JEDDAH: Government spending has been an important growth driver in recent years in Saudi Arabia and Moody’s Investors Service expects the planned reduction in government spending to lead to lower growth of about 1.5 percent this year.

During this ongoing period of adjustment, Moody’s said the Kingdom’s ability to sustain sizeable reserve buffers and avoid a sharp rise in indebtedness will be an important credit driver.

A new report released by Moody’s Investors Service examines how Saudi Arabia’s credit profile developed over the years to withstand currency speculation and temporary oil price shocks.

According to Moody’s, one key difference between past episodes of low oil prices and this time around is that the Kingdom has opted to increase its oil output to maintain its market share, rather than reach a production cut agreement with its fellow OPEC members,

“As a result, real GDP growth emerged relatively unscathed at around 3.4 percent in 2015 (and we expect it to remain positive at around 1.5 percent this year), whereas during a similar oil price shock in the late 1990s, the country underwent an economic contraction following oil production cuts,” said the Moody’s report.

Similar low oil price episodes in the past suggest Saudi Arabia is well positioned to fend off pressures on its currency peg. Fiscal surpluses averaging 11 percent of GDP in the 10 years preceding the current oil price decline enabled the Kingdom to pay down its debt to a very low level and build up large buffers in the form of foreign reserves.

“We believe this provides the government with ample space to support its peg in the short term,” said the Moody’s report.

But the reform effort to diversify the economy and reduce the government’s reliance on oil poses a greater challenge. Recurrent deficits will erode buffers and lead to a build-up of debt. Absent a sustained recovery in oil prices, the medium term trajectory will depend on the government’s fiscal consolidation efforts, according to Moody’s.

Saudi Arabia’s fixed exchange rate, which has been in place since 1986, aims to smooth the effect of oil price swings on the non-oil economy. However, the peg limits the Saudi Arabian Monetary Authority’s (SAMA) ability to use monetary policy to respond to shocks. During times of economic stability, fixed exchange rates are generally associated with lower transaction costs, higher trade openness, lower inflation, and disciplined macroeconomic policies.

But pegs can be costly to maintain when significant domestic and external imbalances develop, which is happening now in Saudi Arabia, Moody’s said.

“We project fiscal deficits of around 12 percent-15 percent of GDP over the next two years compared to a 10 percent surplus on average in the two years preceding the oil price decline; and a current account deficit of 8 percent-12 percent of GDP over the same period compared to a 20 percent surplus on average in 2012 and 2013,” said the report.