has a NFA to GDP of 178%.  Lower commodity prices, if governments don’t adjust spending, will affect the current account eventually, but it is the cumulative current account position (i.e. net foreign assets) that is more important in determining credit quality. Consequently it is the wealthy countries that can withstand lower commodity prices much more easily than the indebted ones. Another way of thinking about this is to take two countries, each running a current account deficit of 5% of GDP. One, say Saudi Arabia, has net foreign assets of 178% of GDP and one, say Brazil, with net liabilities of 45% of GDP. It will only take one year before Brazil exceeds our 50% cut-off whereas for Saudi Arabia it would take ~45 years to reach the same level.      

S&P downgraded Saudi Arabia’s long-term foreign currency sovereign credit rating to A+ from AA- (negative outlook) citing widening fiscal deficits of 16% for 2015, 10% in 2016, 8% in 2017 and 5% in 2018.  Although Moody’s rates Saudi Arabia Aa3 (stable outlook) noting in its November 2 credit opinion; “The Aa3 rating and stable outlook incorporate the expectation of continued strength in government finances and the debt metrics remaining in a strong position. This appears likely for the next year or two, but additional measures to address the budget deficit are required if government finances are to support the rating at its current level.”

Newswires are flagging that Saudi Arabia is looking to tap the international bond market next year having already started to tap the domestic market earlier this year.   Saudi Arabian debt, as a high quality credit, with a lack of outstanding issuance should interest investors.  

A lot of negative news has already been priced into the market although political and geopolitical risks remain; the ‘risk-reward trade-off’ is starting to look asymmetric.  The lack of issuance means there is no USD yield curve for the Saudi Arabian sovereign.  But consider Saudi Electric 5.06% 43, a quasi-sovereign issue, 81% owned by the government; given it is a government-related entity, S&P equalise its ratings with that of the sovereign and downgraded its rating to A1 on a foreign currency issuer basis.  But even on this basis, it is trading ~4 credit notches cheap on our models at a yield of 5.94%and ~5 notches cheap if the Moody’s Aa3 rating is used.  By comparison, CNOOC 4.25% 43 rated Aa3/AA- by S&P/Moody’s, also has a rating that equalised with the Aa3 rated Chinese sovereign rating, trades at a yield of 4.62%, 2.5 notches cheap on our models.  The Aa2/AA rated State of Qatar 5.75% 42 issue trades at a yield of 4.32% and 2.8 notches cheap.  Thus, any US dollar denominated Saudi Arabian sovereign issuance is worth considering.

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