JEDDAH, 22 March 2004 — Buoyed by the highest oil prices in the last few years, fiscal balances in the Kingdom improved noticeably and liquidity levels surged. Moreover, since oil prices are expected to maintain their high levels, the Saudi economy is projected to continue achieving sound macroeconomic performance in 2004, with ample financial revenues to the government to finance its expenditures.

This contributed to the rebuilding of international reserves, which exceeded 80 percent of the Saudi riyal money supply definition (M2), providing a healthy cushion of reserves and healthy liquidity position in the Kingdom in general.

Supported by this, and apparently following a strategy of lowering the public debt, the Saudi Arabian Monetary Agency (SAMA), in coordination with the Ministry of Finance, recently moved toward reducing its repo (repurchasing agreement) and reversed repo rates on Government Development Bonds (GDBs).

This shift in monetary policy signals a certain stance of the government, by making these GDBs more market sensitive by issuing bonds on optional based on government needs and liquidity conditions rather than on offering basis based on banks’ demand.

The GDBs used to provide high returns to Saudi commercial banks. However, the banks’ demand for GDBs as fixed assets on their balance sheet is usually driven by a need to hedge their non-interest bearing accounts as fixed liabilities on the other side of their balance sheet. This is in order to minimize banks’ risk of exposure and protect the legal rights of creditors and equity holders. The hedging instrument, however, is determined by the hedged risk, which again is determined by hedged items. Thus the accounting treatment of the hedging instruments that Saudi banks choose should follow the accounting for the hedged NIBs, which is considered as short-run fixed assets. Therefore, by reducing return and limitation on GDBs supply, Saudi banks will either hold their existing GDB for the next two years or find other hedging tools.

Increasing consumer loans is another hedging alternative which Saudi banks could use as a fixed asset-hedging tool. However, again, under sound macroeconomic conditions and growing business activities, the appetite of individuals to increase their personal debt will narrow. In the long-term period however, and if the economic situation continues to be sound, in addition to accelerating economic reforms and expediting privatization, SAMA in coordination is likely to continue following a structural strategy to reduce the public debt and thereby reducing its issuance of GDBs. Consequently, that policy might encourage banks to increase its purchasing of foreign bonds and utilize international markets, which, to a low extents means increasing capital outflows.

On the other hand, increasing corporate finance by Saudi banks as another hedging instrument might not be suitable, as most corporate loans are based on floating — not fixed — interest rates. However, with the new direction of the Saudi economy associated with huge financing requirements to mega projects and with new expected developments in the Saudi capital market under the new capital market law, Saudi banks are likely to have a wider variety of investment and hedging tools to be utilized. The new capital market law will unfold a number of business opportunities for the bank to diversify its operations away from direct lending to issuing bonds of a long-term maturity, to be traded in the local and international markets, besides their chances of dealing with corporate bonds in the market. Current and further changes in regulation-policy might cause major changes in the strategies of Saudi commercial banks. Policy-makers change banks’ legal framework based on macroeconomic variables, trying to increase banks’ technical efficiency. Successful regulation policy will create positive excess demand for the services of financial intermediaries. However, these decisions do not necessarily imply a unique stimulus for banks and, hence, the development of diverse strategic responses among Saudi banks.

(Dr. Nahed Taher is senior economist at the National Commercial Bank, Jeddah)