Slower loan growth in Saudi Arabia’s banking sector reflects a deteriorating operating environment, according to London-based Fitch Ratings.

Total sector loan growth was still 10 per cent annualised in the first half of 2015, compared to 17 per cent growth in the same period in 2014.

“There are signs of a slowdown on the demand side on government and oil-related projects, and generally the banks are beginning to become more cautious,” says Redmond Ramsdale, director for financial institutions at Fitch Ratings. “Lower loan growth could put pressure on profitability and asset quality, although there are currently no real signs of deterioration.”

Fitch predicts similar growth in the second half of 2015 and a further slowdown in 2016.

Lending in the kingdom is driven by state capital spending, although retail lending is growing. Saudi Arabia plans to review spending following further falls in the price of oil. This is likely to depress the wider economy and banking sector growth.

But government spending is expected to be to slow gradually rather than halt altogether. Many infrastructure projects are too important to delay.

Saudi banks rely on interest income for revenue growth, so lower loan growth suggests profits will also flatten off.

Recent government bond issuances will improve revenues from bank’s securities portfolios. But bond purchases will also reduce liquidity slightly and banks may lend less.

Although levels of impaired loans remained low at 1 per cent, some deterioration is expected as economic growth slows. Banks are becoming more careful and tightening lending conditions in anticipation of this deteriorating environment, especially to the private sector.

The cost of borrowing remains low despite the tighter supply, but will go up as the US Federal Reserve raises interest rates later in the year.

“When [US] federal interest rates go up Saudi Arabia is likely to follow the increase, but it is likely to be a slow manageable increase, of maybe 1 per cent over a year,” says Ramsdale. “This is positive for banks as they have a high proportion on non-interest bearing deposits and their margins will increase. Higher rates could cause a slight slowdown in lending.”

The deterioration in banks’ operating environment will be very gradual and Saudi banks may not feel the effects. Liquidity is still high, banks are still lending and the government is still spending. It could be two years before banks feel the negative effects of the lower oil prices.

Fitch recently changed the outlook for four Saudi banks to negative, based on the fiscal position of the Saudi government. But their A+ ratings were affirmed, for now.