Reserves offer Riyadh a platform for growth

13 March 2009

The massive oil revenues earned in recent years will enable Riyadh to support industrial development.

In November 2008, Western leaders were actively encouraging Riyadh to release billions of riyals into an International Monetary Fund (IMF) emergency package. The request rested on an unspoken assumption that Riyadh was somehow immune to the turmoil enveloping the world’s financial markets.

The steady drip of news since then has defied that casual assumption. With global industrial demand collapsing, oil prices have slipped below $40 a barrel, about $100 off their mid-2008 peak.

The most optimistic forecast for crude prices in 2009 is $80 a barrel. Reduced production, designed to prop up prices by wiping out excess supply, will exacerbate the impact on Saudi revenues. Saudi oil output in January averaged about 8 million barrels a day (b/d), well below the 2008 peak of 9.7 million b/d.

Saudi project sponsors are either pulling projects or delaying them, as the limited availability and rising cost of finance undermines the economics of pushing ahead with their schemes. Corporate finance remains tight, as local banks have sought to reduce their loan-to-deposit ratios.

Financial surplus

Evidence of this slowing down comes via one of the totems of Saudi economic confidence, the Jeddah-based Kingdom Tower. The tower was intended to be the world’s tallest building, at 1,600 metres, but is now on hold after the project manager, the US’ Bechtel, pulled out of the scheme in February. Its backer, Kingdom Holding, recorded a loss of $7.5bn for 2008.

The sense of unease is not confined to foreign companies doing business in the kingdom.

Saudi bank Sabb’s most recent business confidence survey, conducted in the fourth quarter of 2008, paints a picture of Saudi businesses bracing themselves for a slowdown.
Although 54 per cent of respondents to the survey say that they expect their business to grow in the first half of 2009, this is significantly down from the 89 per cent who said they expected growth in the bank’s third-quarter survey.

Yet the kingdom is better placed than many to limit the impact of the downturn, not least because of the current account surplus it has accumulated since 2003, which will enable
Riyadh to spend its way out of the downturn.

“The kingdom has a number of advantages that should have a positive bearing on its perceived risk,” says Howard Handy, chief economist at local bank Samba Group.
“It has the world’s largest supply of crude oil reserves. This gives the country a strategic importance to the global economy that should not be obscured by the recent downturn in oil prices. It also provides the platform for long-term industrial growth.

“Second, the government has substantial financial resources, as well as significant potential domestic demand for its debt, which provides considerable leeway to ramp up spending in support of domestic investment.

“Put another way, the government could, if it chose to, run substantial fiscal deficits for many years without recourse to external borrowing.

This is certainly not the case with many other emerging markets.”

A deficit of SR65bn ($17bn) is projected for 2009, based on revenues of SR410bn and spending of SR475bn.

The current lower project costs and raw material prices make the public investment plans more affordable. The Saudi exchequer has been swelled with a record budget surplus of SR590bn for 2008, based on revenues of SR1.1 trillion. Simply by drawing down the stock of foreign assets built up in recent years - at the end of October 2008, net foreign assets at the Saudi Arabian Monetary Agency (Sama), the central bank, stood at $444bn - it can press ahead with a series of key economic projects.

“A key source of strength for the economy is the huge stock of foreign reserves built up over the years of high oil prices,” says Brad Bourland, chief economist at the local Jadwa Investment.

“These provide an important cushion in dealing with the fall in revenues stemming from lower oil prices and production. The government is prepared to draw down these reserves to finance its capital spending programme, which is an important stimulus to the economy.”

The banking sector, though clearly suffering the trickle-down effect from international banks’ departure, is well capitalised, in sharp contrast to many Western central banks.

Sama has spent recent years strengthening its banking supervision, while astutely ploughing its booming revenues into buying up US Treasury paper. Sama has also aggressively reduced interest rates.

“Sama is regarded as one of the more conservative regulators in the region, but the value of this is now clear,” says Handy. “The mandatory loan-to-deposit ratio limit of 85 per cent, along with strict caps on personal lending, have helped provide a solid underpinning to Saudi banks’ balance sheets, leaving them well placed to cope with the current uncertainty.”

Such guarantees provide the fuel for the government’s expansionary fiscal policy. Capital spending for 2009 is projected to be SR225bn, up 36 per cent on the budgeted level in 2008.

Enhancing physical and social infrastructure remains the overriding aim of Riyadh’s spending.

However, this does not mean all Saudi projects will emerge unscathed. Tight credit conditions are likely to persist, at least until international banks return to the Saudi market.

However, more state funding through specialised credit institutions will enhance the availability of lending for the key infrastructure projects. The government is committed to injecting another SR5bn into its Real Estate Development Fund as part of a five-year plan initiated in 2008.

Another SR10bn will be deposited in the Saudi Credit & Saving Bank, and an estimated SR40bn will be disbursed by other specialised credit institutions such as the Saudi Industrial Development Fund (SIDF).

According to Bourland, despite last year’s slowdown, private sector non-oil growth, the key measure of economic activity, is expected to rise in 2009 and remain healthy in 2010, supported by stimulative fiscal and monetary policies.

Economic stimulus

The economic stimulus package should help to keep key infrastructure projects broadly on track. “The government is clearly determined to pick up some of the slack left by dwindling private investment, and we expect the public sector to increase its stakes in various infrastructure projects,” says Handy. “The Public Investment Fund and the SIDF will play key roles in this.”

A lot will clearly rest on Saudi Arabia’s success in putting a floor under oil prices, with a strategy under way to slash more than 4 million b/d off Opec’s output from the cartel’s September 2008 peak of 29 million b/d.

The market appears at least to have found a bottom at the $40-a-barrel mark, significantly down on the $147-a-barrel peak of July 2008 but still comfortably above the $36-a-barrel for which the government has officially budgeted.

The steep fall in contractor and materials costs associated with the economic downturn has provided another advantage; by enabling state oil giant Saudi Aramco to push on with key expansion projects at a reduced cost. For example, the Karan field expansion is now set to go ahead with a 15 per cent reduction from the price tag of $5bn just a few months ago.
Some longer-term structural issues such as inflation, which had concentrated the minds of economic policymakers for most of 2008 but were swiftly superseded by the enveloping financial crises, still need to be resolved.

Lower commodity prices and a strengthening of the riyal will cause inflation to fall back rapidly through 2009, keeping it below the 9.2 per cent estimated average for 2008.
The Consumer Price Index (CPI) fell sharply towards the end of 2008, down to 9.5 per cent from 10.9 per cent in October.

Price growth should continue to ease, although other monetary policy issues will rise up the agenda. The GCC states’ dollar currency peg, the cause of much speculation over a possible revaluation last year, is one such issue.

The move towards GCC monetary union may cause more discussion of the exchange rate than there has been in recent months.

“As the deadline looms, intra-GCC discussions about the mechanics of monetary union will become more frequent and intensive,” predicts Handy.

The main cause of pressure on the dollar peg was that the low interest rate policy Sama was compelled to adopt was inconsistent with the need to fight inflation. This, explains Bourland, was being aggravated by the weakening of the dollar.

“Now economic policy is focused on restoring confidence and reviving bank lending, which is justifying low interest rates,” he says.

“Commodity prices have plunged, making inflation much less of a problem. However, it is likely that much of the recent dollar strength will be reversed over 2010, which may revive the debate.”

The longer-term issue of GCC monetary union is one that will keep the dollar peg issue bubbling away. If the dollar weakens significantly over the next two years - a reasonable assumption given the scale of the injections of cash being made into the US banking system by the Federal Reserve - then pressure might grow for the adoption of a peg to a basket of currencies, in a bid to limit imported inflation.

In the meantime, Saudi Arabia will pursue its public spending agenda, designed to undo the damage caused by the collapse of the global credit markets. In doing so, it will be sustained
in the knowledge that the kingdom’s position as holder of the world’s single largest resource of crude oil grants it a platform for growth of which others can only dream.

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