Earlier this week, the Saudi Government issued its first riyal denominated sukuk which comprised 3 tranches (3, 5 and 7 year maturities) and raised SAR 17bn (USD4.5bn). The issue was well received with SAR 51bn of orders: last year the government had focused its domestic fund raising in the conventional bond segment and the April issue of USD9 bn was an international sukuk so there was a lot of pent up demand for a domestic sukuk.
Saudi Arabia’s Eurobonds have also performed well despite the ongoing stand-off with Qatar and Fitch downgrading its rating at the end of March (foreign long term) to A+, from AA-; Saudi Arabia 4.5% 2046 has rallied ~6 points since the start of the year and the spread tightened ~20 bps to 147 bps over Treasuries. While the diplomatic spat is negative from a geopolitical point of view, it looks to be limited in its economic impact; Qatar comprises less than 1% of the Kingdom’s exports and imports and has limited financial interlinkages with Qatar. Any escalation of the dispute to encompass Iran would be a negative development but our base case remains that it is in all parties’ best interest to find a diplomatic solution, although it may take some time. The US and Kuwait are mediating in this respect.
The other key challenge facing Saudi Arabia is dealing with its high dependence on the oil related revenue; Moody’s note that oil revenues account for 90% of government revenue between 2011-14 such that ‘The fiscal balance swung from an average surplus of 10.5% of GDP between 2011 and 2013 to a deficit of 2.3% in 2014, which widened further to 14.8% in 2015.’ However, given Saudi Arabia had accumulated a sizeable reserve buffer during the period of strong oil prices it has the ability to run deficits for a period of time while an adjustment strategy is put into place. Moreover, government debt levels were 1.6% of GDP in 2014 so the government has been able to tap the debt market. At the end of 2016 government debt had reached 13.2% of GDP which is still very low.
Over the medium term, the key issue is how effectively Saudi Arabia is able to execute on its National Vision 2030 which has a key aim to diversify the economy away from its oil dependency and increase private sector employment. National Transformation Program (NTP) 2020 and Fiscal Balance Program 2020 are steps towards the overall vision. There has been some progress: Moody’s note that official numbers suggest the deficit narrowed to 12.8% of GDP in 2016 helped by a 15.6% expenditure cut and reduced capital spending. The government has a general government deficit target of 7.7% of GDP for 2017 although Moody’s estimate it will be closer to 10.7%. Saudi Arabia has implemented some tax increases (e.g. on foreign workers and excise taxes) and raised utility prices and has plans to implement a VAT increase along with GCC members in 2018. There has been some tempering of austerity measures with the rescinding of salary cuts and reinstatement of bonus payments but these have been relatively small. Areas needing further progress are the IPO of Saudi Aramco along with further energy price increases. However, there is a lot to be done if the fiscal deficit is to meet the target of a balanced budget by 2020, particularly as GDP fell 0.5% yoy in Q1’17.
A recent IMF working paper ‘A Crude Shock: Explaining the Impact of the 2014-16 Oil Price Decline Across Exporters’ concluded ‘Perhaps surprisingly, the degree of oil dependence was not a significant determinant of the impact of the shock.’ The paper found ‘that to a large extent, the impact of the oil price shock on economic growth is indeed related to economic fundamentals entering the shock. Our results suggest that countries that weathered the shock better tended to have a stronger fiscal position, higher foreign currency liquidity buffers, a more diversified export base, a history of price stability, and a more flexible exchange rate regime. Within the group of oil exporting countries, these factors outweigh any effects coming from the importance of oil, as the impact of the shock is not found to be related to the size of oil exports, or the share of oil in fiscal revenue or economic activity.’
So while Saudi Arabia has not had a flexible exchange rate to absorb the impact like Russia has, its considerable buffers have nevertheless kept it in good stead. For us, NFA is a central tenet of our investment process and helps us exploit inefficiencies in credit markets which are often driven by knee-jerk reactions to events. Moreover, by targeting bonds trading several notches cheap a lot of any negative news/downgrade risk is likely to have already been priced in.