Austerity Economics in Saudi Arabia

Published in Forbes Middle East, 15 November 2016

The Saudi central bank has had to step in as the country’s banks deal with a slowing economy, shrinking deposits and tighter liquidity.

Evidence of the strain the Saudi economy is under is coming thick and fast these days. On 26 September, 2016 the government ordered sharp pay cuts for officials in its latest effort to keep its fiscal position under control. A major bond issue is planned to help plug the large budget deficit, which is expected to be around 15% of GDP this year according to local bank Samba.

The country’s banks have been unable to avoid the fallout from the wider economic difficulties. Deposits have been dropping and demand for credit has been rising, leading to a liquidity squeeze. To try and alleviate some of their pain, on 25 September 2016 the central bank, the Saudi Arabian Monetary Agency (SAMA), said it would deposit SR20bn($5.3bn) with the country’s banks to support “the stability of [the] domestic financial condition”.

It was not the first such move by SAMA. The central bank has already offered around SR12bn in deposits and short-term loans to Saudi banks to ease short-term liquidity pressure. The latest move was both expected and welcomed by observers.

“It was clear that the banks had some stress and needed dollars. It’s just a reflection of the low oil price, the low amount of petro-dollars. The Saudis continue to act in a reasonable fashion and continue to provide liquidity support for the banking system,” says Peter Kinsella, head of emerging markets economic and foreign exchange research at Germany’s Commerzbank.

The problems facing the Saudi banks, and indeed the economy as a whole, stem from the low oil price Kinsella mentions. With far lower hydrocarbons revenues, the government has had to draw down some of its deposits and raise more debt to cover its spending commitments. The authorities have been trying to reduce expenditure too. Subsidies have been cut, projects put on hold, and payments to contractors delayed. With less government money in the system, private sector firms have had to turn to the banks for more credit to cover their short-term needs.

All this adds up to a difficult set of circumstances. “The Saudi banking system has faced a new challenging environment since mid-2014 when the oil price correction led to a considerable tightening of domestic liquidity,” said Brahim Razgallah, an economist at U.S. bank JP Morgan, in a research note issued on 2 September, 2016. “Despite the common shock across GCC countries, the kingdom has been one of the most affected, with pressure on interbank rates being the highest.”

What is more, the speed of change has been fairly rapid. According to SAMA, government deposits had fallen from SR1.6 trillion in August 2014 to SR1.06 trillion by August 2016, a drop of some 35% in just two years. Although the rate of withdrawals has slowed in recent months, the government will continue to use up its savings for the foreseeable future. Private sector deposits may be more reliable, but they aren’t able to offset the government’s withdrawals.

Saudi banks are not used to seeing deposits drop—total account balances have grown in an unbroken run since the early 1990s. In the 10 years to 2015, deposits grew by 10.5% a year, according to the local AlJazira Capital. In contrast, Samba thinks the banking sector will see deposits shrink by 0.5% this year, while private sector credit will grow by 9%.

That will lead to further rises in the loan-to-deposit ratio, which has already increased from 80% to 88% in the 12 months to the end of June this year. Acknowledging the situation, SAMA increased the limit on banks’ loan-to-deposit ratios from 85% to 90% in February 2016. However, the ratio has continued to grow since then, reaching above 90% in July according to some measures. That in turn is increasing the pressure on banks to compete strongly for deposits and to look elsewhere for funding. Moody’s Investors Service says more expensive wholesale market funding has increased from 6.1% of the overall bank funding in December last year to 7.9% by June 2016. The recent support from SAMA will help to relieve the pressure in this area. SAMA has also started to provide seven and 28-day repurchase agreements alongside its existing one-day repos, which will allow banks to access short-term borrowing at a lower and more stable cost than in the wholesale markets.

Even so, the situation is far from resolved. “We believe the deterioration of liquidity in the Saudi banking sector has slowed down. However, it has yet to stabilise as much as in some other GCC markets,” says Redmond Ramsdale, senior director for financial institutions at Fitch Ratings.

A good indicator of the pressure on the sector is the main interbank lending rate, the three-month Saibor. It has risen from 1.33% at the turn of the year to reach 2.27% in August, its highest level since December 2008.

And banks can’t escape from the gloomy outlook for the economy, which analysts suggest will only grow by between 0.6% and 1.7% this year. That may well include periods of contraction, although perhaps not a full-scale recession.

“Our GDP tracker, which is constructed from monthly activity data, suggests that the slump in Saudi Arabia’s economy has deepened, with output falling by around 2.3% year-on-year in June,” says Jason Tuvey, Middle East economist at London-based Capital Economics. “Over the second quarter as a whole, we estimate that output fell by 2% year-on-year. If our tracker is correct, this would be the first contraction in the Saudi economy since 2009. A recovery is likely to get underway over the rest of this year and in 2017-18, but it is likely to be slow-going.”

Despite all this, the banks are still in a fairly healthy position. Non-performing loans make up just 1.2% of the sector’s total loan book and most of the larger banks continue to report liquidity coverage ratios (LCRs)—a measure of their ability to meet short-term liquidity demands—well above 100%, even if these too have been falling.

And even if their use of market funding has been on the rise, banks can still rely on customer deposits to provide most of their funding needs at a cheap rate. According to Fitch, customer deposits represented 93% of total non-equity funding as of December 2015. Two-thirds of those deposits are in demand accounts that don’t pay any interest. In some cases the figure is far higher—for Al Rajhi Bank and National Commercial Bank (NCB) it is 99% and 82% of deposits respectively. This does make banks vulnerable to changes in customer attitude—as seen with the drop in government deposits over the past two years—but the benefits of low-cost funding are also clear.

In this environment, it’s unsurprising to find that the recent financial performance of banks has been rather mixed. According to data compiled by financial website Argaam, overall profits barely rose in the first half of 2016, reaching SR23.3bn compared to SR23.1bn in the first half of 2015. However, the second quarter of 2016 saw a year-on-year decline in profits for the first time in at least five years.

Of the country’s 12 local banks, six posted a rise in first-half profits, with the larger banks tending to do best. The country’s largest bank, National Commercial Bank, posted a 2% gain to SR5.1bn, while its closest rival Al Rajhi booked an 18% rise in profits to SR4.1bn. The far smaller Alinma Bank saw profits rise 13% to SR800m. Others posting gains included SABB, Bank Saudi Fransi and Riyad Bank. Among the rest, the steepest falls were at the Bank AlJazira, which saw profits slump 42% to SR558.8m, and Saudi Investment Bank, where they dropped 29% to SR532.4m. Others posting lower profits included Saudi Hollandi Bank, Arab National Bank, Samba and Bank Albilad.

“The overall liquidity of the large banks is becoming increasingly stretched, but they are managing this well,” said Fitch Ratings in a report issued on 26 September 2016, after the latest SAMA funding had emerged. However, the tough market conditions are unlikely to ease substantially for some time. That means that the recent intervention by SAMA may yet need to be followed up with more assistance before long.