Saudi Bonds Provide Much-Needed Breathing Room

The changing oil market may not allow the kingdom to simply wait until prices recover.

Saudi Arabia blazed the global debt capital markets with its first-dollar denominated Islamic bond offering. The $9 billion bond attracted more than three times as many bids as were offered. The money will provide additional breathing room to the government’s finances, just as the $17.5 billion international bond debut last year, which was the largest of its kind in emerging markets. The borrowings, along with rising non-oil revenue, should help arrest the decline in foreign-exchange reserves since 2015.

Understandably, reserves are an essential policy toolkit that all nations covet. They provide insurance against shocks. Unlike many emerging economies, Saudi Arabia saved a lot during the oil boom of the 2000s. Just like a family savings plan, reserves can be used to prevent a balance of payment crisis and provide economic and financial stability.

Oil prices have come a long way. Brent crude has jumped by more than 50 percent from $29 per barrel in January 2016 to $55 per barrel now. Although it’s true that Saudi Arabia’s foreign assets are declining, the pace is slowing in absolute terms. But why are they falling in the first case?

Foreign assets for Saudi Arabia, as well as other resource-based economies, decline when a price shock takes place. At the onset of a price shock, there is an adjustment period between expenses and revenue. For Saudi Arabia, 2015 was an adjustment year as foreign assets declined by $115 billion from a peak of $724 billion. The drop slowed in 2016 to $80 billion. Had it not been for $28 billion in accumulated past due private sector arrears, which were paid in 2016, foreign assets would have declined at a much slower pace.

In 2015, $116 billion was the draw down as Brent crude plunged dramatically from $99 per barrel to $52 per barrel. The extent of the dive took most economists and pundits by surprise. As the realization that oil prices could very well remain low for some time sunk in, the authorities embarked on a defining project to dramatically alter the way the country’s economy was managed: Vision 2030 and the 2020 National Transformation Plan.  

The urgency that defines the economic agenda is based on the crux of the principal: Saudi Arabia cannot rely on one volatile, ever-changing source of income. Oil prices could have entered a structural shift that doesn’t afford Saudi Arabia the luxury of waiting until prices recover. Much has been said already about the new normal in oil prices: a stronger dollar, a secular decline in demand in oil consumption in advanced economies, and the growth of shale point to new oil price equilibrium.

The fiscal adjustment, although equally ambitious, is a necessity in order to arrest the depletion of foreign reserves and generate new sources of non-oil revenues. New fiscal realities are impacting all. The cuts to public allowances that came in October demonstrate the government’s determination to build a new economy. The vestiges of a bloated public sector have to be tackled. There isn’t a perfect time and for as much as civil service reform is an ever-discussed topic, there is something today being done to address that.

Fees are in the offing, which had been seen as taboo. The structure of the economy will change as price inefficiencies are adjusted. Fees paid by commercial entities and households, as well as all kinds of municipality charges, have to be revamped. This is something the United Arab Emirates has done successfully. In Saudi Arabia, municipal fees have remained unchanged, until four months ago, for more than 60 years.

Monthly data point to a deceleration of reserve depletion this year against 2016 and 2015. Reserves fell 13.3 percent in February from a year earlier, compared with a 17.3 percent drop in February 2016. Reserve depletion typically spikes in the early months of each year due to overall expenses and gradually slows down as the year ensues.

Saudi Arabia has options. In the 1990s, when oil took a steep dive, reserves fell to $38 billion in 1999 when the economy’s size was $166 billion. Local debt was issued and the kingdom kept its currency peg to the dollar. Today, debt to GDP is below 15 percent, which allows for plenty of space to issue debt before the government’s 30 percent ceiling is reached. It can raise billions of dollars from the international debt market as its economy grows in size, since the numerator is the determining factor. Even under the worst case scenario if the economy grows below trend, it will still be able to borrow at least $117 billion in additional debt before the ceiling is reached and still maintain one of the lowest debts-to-GDP ratios within the Group of 20.

Although Saudi Arabia has an open capital account, import cover is often seen as a relevant measure of how long a shock -- of revenue in the case of the kingdom -- can be weathered. Three months’ coverage is typically used as a benchmark. Saudi Arabia’s import coverage was just below 28 months, and even if foreign assets are depleted by around 8 percent annually, coverage will by 2020 be one percentage point above the 2015 global average of 12.8 months. This will be enough to cover the recommended reserve buffer as per the International Monetary Fund for commodity intensive economies.  

Business sentiment is improving in Saudi Arabia even if headline growth remains low due to falling oil output. Absent of a spike in oil prices, slowing foreign-reserve depletion will also hinge upon tapping debt capital markets again. Saudi Arabia has made a successful imprint in global markets by wooing investors and tightening yield spreads. This is just the beginning.    

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