Downlded from Saudi Arabia: Baseline Macroeconomic Forecast · PDF file · 2016-02-03Baseline Macroeconomic Forecast ... global growth—remains reasonably firm (even if...

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January 2016

Report Series

Office of the Chief Economist

Economics Department

Samba Financial Group

P.O. Box 833, Riyadh 11421

Saudi Arabia

[email protected]

+9661-477-4770; Ext. 1820 (Riyadh)

+4420-7659-8200 (London)

and other publications can be

Downlded from www.samba.com

Saudi Arabia:

Baseline Macroeconomic Forecast 2016-20

Executive Summary

The global economy has got off to a rocky start this year. China’s slowing manufacturing sector, nose-diving equities markets and weakening currency are unnerving many, who also wonder how the government is going to unwind its massive credit stimulus without triggering defaults and bankruptcies throughout the economy. The weakening renminbi has exacerbated the fall-off in China’s demand for a range of commodities and capital goods, and has hit Emerging Markets hard. These markets were already under pressure from a rising US dollar and higher interest rates, and with export earnings sliding, liquidity is tightening in many EMs, dampening new investment.

For all the gloom, developed economies are continuing to expand at a reasonable pace. The US and UK are continuing to perform well, by and large, and increased social tensions have not derailed the slow but steady recovery in the Eurozone. However, this has been largely ignored by financial markets, with equities and high-yield under particular pressure.

Oil prices have continued to fall, with Brent edging below $28/b in late January. Prices appear to have become unhinged from fundamentals: there is clearly a supply glut, but prices at this level will not spur the necessary investment for future supply, particularly as IOCs continue to shelve development plans at a record rate. We expect Brent to recover somewhat this year, to average $45/b, though it is only in 2017 that we are likely to see a significant rebalancing, allowing Brent to move up to $65/b.

For Saudi Arabia 2016 is set to be extremely challenging. The fiscal stance has been tightened considerably, and additional cuts to capital spending and procurement are likely this year. Most notably, subsidies on utilities, gasoline and gas have all been reduced. This is welcome from a fiscal perspective, but will provide further headwinds for consumers and businesses. As a result we expect virtually no expansion of the nonoil economy this year. The following years should be a little less arduous as oil prices rise and the authorities’ fiscal stance loosens slightly. But the days of double-digit spending growth are clearly gone, and the economy will need to adjust to a very different landscape in the years ahead.

Budget financing will continue to place a strain on international reserves, but growing domestic debt issuance—for which there is plenty of room and appetite--will help to reduce the rate of drawdown. We expect pressures on the currency to abate over time, and the dollar peg to be maintained.

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The Global Economic Backdrop

It’s been a rocky start to the new year, especially for EMs

Global economic activity and financial markets have got off to a rocky start this year. Many Emerging Markets (EMs) continue to struggle, amid fears over a sharper slowdown in China and the authorities’ ability to smoothly unwind imbalances built up in the economy following years of excessive credit growth. While risks are elevated, we do not think China is headed for a hard landing, and instead will maintain growth at around 6-6.5 percent. This should help commodities find a floor, and help to stabilise prospects in EMs. However, this is some way off, and for the moment EMs are struggling, particularly as many of them have large corporate exposures to a strengthening USD. Capital is flowing out of EMs, leaving little to invest.

In contrast, most advanced economies are performing moderately well. Despite elevated social tensions, growth is picking up in the Eurozone (EZ), incomes and confidence are rising in the UK, Japan is stable with a stimulatory policy environment, and domestic consumption in the US—still the main engine of global growth—remains reasonably firm (even if investment is struggling). However, financial markets remain jumpy, with the adjustment to higher interest rates putting a strain on the US high yield and equities markets. Generalised global unease over China and EMs has added to the “risk off” atmosphere, and US Treasuries are back in vogue, with yields now lower than they were before base rates were raised in December. Markets are also unsettled in the Eurozone and Japan, though they have more—and possibly intensified—quantitative easing to look forward to. This will likely mean euro and yen weakness against the dollar for at least a year.

Low oil prices persist as the “supply response” is delayed

Persistently low oil prices were supposed to bring a supply response from non-OPEC producers, but this is happening more slowly than expected, and has been offset by surging OPEC supply. As a result, expectations that physical markets would start to rebalance during 2015 have had to be re-thought and most do not expect any significant adjustment until much later this year. For the moment, stocks remain near historic highs and prices at a 12-year low.

For all this, the demand outlook is not too bad. Global oil demand staged a healthy recovery during 2015 to grow by around 1.5mb/d. Lower oil prices and recovering economies helped drive an increase in OECD demand and, despite concerns over China and Emerging Markets, non-OECD oil demand also continues to grow. We expect that global growth will weaken somewhat in 2016, but assuming China avoids a hard landing oil demand growth should hold at 1.3mb/d this year.

On the supply side of the equation, US shale output was volatile but surprisingly resilient in 2015, with producers slashing investment but eking out more from the most productive wells. These efforts can only go so far, and with the slump in investment and higher financing costs putting a strain on over-leveraged balance sheets, we think US shale output will go into reverse this year. The less nimble

2013 2014 2015f 2016f 2017f

World 3.0 3.0 2.9 2.9 3.0

US 2.2 2.4 2.5 2.7 2.8

Japan 1.5 -0.1 0.5 1.0 1.0

Euro area -0.4 0.9 1.5 1.7 1.7

China 7.7 7.3 6.8 6.2 6.0

Emerging Markets 4.0 3.9 3.4 3.4 3.7

Saudi Arabia 2.7 3.5 3.1 0.6 1.8

US 0.25 0.25 0.50 1.25 2.25

Japan 0.10 0.10 0.10 0.10 0.10

Euro area 0.25 0.15 0.05 0.05 0.05

Brent 107.0 100.0 58.0 45.0 65.0

Samba estimates and forecasts

Real GDP growth (percent change)

Official policy rate (end period)

Oil Price ($/b period average)

World Economic Outlook

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international oil companies (IOCs) have already shelved investment projects worth some 20 billion barrels of oil, with more cancellations likely this year.

OPEC production is also likely to ease off somewhat this year. Saudi will fight to maintain market share in East Asia, and will cede little ground to fresh Iranian supply, but there is only so much additional supply that can be absorbed in current market conditions.

Current prices are far too low to spur necessary investment, and the market should rebalance eventually

Assuming global oil demand holds up as we expect, this should allow for a rebalancing of market fundamentals later this year that will set the stage for a price recovery in 2017. The need to work down the large stock overhang and absorb new Iranian supply will keep prices suppressed this year, when we project Brent will average $45/b, but in 2017 we think the average will be up to around $65/b. Assuming this trend of rising demand growth and slowing supply continues, then Brent should be able to work its way back up towards $80/b by 2020.

This projection is relatively bullish, particularly compared with futures markets, and we recognise that there are large downside risks in the short-term, especially on the demand side. However, current prices appear too low for medium or long-term market equilibrium: prices in the $30/b-$40 range are simply not high enough to make investment in new fields economic (in most cases). Thus, unless there is a pick-up reasonably soon, the recent large investment cutbacks by IOCs might be setting the stage for an uncontrollable price surge further down the line.

The Outlook for Saudi Arabia

Introduction: a very different policy stance and a subdued growth outlook

We have revised our medium term economic outlook for Saudi Arabia in line with changes to our oil price forecast and the 2016 budget. The latter was a bell-weather for the economic outlook: the government appears committed to getting the fiscal position back on a sustainable footing, even if that means a much weaker growth performance.

We now envisage a further cut to government spending this year, following last year’s unexpected 13 percent reduction. Our oil price forecast suggests that the government might not squeeze spending quite as much as the budget suggests, but we still anticipate a 9 percent reduction from last year’s actual.

The situation should improve in 2017 as oil prices gain strength, supported by a weaker dollar. But the fiscal stance is unlikely to be relaxed significantly, and activity in the nonoil economy is likely to remain subdued by recent standards. Only in 2018-20 will there be sufficient fiscal stimulus to push nonoil growth up to the sort of averages achieved earlier in the decade.

The fiscal outlook will remain challenging, but the government’s commitment to spending restraint coupled with the substantial scope for domestic debt

Current oil prices are too low to encourage investment for future production

Saudi Arabia is confronting a very different economic environment to that of just a few years ago

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issuance should relieve pressure on international reserves and we think that the authorities will be able to deal quite comfortably with any pressures on the exchange rate peg.

Government revenue set to fall again, but not by as much as in 2015

The downward adjustment to our oil price forecast, allied to the measures set out in the 2016 budget, have led us to revise our medium term economic outlook for the country.

Starting with the outlook for oil income: we now expect Brent to average $45/b in 2016 given the persistence of large stocks. Prices are expected to pick up in 2017 as the dollar weakens and demand recovers somewhat, helping to rebalance the market and allowing Brent to average $65/b that year. Prices should continue their moderate upward trajectory in 2018 and beyond (see above).

Saudi oil output growth cannot really be sustained at the rate registered last year, but its overall strategy is unlikely to change. The Kingdom is fighting to gain (or maintain) market share, especially in East Asia, which most see as the centre of long-term oil demand. To withhold production in a bid to support prices would effectively mean allowing competitors such as Russia and Iran to fill the gap left by the Kingdom. Thus, any price boost would likely be temporary and the Kingdom would end up losing market share. That said, global oil demand, including in East Asia, is currently soft, and there is only so much additional oil output that can be supported; thus, we think Saudi production growth will weaken appreciably this year, growing by less than 1 percent, following last year’s near-6 percent increase. A slight pick-up in this rate is likely in the 2017-20 period as demand gradually firms.

Thus, the government’s oil revenue is set for another downturn in 2016, following last year’s 51 percent decline. However, one important offsetting factor is the likelihood that Saudi Aramco will withhold less export revenue than last year given its reduced investment needs. Therefore, the decline in government oil revenue this year is set to be milder than might have been the case at around 13 percent.

There are some striking initiatives on the nonoil revenue side

A notable feature of the 2016 budget statement was the sharp rise in nonoil revenue in 2015. This increased by 29 percent to reach SR164 bn. This is almost 7 percent of GDP and represents 27 percent of total revenue—the highest proportion for many decades. Of course, this partly reflects the collapse in oil revenue, but the nominal gain is still encouraging. The main reason for the strong showing was investment returns from SAMA and the Public Investment Fund, which gained a substantial 81 percent over the year. At first sight, this is curious since SAMA’s net foreign asset base was eroded and its investments are thought to be primarily in US Treasuries, which made only moderate returns in 2015. It seems likely therefore that the gains are related to historic cost accounting (i.e. gains realised over different time periods) rather than mark-to-market positions over the calendar year.

Oil revenue is expected to fall by 13 percent this year, though this is an improvement on the 50 percent drop in 2015

There was a welcome upturn in nonoil revenue last year and a number of new initiatives suggest that nonoil revenue will become much more important in the years ahead

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The outlook for nonoil revenue is somewhat hazy: US Treasuries will offer higher yields as the base rate rises. In general terms, customs duties are likely to fall in line with import spending, though the government says it is committed to applying additional fees to the importation of harmful products such as tobacco and soft drinks which should provide a minor offset. Fees for all sorts of government services are also likely to rise, while subsidies have also been reduced.

The biggest gain here is the reduction of subsidies on gasoline, with a 66 percent rise on the lower grade gasoline, and a 50 percent increase on premium announced immediately after the budget, and we anticipate upward adjustments over the medium term. The benefit to government coffers is unlikely to be immediate since higher domestic prices should induce lower demand, meaning that any domestic revenue gain is likely to be small. However, reduced demand should free up additional crude for export, which will generate much higher revenue (even at today’s depressed prices).

Working out the saving is tricky because domestic consumption of liquids has been volatile from year to year, but if one assumes that consumption would have continued at the five-year average of 4 percent a year if subsidies had been left untouched, and if one then assumes that cuts to subsidies will in reality mean that consumption declines at a gentle 2 percent a year, then the additional export earnings amount to some $90bn over the 2016-20 period, equivalent to an average of 2.3 percent of GDP a year. Of course, there are other variables that will muddy the equation, such as the impact of the additional exports on the global price of oil, but the potential savings are clearly substantial. Moreover, from a strategic perspective the lifting of subsidies is a vital move to stem domestic consumption of energy, which if left unchecked could well have undermined the Kingdom’s status as a major oil exporter.

The potential introduction of VAT also offers another decent nonoil revenue gain. GCC-wide initiatives of this sort seldom bear fruit, but in the new oil price environment a VAT seems likely to go ahead within the next couple of years. Based on extrapolations from points of sale data, and assuming that the rate is introduced at 5 percent, we estimate that this could yield around SR35 bn to the government, equivalent to about 1.2 percent of 2018 GDP.

Box 1: the 2016 budget and related policy developments

The 2016 budget was unusual for a number of reasons. First, the budget projected a cut in central government spending, both in budget-on-budget terms (2.3 percent) and budget-on-actual (16 percent). This is the first time in many decades that a spending cut has been projected, and is a telling signal of the government’s determination to bring the fiscal position under control. As a share of GDP spending in 2016 is set to fall by six percentage points, assuming the budget is realised.

The second departure was the degree of detail released compared with previous budgets. This might reflect the realisation that potential foreign

The phased removal of gasoline subsidies is a very welcome development, both from a fiscal and strategic perspective

Together, the phased removal of gasoline subsidies and the introduction of VAT could net the government revenue equivalent to 3.5 percent of GDP a year

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investors in any future sovereign bond issue would require a certain level of disclosure to make informed investment decisions. Yet it was still a surprise to see the disaggregation of military spending, for example. Including security spending, this item has a budget of SR213 billion, around a quarter of overall spending (lower than the 35 percent appropriation for 2015) or 9 percent of forecast of GDP. This is very high by global standards—the UK, for example, spends just 2 percent of GDP on its military—but is reassuring in that it provides considerable scope for future savings.

The third innovation was the outlining of profound fiscal and structural reforms, such as the establishment of a public finance unit in the Ministry of Finance. This unit would set a budget ceiling within a medium-term expenditure framework and “ensure adherence to this ceiling”. Historically, the MOF has held little sway over departmental expenditure, and over-spending has been a key feature of fiscal performance. Moreover, the budget also speaks of privatising “a range of sectors and activities”. These were not specified in the budget document, but in an interview with the Economist, the defence minister, Mohammed Bin Salman, who is generally seen as the driver of economic reform, referred to the development and eventual sale of a range of state assets, such as mining and land, and involving the private sector in sectors such as healthcare and even education. Most notably, the prince also said he was “enthusiastic” about the notion of privatising Saudi Aramco.

With regard to the latter, we assume that the objective would be to attract foreign investors, though the listing would presumably be confined to the Tadawul. Putting a value on Aramco is tricky: it has 261bn barrels of oil, which is ten times the holdings of the most valuable private firm, ExxonMobil, which is worth about $323 billion. Moreover, Aramco is able to get its oil out of the ground far more cheaply than ExxonMobil. Added to that, Aramco also has a substantial gas reserve as well as refineries and joint ventures with firms at home and abroad. However, to value Aramco at say $5 trillion-plus would be misleading because it is not run like ExxonMobil. The state firm has a broad-reaching “strategic” role that means it is responsible for a wide range of economic development projects throughout the Kingdom.

As investors in Gazprom, Rosneft (both Russian) and Brazil’s Petrobras have discovered, this is not an easy tension to overcome: all three companies are now trading at significant discounts to their respective book values. For this reason, potential investors and the authorities are likely to focus on clearly-defined, corporatized units (or subsidiaries) of the downstream elements of its oil operation. But even here, considerably enhanced financial transparency would be necessary. For all the obstacles, there is a more successful case history closer to home: decades ago the Saudi government listed 30 percent

Saudi Budgets

(SR Bn) 2009 2010 2011 2012 2013 2014 2015 2016

Revenue 410 470 540 702 829 855 715 513.6

% change -8.9 14.6 14.9 30.0 18.1 3.1 -16.4 -28.2

Expenditure 475 540 580 690 820 855 860 840

% change 15.9 13.7 7.4 19.0 18.8 4.3 0.6 -2.3

Balance -65 -70 -40 12 9 0 -145 -326

Source: Min of Finance

The potential privatisation of Saudi Aramco (or a part of it) is fraught with uncertainty, but the example of SABIC offers a positive precedent

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of another crown jewel, SABIC. The company is now a Fortune 500 company with a valuation of $204 billion and annual revenues of around $50 billion.

Fiscal stance to tighten again in 2016 and remain constricted thereafter

Notwithstanding the welcome initiatives and projections for nonoil income, there is little doubt that the government’s fiscal stance is set to tighten again in 2016 and remain constricted in the years ahead. This much is clear from the 2016 budget and its accompanying statement which, after all, project a reduction in spending. Our projections suggest that total revenue (in nominal terms) will not recover to the 2014 level until 2021-22, and the authorities are acutely aware that to reassure potential investors in government debt—both home and abroad—it must be able to demonstrate fiscal restraint and show that the deficit is on a sustainable path.

Capital spending is much easier to reduce (politically), and this item will bear the brunt of the adjustment. Our estimates suggest that public investment was reduced last year by around a quarter, and we think a further 8 percent cut is in prospect this year. For the moment, ongoing investment projects are unlikely to be shelved, but savings in inputs will be looked for and timelines might well be extended. As with last year, ministries will not be allowed to re-allocate spending from one project to another: if a particular project does not go ahead, or turns out to be cheaper than expected, then any savings cannot be spent on a different project. In general, projects that do not offer a water-tight economic case are unlikely to be approved by the Council of Economic and Development Affairs.

Current spending is a different matter: the largest element of this is wages, salaries and other benefits. The government’s strategic vision involves encouraging as many Saudi graduates as possible to opt for private sector careers, but this will not involve withdrawing public sector job opportunities, though it might perhaps involve making public sector jobs slightly less attractive by trimming some associated benefits (note that this year spending on salaries will see a reduction as there will be no repetition of last year’s bonus salaries). Rather, the emphasis will be on cutting other aspects of current spending, most obviously “purchases of goods and services”. This is a broad spectrum, from office furniture to munitions, but we think this element was the equivalent to 8 percent of GDP in 2015, and there are clearly additional savings to be made.

We expect government spending to be cut by around 9 percent this year

For 2016 therefore, we forecast an overall cut to government spending of around 9 percent, following last year’s 13 percent cut. The spending outlook for 2017-20 is complicated by the Islamic calendar, which means an additional month of government spending in 2018, but broadly speaking we expect a slight relaxation of the spending stance during those years as oil prices

The fiscal positon has tightened considerably and there is unlikely to be a significant loosening even as oil prices recover

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recover. That said, there is unlikely to be any return to the laxity that marked the 2010-14 period (let alone 2005-09): the oil price crash of 2014-15 was a sharp reminder that Saudi Arabia remains an oil-dependent economy and we think that the authorities will stay cautious in their approach to spending over the medium term and beyond. Thus, we think annual spending growth will be confined to less than 5 percent in the 2017-20 period; indeed, we think spending will decline to some 50 percent of nonoil GDP in 2020—about 25 percentage points lower than in 2014.

Fiscal financing will be testing, but manageable

We project an aggregate fiscal deficit for 2016-20 of almost SR900bn.This is less than we were forecasting until quite recently, and reflects the government’s apparent determination to bring the fiscal position under control. But this is still a sizeable sum—an annual average of 6.5 percent of GDP for the period—so how will it be financed? The short answer is a mix of savings drawdown and debt issuance. Note that government deficits are not, as is often characterised, simply “financed by a drawdown of net foreign assets”—or at least it is not that straightforward. If the government is running a fiscal deficit, it will draw on its substantial riyal savings with the local banking system to fund the difference: why would it tap foreign exchange to fund its Saudi riyal position? Only if it has specific FX costs will it draw on its NFA. The SR drawdown ends up with domestic households and businesses. Some of this will be spent (largely on imports, given the Kingdom’s high import-dependency, thereby adding to the current account deficit) and some will be saved. The paucity of local savings opportunities means that a large chunk will be channelled into foreign assets. This is where the NFA drawdown happens. To think of it another way, if the government spends less, there will less private investment in foreign assets and therefore a smaller drawdown of NFA.

For simplicity’s sake, it is still easier to “take a shortcut” and think in terms of the government drawing down its NFA to finance its position because its drawdown of domestic savings ultimately shows up as a reduction of foreign assets. However, it is worth bearing these mechanics in mind since a broader range of local investment opportunities would stem the drawdown of NFA by private actors (all else being equal).

Government debt will provide the bulk of financing

One domestic investment opportunity is local government debt, which can absorb banking sector liquidity and should reduce the amount that banks invest abroad. This is clearly the government’s preferred approach: they are mindful that the drawdown in NFA has contributed to speculative pressure on the exchange rate peg, and in the years ahead we expect the authorities to issue much more local debt in a bid to relieve pressure on the peg. Thus, we expect that roughly SR600 bn, or some 70 percent of the fiscal financing requirement will come from domestic (and some foreign currency) debt

The fiscal financing outlook is challenging but manageable assuming a) the authorities stick to their plans and b) oil prices recover as we expect

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issuance. It is worth emphasising that unlike most countries, Saudi Arabia is starting from a very strong positon in terms of “debt space”. Domestic debt-to-GDP was just 8 percent at end-2015; we project that it will rise to a still-comfortable 24 percent of GDP by end-2020.Local banks have considerable “head room” to absorb this debt. The loan-deposit ratio (SAMA measure) was 84 percent in November 2015. True, this was only one notch below SAMA’s mandatory limit of 85 percent, but this was comfortably below most peers and SAMA may in any case choose to adjust the limit. Banks also have non-statutory deposits with SAMA worth some SR50 bn to draw on, and indeed SAMA could choose to lower reserve requirements to free up additional liquidity. Banks also have sizeable NFA of their own to sell, should they choose. These were worth some $54 billion, or 8 percent of GDP in November.

The issuance of government debt has already led to some “crowding out” impact on liquidity

Nevertheless, despite the space on banks’ balance sheets, the absorption of government bonds is bound to generate some tightness in liquidity (indeed, it already has) particularly if deposit growth slows sharply—which seems inevitable in the short-run as government spending is cut. Under normal circumstances, one might expect private sector credit demand to ease too as the economy cools; however, this is not happening yet because payment delays associated with the tight fiscal stance means that more private sector firms are seeking short-term bank finance.

The remaining thirty percent of the fiscal financing requirement will be covered by savings drawdown. We put net public sector deposits in the banking system at around SR2.1 trillion at end-2015 (85 percent of GDP). This includes the column listed as “other Items, net” in the monetary system’s liabilities from the SAMA bulletin; the “other items” is not explicitly government assets, but the vast majority is likely to be. We project that this SR2.1 trillion will have dwindled to about SR570 billion, or 17 percent of GDP, by end-2020.

There are two ways of looking at this. Negatively, one might be alarmed by the scale of the drawdown and the concomitant build-up of liabilities, which will of course incur future financing costs. More positively, one can say that

Saudi Arabia Fiscal Financing 2014 2015e 2016f 2017f 2018f 2019f 2020f

(SR billion)

Central government balance -97.0 -388.7 -342.1 -183.1 -139.6 -110.2 -117.2

(% GDP) -3.5 -15.9 -14.6 -6.8 -4.8 -3.6 -3.5Central govenrment gross domestic debt 98.9 197.8 385.7 520.7 624.9 718.6 812.0

(% GDP) 3.5 8.1 16.4 19.3 21.4 23.2 24.4

General government deposits with banking system 1560.7 1172.0 829.9 646.8 507.2 397.1 279.9

(% GDP) 55.8 47.8 35.4 23.9 17.4 12.8 8.4

General government net domestic deposits 1461.8 974.2 444.2 126.1 -117.6 -321.5 -532.1

(% GDP) 52.2 39.8 18.9 4.7 -4.0 -10.4 -16.0

"Other items" net 940.0 1100.0 1100.0 1100.0 1100.0 1100.0 1100.0

(% GDP) 33.6 44.9 46.9 40.7 37.6 35.5 33.1

General govt. net domestic deposits (incl. "other items") 2401.8 2074.2 1544.2 1226.1 982.4 778.5 567.9

(% GDP) 85.8 84.7 65.8 45.4 33.6 25.1 17.1Sources: MOF, SAMA, Samba

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despite sizeable deficits the government remains a net creditor out to 2020 (and probably beyond given the likelihood that the fiscal position would return to surplus in 2022 or thereabouts). In addition, although the debt stock incurs costs, it should also substantially deepen the local debt capital market and provide a much-needed yield curve.

For the reasons noted above, the change in foreign assets is likely to broadly follow the draw-down in the stock of domestic assets, but not completely: the stock of NFA will also be influenced by other flows on the financial account, which in the second half of the forecast period are likely to be positive (see below).

Tighter fiscal stance will mean significantly weaker GDP growth

What implications does the fiscal outlook have for GDP growth? The starting point is 2015, which provides a puzzling growth story. Nonoil GDP growth was officially reported at 3.6 percent, while government spending fell by almost 13 percent. Given a correlation of .97 between government spending and nonoil GDP growth this is a difficult circle to square, particularly as the contribution from nonoil exports is likely to have been negative. The growth data were compiled before the end of year and may well be revised down, but they should be borne in mind when considering 2016.

All the signs are that economic activity will be subdued in 2016. As noted above, the contribution from oil production will be modest given a gentler increase in oil exports. However, nonoil export volume growth (primarily petrochemicals) should remain reasonably robust as Asian buyers are attracted by knock-down prices. And with import volumes also likely to be sharply down, the contribution from net trade should be positive.

Private investment will almost certainly contract this year

But that is largely where the good news ends. Domestically, private investment will take its cue from government spending, which as we have noted is almost certain to be reduced, especially on the capital side. Many firms—particularly those in the manufacturing sector—are facing higher energy and power costs, and this will weigh on investment decisions, as will a higher cost of capital as interest rates rise and liquidity tightens. Companies are experiencing payment delays, and this has obliged increasing numbers to opt for short-term bank financing instead of funding for investment. The contracting sector is also under pressure over labour regulations, and it will be a year of retrenchment for many firms in this segment. Foreign direct investment inflows seem set to continue the weakening trend of recent years, particularly now that the cost of gas feedstock for petrochemicals projects has been raised, thereby narrowing the cost advantage that Saudi firms enjoy over US rivals. The announced subsidy cuts raise the price of methane (the main input for methanol) to $1.25/MMBTU from $0.75/MMBTU. We calculate that a $0.5/MMBTU increase in methane gas costs will add over $15/MT to methanol production costs.

The fiscal squeeze will have a material impact on economic activity this year

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Higher gasoline prices will hit consumption and trade

Consumption has generally been much more stable and resilient than investment thanks mainly to strong demographics and solid gains in real public sector wages. However, it faces a number of headwinds this year, not least the increase in gasoline prices, which will erode disposable income, as will an increase in interest rates on credit card and personal loan debt. Nor are consumers likely to benefit from any bonus salary payments this year, and for that reason alone it seems doubtful that consumption will offer much contribution to growth. A stronger dollar should offer some support, but obviously only if wholesalers and retailers pass the savings on: there are already signs that shoppers are becoming more cost-conscious when choosing brands. Yet the push for government savings will also affect trade and consumption as many ministries—especially Health—opt to run down inventories rather than commit to new supplies.

With these trends in mind, we expect that official figures will end up showing barely any expansion in the nonoil economy this year. Indeed, our sense is that a recession may well be in store given contraction in key sectors and the lack of any obvious growth drivers, but we are doubtful whether this would be recorded as such.

Performance in 2017 and beyond should improve with higher oil prices and a slightly looser fiscal stance

The outlook for 2017 is somewhat better, if only because we expect the authorities to loosen their fiscal stance slightly as oil prices begin to recover. This is unlikely to be by much (we have pencilled in less than 4 percent growth in spending) but following two years of government cuts, this is likely to have an outsize impact on confidence. Of course, interest rates will still be moving higher, as will gasoline prices, and this will likely put a ceiling on both investment and consumption with a weaker dollar also spurring an increase in import costs. Thus, we doubt that nonoil growth will exceed 2 percent, though after the previous year, this will likely “feel” much better than that.

There should be a material improvement in 2018-20. If our oil price forecast is any guide, then the fiscal stance should loosen further and interest rates are also likely to have peaked. Liquidity is unlikely to be abundant—the government will still have financing needs—but the investment climate is set to be considerably better than in the 2016-17 period. Consumers too are likely to respond to some uplift in nominal public sector wages, especially in 2018 when the Islamic calendar means that an extra month of government spending will be a factor. The impact of the calendar will mean some volatility in the growth performance during this period, but we expect that the nonoil economy will be expanding by more than 5 percent in 2020.

Consumption growth will depend largely on how households cope with higher gasoline prices and increased debt servicing costs

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Inflation will rise but should remain contained at around 3 percent

Inflation has been very subdued (as it has in most of the world), but is set for some uplift in the years ahead. The likely impact of higher gasoline, electricity and water prices is difficult to project, since these items are not disaggregated from housing (i.e. rents) in the consumer price index (though minerals and fuels account for 10 percent of the wholesale price index). Moreover, there are likely to be second-round effects as transport and power costs rise for industry and services. A countervailing force will be the stronger dollar, at least in 2016, which will dampen import costs for both consumers and businesses, though this is likely to reverse in 2017. A generally subdued consumption environment should also serve to keep prices in check. Thus, a consumer price inflation rate of 2.8 percent seems likely this year (up from 2.1 percent in 2015), with inflation peaking at 3.1 percent in 2019.

Trade surpluses should be maintained, but they will be smaller than in recent years

The balance of payments outlook is much more challenging than in recent years. It will be characterised by current-account deficits and significant capital outflows in the next couple of years, followed by a return to broad stability in the 2019-20 period. Large trade surpluses have been the mainstay of Saudi Arabia’s economic growth and development. We expect that the country will continue to record surpluses, but they will be smaller than in recent times, particularly this year. Export earnings will naturally be negatively affected by oil prices, which will dampen both oil and petrochemicals earnings (the only significant nonoil export). Import spending fell by 9 percent last year, reflecting retrenchment by both the private and public sectors (along with some softening of costs as the dollar strengthened). One can expect more of the same this year, with some recovery in import spending anticipated after that as government spending and private confidence gradually revive. Thus, following a low of just $40 billion in 2016, the trade surplus should pick up steadily to reach around $150 billion by 2020—still some way below the 2014 surplus.

Invisibles will see larger outflows as foreign workers leave and take their money with them

The invisibles account has always recorded deficits and it will continue to do so. Services flows will follow import spending, and remittances outflows will obviously track employment conditions in the Kingdom, though there could be higher-than-expected outflows in tough times as expatriates leave the Kingdom and take their savings with them (technically this should be recorded as a capital outflow, but repatriations are likely to use the same mechanism as ordinary remittances outflows). Income earnings will be eroded by a declining capital base as NFA are drawn down, along with a generally poor global investment environment, though flows should begin to pick up again in the 2019-20 period.

Unlike in previous years, the balance of payments is now an important issue. We think that pressures will be contained and expect the position to return to stability by 2019

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These trends suggest that the current account will move into a larger deficit this year—indeed, quite a significant one of some $70 billion, or 11 percent of GDP—reflecting mainly the continued fall in oil earnings. Smaller deficits with a return to balance in 2019-20. Clearly, this is a very different environment to the first half of this decade, when the current account returned average surpluses of 18 percent. In fact it is more reminiscent of the 1990s when deficits were recorded more often than not.

Financial account will be dominated by fiscal financing flows, though privatisation offers scope for offsetting inflows

This year the financial account will remain dominated by outflows related indirectly to fiscal financing (see above). These flows are not listed as such, and are most likely to be found in the “net errors and omissions” column. We expect these flows to subside substantially from 2017 onwards as the government’s fiscal deficit shrinks. We expect private inflows to pick up, but it is difficult to be too precise about their size. Efforts to attract FDI and portfolio inflows will clearly be stepped up, and with the likely inclusion of the Tadawul in the MSCI EM index from 2017, portfolio inflows could become a reasonable element of the balance of payments. A concerted and realistic privatisation effort should also attract foreign capital. However, the uncertainties attached to the programme suggest caution, and we project that such inflows (portfolio and direct) will be around $17 billion on a net basis in 2020.

The “twin deficits” will mean a further l drawdown in NFA this year

With sizeable “twin deficits” the drawdown in net foreign assets is likely to be pronounced this year, at about $120bn leaving around $480bn at end-year, equivalent to about 77 percent of GDP. The following two years are likely to see additional drawdowns, with a low of $420 billion, or 54 percent of projected GDP at end-2018. From there, we see a recovery as the current account moves back to balance, and net flows on the financial account also turn positive as the fiscal financing requirement diminishes. Thus, by end-2020 we forecast that official net foreign assets will have recovered to around $435 billion (49 percent of GDP). Note that we have not included sovereign (i.e. foreign) debt issuance in our projections, as it remains unclear how much and when such debt might be sought from international markets. Still, this provides some positive risk to the NFA outlook (external sovereign debt is currently zero).

Saudi Arabia: Balance of Payments

$ bn 2016 2017 2018 2019 2020

Current account balance -69.1 -21.4 -17.2 -1.7 0.1

FDI (net) 0.0 2.0 4.0 7.0 8.0

Portfolio (net) -2.0 4.0 5.0 7.0 9.0

Other Investment (net) -9.0 -9.0 -7.0 -4.0 -1.0

Errors & Omissions (net) -41.1 -12.8 -9.4 -4.4 -6.3

Change in NFA (-= increase) 121.2 37.2 24.6 -3.9 -9.7

Source: Samba

The current account is set to record a deficit equivalent to 11 percent of GDP this year

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With renewed pressures on the exchange rate (see Box 2), Saudi Arabia’s NFA position is back in focus. It is therefore worth putting the size of its NFA holdings in perspective, particularly as NFA/GDP is less instructive in Saudi Arabia’s case given the role of oil prices in nominal GDP. Reserves were worth 51 months of imports (three months is generally considered adequate) or 25 months of all current-account outflows at end-2015. Our forecast suggests that even at their lowest nominal point, at end-2018, NFA will still be worth 36 months of imports, or 17 months of current account outflows. From another perspective, reserves are currently equivalent to about 1.5 times the domestic money supply (M2). This means that if all the elements of broad money were to exit the system today, the central bank would be able to fund all redemptions in dollars at the pegged rate and still have some $200 billion left—equivalent to some 18 months of imports.

Box 2: Pressure on the Peg

Lower oil prices and the abrupt fiscal adjustments seen in much of the GCC have raised questions about the sustainability and desirability of the region’s exchange rate pegs.

In terms of sustainability, Saudi Arabia’s peg to the dollar has certainly come under pressure in the forward market: indeed, the pressures now surpass those witnessed in 2007-08 and in 1997-98. Some of this is a result of tight domestic liquidity (thanks to higher interest rates and government debt availability), but some is undoubtedly speculative pressures coming largely from hedge funds through FX options. The cumulative notional on USD calls could well be in the $75-100bn range now. Can the authorities withstand these pressures? The answer depends largely on one’s outlook for FX reserves—and by extension one’s oil price forecast. Given our baseline forecast, our answer is “yes”. As noted elsewhere, we expect that official net foreign assets will stabilise in nominal terms, helped by a recovering current-account performance and a narrowing fiscal deficit, to end 2020 at around $435bn. This should be enough to deal with any speculative attacks quite comfortably.

What about the desirability of a devaluation? In Saudi Arabia’s case there would be no help for export competiveness since its exports are almost all denominated in dollars. Rather, the main advantage would be the boost to the SR value of the government’s dollar earnings. However, it would also raise the cost of expenditures since a large portion of these are imported goods and services (and manpower). The net gain for the government might therefore be modest, and could certainly be offset by the domestic upheaval associated with a loss of purchasing power, and no doubt a significant rise in inflation. Moreover, if exchange rate depreciation were to result in expectations of further weakening to come, savers would have a strong incentive to increase the share of foreign assets in their portfolio, creating further outflows and eroding FX reserves even more.

Saudi NFA holdings are some of the biggest in the world. They are equivalent to 1.5 times the domestic money supply or 51 months of import cover

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With the advantages of a devaluation far from clear-cut, and a war chest to resist speculative attacks (allied to a macroeconomic improvement in the medium term) we expect that the current peg to the dollar will remain in place. That said, some loosening of liquidity—possibly through an adjustment of banks’ reserve requirements—might be necessary to dampen the impact of speculation in the forward market.

Saudi Arabia: Baseline Macroeconomic Forecast 2013 2014 2015e 2016f 2017f 2018f 20119f 2020f

Nominal GDP ($ bn) 744.3 746.2 653.3 625.6 720.3 780.4 827.6 886.8

GDP per capita ($ '000) 24819 24387 20709 19233 21500 22616 23284 24224

Real GDP (% change) 2.7 3.5 3.4 0.6 1.8 3.6 1.8 4.2

Hydrocarbon GDP -1.5 0.7 3.1 1.3 1.5 1.5 2.0 2.5

Non-hydrocarbon GDP 5.8 5.3 3.6 0.2 1.9 5.0 1.6 5.3

Nominal GDP (% change) 1.4 0.3 -12.4 -4.2 15.1 8.2 6.0 7.2

Hydrocarbon GDP -4.1 -5.2 -35.9 -19.1 42.1 8.5 8.6 5.0

Non-hydrocarbon GDP 6.9 5.1 6.5 3.0 4.8 8.0 4.7 8.3

Commercial bank deposits (SR bn) 1402.0 1575.6 1670.0 1736.8 1823.6 1914.8 2048.9 2233.3

% change 11.2 12.4 6.0 4.0 5.0 5.0 7.0 9.0

Commercial bank loans to private sector (SR bn) 1065.5 1194.5 1284.1 1258.4 1271.0 1321.8 1387.9 1471.2

% change 12.5 12.1 7.5 -2.0 1.0 4.0 5.0 6.0

3 month interbank rate (end year, percent) 0.9 0.9 0.9 2.5 3.1 3.9 3.6 3.1

CPI inflation (% change, average) 3.5 2.7 2.1 2.8 2.9 3.0 3.1 3.0

Hydrocarbon exports ($ bn) 322.1 284.7 157.0 121.2 181.8 200.8 221.9 236.3

% change -4.6 -11.6 -44.9 -22.8 50.0 10.4 10.6 6.5

Current account balance ($ bn) 132.8 92.9 -45.6 -69.1 -21.4 -17.2 -1.7 0.1

(% GDP) 17.8 12.4 -7.0 -11.0 -3.0 -2.2 -0.2 0.0

External debt ($ bn) 1

74.0 79.0 80.6 82.2 83.8 85.5 87.2 89.0

(% GDP) 9.9 10.6 12.3 13.1 11.6 11.0 10.5 10.0

(% current account receipts) 17.9 20.9 33.3 39.3 30.9 28.7 26.2 24.4

Fiscal revenue (SR bn) 1156.0 1044.0 608.5 568.5 762.3 864.3 911.9 970.6 (% change) -7.3 -9.7 -41.7 -6.6 34.1 13.4 5.5 6.4Fiscal spending (SR bn) 993.0 1141.0 997.2 910.6 945.4 1003.9 1022.1 1087.8

(% change) 8.3 14.9 -12.6 -8.7 3.8 6.2 1.8 6.4

of which, capital 401.0 471.0 357.0 328.0 337.8 348.0 382.8 409.6

(% change) 31.5 17.5 -24.2 -8.1 3.0 3.0 10.0 7.0

current 594.6 670.0 640.2 582.6 607.6 655.9 639.3 678.2

(% change) -2.8 12.7 -4.4 -9.0 4.3 8.0 -2.5 6.1

Fiscal balance (SR bn) 163.0 -97.0 -388.7 -342.1 -183.1 -139.6 -110.2 -117.2

(% GDP) 5.8 -3.5 -15.9 -14.6 -6.8 -4.8 -3.6 -3.5

Public sector gross deposits with banking system (SR bn) 1641.5 1560.7 1172.0 829.9 646.8 507.2 397.1 279.9

(% GDP) 58.8 55.8 47.8 35.4 23.9 17.4 12.8 8.4

Public sector gross domestic debt (SR bn) 93.8 98.9 197.8 385.7 520.7 624.9 718.6 812.0

(% GDP) 3.4 3.5 8.1 16.4 19.3 21.4 23.2 24.4

Other public sector domestic deposits (SR bn) 854.8 940.0 1100.0 1100.0 1100.0 1100.0 1100.0 1100.0 (% GDP) 30.6 33.6 44.9 46.9 40.7 37.6 35.5 33.1Total net public sector deposits with banking system (SR bn) 2402.5 2402.2 2074.2 1544.2 1226.1 982.4 778.5 567.9

(% GDP) 86.1 85.8 84.7 65.8 45.4 33.6 25.1 17.1

Memoranda: Oil price (Brent; $/barrel) 107.0 100.0 58.0 45.0 65.0 70.0 75.0 77.0

Crude oil production ('000 b/d) 9380 9666 10243 10213 10315 10418 10574 10786

SAMA's net Foreign Assets ($ bn) 753.1 724.3 603.4 482.2 445.0 420.4 424.3 434.1

(% GDP) 101.2 97.1 92.4 77.1 61.8 53.9 51.3 48.91 Foreign liabilities of Saudi banks and non-financial enterprises.

Sources: SAMA; Ministry of Finance and National Economy; World Bank; Samba.

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James Reeve Deputy Chief Economist [email protected] Andrew Gilmour Deputy Chief Economist [email protected] Thomas Simmons Economist [email protected]

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1. Are not intended to be a complete or comprehensive study or to provide advice and should not be treated as a substitute for specific advice and due diligence concerning individual situations;

2. Are not intended to constitute any solicitation to buy or sell any instrument or engage in any trading strategy; and/or

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Samba Financial Group P.O. Box 833, Riyadh 11421 Saudi Arabia