Kingdom building on excess foreign assets

Saudi Arabia's stimulatory fiscal policies are part of the larger countercyclical trend adopted by countries including China, India and a few others, based on healthy internal and external balance sheets and macroeconomic stability. Although the debate over finding the right balance between state involvement in the economy and laissez-faire economics cannot be appropriately articulated here, the Saudi economy has benefited from a fiscally supportive state now more than ever before.

The kingdom has committed to raising its expenditure budget by 14 percent this year to SR540 billion - almost double projected spending in 2005. Unlike other members of the G20, Saudi Arabia is able to accommodate sweeping increases in public spending without exacerbating its domestic debt position due to: its substantial holdings of foreign assets; and its ability to replenish them in the relatively high oil price environment that continues to prevail.

After declining for most of last year, the Saudi Arabian Monetary Agency's (SAMA) net foreign assets witnessed a 4.2 percent jump in December to SR1.52 trillion - 109.8 percent of the kingdom's 2009 gross domestic product. That marked the biggest month-on-month jump in SAMA net foreign asset holdings since July 2008, when oil prices had touched a peak near $150 a barrel. Oil prices have fluctuated around $75 a barrel for the past three months - a level the government regards as adequate for both producer and consumer nations.

Combined net foreign assets of SAMA and commercial banks, often used as a benchmark by ratings agencies to assess macroeconomic sovereign risk, stood at about 117 percent of GDP in 2009, up from 95 percent in 2008 - incomparable in the region and among many G20 nations. The big jump was mostly due to a sharp change in nominal GDP. Net foreign assets also declined by only SR52.6 billion in a year marred by the worst global financial crisis for six decades. Oil export revenues fell 46 percent in 2009 from record levels in 2008, while net foreign assets saw a very manageable 3.1 percent decline aided by higher oil prices in the second half.

For years, SAMA has followed a policy of investing its surplus oil revenues into a variety of low-risk assets, with more than 76 percent of foreign assets invested in foreign securities, a category that includes government bonds like U.S. Treasuries. Very little is invested in equities which, as this global crisis has taught us, are not easy to liquidate when a sovereign needs funds.

However, in the past year, it was SAMA's very-liquid deposits in foreign banks that became the central focus of foreign asset inflows and outflows. While the central bank's investments in foreign securities were relatively steady in the fourth quarter, its deposits with banks abroad jumped almost 41 percent, including a 25 percent rise in December alone to SR335.7 billion. It appears clear that the government would like to keep funds in an accessible form as it ramps up expenditures this year, projecting a fiscal deficit of SR75 billion. This is in line with the state's conservative oil outlook for its budget and its ability to draw secondary and tertiary funds from within the country.

During the first nine months of 2009, SAMA drew down its deposits with banks abroad by 37.1 percent, or SR140.7 billion. Over the same period, holdings in foreign securities declined by a smaller SR83.1 billion, or 7.2 percent. Keeping in mind the generous cushion of foreign assets and comparatively low domestic debt to GDP ratio of 16.3 percent, the government has significant leeway to uphold deficit spending, although we anticipate the kingdom can support its stimulatory 2010 spending plan and turn a surplus of SR77.9 billion.

We continue to regard Saudi Arabia's position vis-à-vis domestic debt as unique compared with its neighbors in the Gulf and under the G20 umbrella. As a percentage of GDP, Saudi public debt, all of which is domestic, is likely to fall to 13.2 percent in 2010 according to our forecast and 18 percent as per the IMF's forecast. From a macroeconomic perspective, the growth threshold for external debt is considerably lower than for domestic government debt.

By contrast, the IMF foresees UAE external debt standing at 35.6 percent of GDP this year and Qatar's at 61.4 percent of GDP. Dubai has weighed down the UAE debt position substantially; outstanding debt of some $100 billion amounts to about 120 percent of the emirate's GDP. Saudi Arabia has reduced its public debt burden by 63 percent since 2003 as it took advantage of a high oil price environment. This included a 4.3 percent reduction in the debt burden in 2009, when economic growth slowed to just 0.2 percent.

Saudi Arabia has been a credible financial facilitator and supporter, without creating confusion in the market about what is explicitly sovereign backed and what is not. Global markets are, hence, starting to differentiate risk profiles within the Gulf. Unlike holdings of other regional sovereign funds, SAMA's foreign assets are managed as a stabilization fund not as a futures fund. SAMA also releases details of its foreign asset holdings in a monthly report, making it easier to gauge the financial strength of the central bank than it is with other Gulf countries, where sovereign funds release little or no data. Central bank foreign assets elsewhere in the Gulf are very low due to variations in investment policy and outlook.

The core financier

What is apparent from Saudi bank private sector credit data in the past year is that without state funds, many crucial expansion projects would be held up for months waiting for lenders to slacken strict lending policy. Despite very low interest rates in Saudi Arabia and elsewhere, a pickup in lending has not happened with as much strength as many policymakers had hoped.

Bank claims on the private sector declined 1.9 percent month-on- month in December, effectively erasing all of the gains in bank credit since July. Private sector credit in Saudi Arabia had witnessed monthly contractions for most of the first part of 2009, after having soared 28 percent in 2008 from the year earlier and more than tripling since 2003.

The downturn in bank credit was not simply linked to corporate transparency issues surrounding the debt troubles of business families. It began months before the Saad Group-Algosaibi debt issue emerged in May 2009, stemming from risk aversion among local and global banks propagated by the post-Lehman global credit crunch.

We regard December's big drop in private sector credit as seasonal and particular- banks took sharp fourth-quarter provisions against expected non-performing loans in an effort to start 2010 with a cleaner slate. Private businesses, meanwhile, paid off outstanding debt as creditors and lenders closed end-of-year books. Banks wanted to show better financial results and pressured private entities to close pending credit facilities.

Paying off debts is healthy, but we need to ask whether private sector appetite exists for fresh lending once this cycle is over. In our view, banks' reluctance extend new loans has reached a trough and they will begin to lend.

However, should the contraction stem from reluctance in the private sector this could have important implications for the pace of the recovery this year. Lack of credit availability is the principal reason why economic recoveries tend to be much slower and more protracted than normal. Policymakers in Saudi Arabia have long recognized this danger and they have done their bit to facilitate liquidity and lending. Banks and the private sector have to do their part.

Money supply growth in Saudi Arabia has also been subdued in recent months, in many ways reflecting the contraction in bank loans. Annual growth in broad money (M3) slowed for a third month in December to 10.7 percent, while M2 growth stood at a low 6.5 percent, contracting from the month earlier. The main source of the decline in M3 can be attributed to the contraction in bank lending and its negative impact on the monetary transmission mechanism. Money supply is also impacted by anaemic growth in time and savings bank deposits which, because loans are subsequently deposited back into the system, mirrors the decline in outstanding loans. The trade off is that declining money supply helps mitigate upward pressure to inflation, which hovered at 4.2 percent in December, similar to its level in the prior five months. We do not expect much variation from this level during 2010, with inflation averaging 4.3 percent for the year.

We expect the risk aversion gripping Saudi banks is only going to let go slowly this year, and until it does, new projects under way will have to find alternative, more cost- effective mechanisms for funding, which we discuss below. As we have stated in the past, credit growth is likely to accelerate toward the second half of the year, with a full- year rise in claims on the private sector at 8 percent, compared with a contraction of 0.04 percent in 2009, the first annual decline in at least 15 years. In the event that 8 percent credit growth is not reached, our private sector baseline forecast would need to be revised, placing downward pressure on the final GDP figure. Banks are, nonetheless, liquid; their foreign asset holdings jumped 37 percent in the year to December. While credit growth momentum is easily lost, it is not easily recovered, as we have seen in Saudi Arabia and among developed markets.

In our view, private Saudi entities have not in most cases taken on unmanageable amounts of debt that would hinder their future growth. Rather, they are seeking to de-leverage, leading to a noticeable decline in short-term borrowing (less than one year) versus a rise in medium-term (one to three years) and long-term (more than three years) lending. Saudi businesses continue to be profitable and competitive, indicating that they will gradually return to credit markets later this year to finance expansion, albeit at a slower pace. Bank claims on the public sector, down 25 percent year on year,  rose 1.2 percent month on month in December and has shown signs of a pick up since October 2009.

Keeping projects on target

While the global economic crisis has affected the way projects are financed, the government's goal is that tighter credit conditions will not disturb the projects themselves.

In a clear articulation of this policy, the government announced last May that a SR22.5 billion power and water desalination plant at Ras Azzour in eastern Saudi Arabia would no longer be designated as an independent power and water project (IWPP) -- a mechanism the government introduced to promote the inclusion of private sector firms in the utilities sector. Saudi Arabia re-tendered the project in November, stipulating it would be financed entirely by the government in order to reduce project costs.

The role of PIF and other state agencies has become accentuated as a result of the government's interest to ensure progress on all fronts of the infrastructure spectrum, even for projects initially designated to the private sector.

The government in its 2010 budget allocated SR48.3 billion to be disbursed to specialized credit institutions, including PIF, SIDF, the Real Estate Development Fund, Saudi Credit and Savings Bank, Agriculture Development Fund and Government Lending Program. The anticipated allocation is 20 percent higher than the 2009 budget and five-fold more than 2005.

The King Abdullah Economic City is one such private investment mega-project under way along the Red Sea north of Jeddah. Emaar Economic City, the Saudi-listed developer of the mega-project, has faced delays in delivering housing and business units, as well as with its expected mega port, due to lack of investor appetite. In the event that a state agency extends a financing facility to Emaar Economic City, which some anticipate will happen in order to avert further project delays, this would mark further evidence of public funds being used to back projects of strategic importance, even if they do not fall directly under the aegis of the state. We expect to see this trend continue due to the high cost of private sector borrowing and risk aversion among banks.

State-run utility Saudi Electricity Company (SEC) obtained a SR2.6 billion, 15-year soft loan from PIF in July 2009 for projects it is undertaking in Riyadh.

The state's Public Pension Agency (PPA), meanwhile, is developing the King Abdullah Financial District at a cost of SR29 billion.

In January, the government called on Saudi Aramco to build the proposed 250,000-400,000 barrels per day Jazan refinery, initially slated as an independent project, after the project tender attracted only two bids from local oil companies with no interest from global players. With state backing, the refinery is more likely to achieve a 2015 target start date. The refinery is part of the broader Jazan economic city unveiled in 2006, which has received less private investment than initially hoped.

One drawback of the government's stimulatory spending plan that we have raised in the past is that it has not adequately passed down benefits to the small and medium-sized private enterprises (SMEs). Still, this trend toward using the state as the primary financier for projects should not be viewed as a detrimental for the Kingdom's privatization effort. Over the past year, we estimate there has been a 43 percent surge in government financed projects awarded to the private sector.

The state is expected to take a greater role in financing only on a case-by-case basis, where it regards a failure to intervene could lead to project delays or drive up costs in a way that does not make economic sense. This policy should gradually shift once there has been an amelioration of the credit conditions -- i.e. banks resume lending at reasonable levels and the cost of credit for private sector partners becomes manageable. However, an immediate pickup in bank lending is not likely during 2010.

Over the past few years, PIF has provided significant financing to various projects. Other government agencies, most notably the Saudi Industrial Development Fund (SIDF), have financed projects along with PIF. SIDF lends up to SR600 million for individual projects, a cap raised from SR398 million a few years ago.

These two government funds have in many cases supported expansion plans of private companies during the turbulence of the past year and a half. Unable to get loans from local or foreign banks, many companies have sought alternative financing avenues. In January, SIDF extended loans to Nama Chemicals Co, which received SR210 million, and Saudi Cables Co, which secured SR160.5 million for financing a power cable plant.

Al Abdullatif Industrial Investment Co, a carpet maker, also negotiated a SR91 million loan from the SIDF last summer to help it raise production, while in April National Shipping Co. agreed on an SR1.05 billion Islamic loan from PIF to enable it to expand its fleet of tankers.

Private sector players have, meanwhile, managed to access some bank credit facilities in recent months. Saudi Aramco and Total last month concluded a SR22.5 billion bank lending facility designed to partly finance the construction of an oil refinery at Jubail. It is widely anticipated that some of the remaining SR22.5 billion of the project's cost would be covered by PIF.

Meanwhile, we are witnessing a shift in how some state-owned companies, such as SEC, seek financing for projects. SEC has allowed banks to bid for more than one contract within the same project, such as the P11 power project. This differs from a prior policy of allowing banks only one bid each, thus fostering greater price competition and adapting to challenging conditions globally.

Shouldering the burden

Boosting private sector involvement in Saudi Arabia's nonoil sectors is a crucial and necessary part of the Kingdom's future expansion. Growth in private sector GDP slowed to 2.5 percent in 2009 and while we foresee it climbing by a higher 3.7 percent this year, it remains far from levels recorded in 2004-2007 that surpassed 5 percent annually. Such lower levels of private sector expansion are not sufficient to keep up with the demands of an ever-expanding national labor workforce.

Meanwhile, government sector GDP has been growing more quickly, accelerating to 4 percent in 2009 from 3.7 percent in 2008. We expect the growth rate will rise again this year to 4.1 percent. The government has stepped in to keep the economy from avoiding a recession in 2009 and encourage growth momentum in 2010.

The public sector has absorbed a great deal of the new job entrants in recent years, but with the young Saudi population demographics the private sector will have to do its part. That the public sector is now the biggest employer for Saudis has averted a labor induced recession and a deep consumer depression in 2009. It has offered enormous social protection for Saudis since private firms did embark on periodic layoffs, mainly of non-nationals, in 2009. This, however, does not absolve anyone from creating employment mechanisms for nationals in the private sector.

Between 2004 and 2009, new entrants into the labor market reached around 220,000 per year, according to Ministry of Economy and Planning data. While it had been anticipated that the number of employed Saudi nationals over this period would rise to 4.75 million from 3.5 million, by the end of 2008, the total Saudi employed labor force reached only 3.75 million.

The advisory Shoura Council agreed to a proposal in February to pay out monthly allowances for young unemployed Saudis of at least SR1,000 per year until they find jobs. In January, the advisory council also approved a 5 percent increase to pensions paid to retired public employees. These and other social welfare programs will amplify the pressure on the government to keep public spending at historically high levels, underpinning the need to have the private sector shoulder more of the burden.

The signals are promising that conditions for the private sector to excel will improve through the course of 2010, although not exceptionally. According to our estimates, the Kingdom's export revenues will rise almost 19 percent this year and import flows should gain 18 percent in keeping with greater economic activity.

Recent letters of credit data also provide scope for cautious optimism. Private sector imports financed through commercial banks (settled LCs) rose to SR15.72 billion in December -- the highest level of 2009. New LCs, meanwhile, were 2.6 percent higher than they were a year earlier, a good signal that appetite among businesses in general is improving. The discrepancy between settled and new LCs is likely the result of businesses settling accounts in the month of December. We will be watching for signs for a pick up in new LCs and credit allocations.

Creating an environment where SMEs are able to better tap bank credit is a vital part of reducing dependence on large family businesses. With greater SME involvement, private sector growth momentum would not suffer as sharply from economic downturns as the one witnessed in the past year. Aside from credit allocations, SMEs, too, should modify their organizational and administrative structures to enable them to gain better access to credit. These longer-term goals are vital in shifting the balance of influence in favor of private sector participants.

(Concluded)

(John Sfakianakis is group general manager and chief economist at Banque Saudi Fransi, Riyadh.)